Managing Exports

Chapter 6
• Import-Export Sales and Exchange Rates
• The Market for US Dollars as Foreign Exchange
• Foreign Exchange Risk Management
• Determinants of the Long-Run Trends in Exchange Rates
• Purchasing Power Parity
• International Trade and Trading Blocs (EU & NAFTA)
• Comparative Advantage and Trade
• Trade Deficits and the Balance of Payments
2005 South-Western Publishing Slide 1
Import-Export Sales and Exchange Rates
• More and more firm are becoming multinational
enterprises.
• Exports and imports are influenced by
changes in international exchange rates.
• Differences in long run inflation rates (according
to the theory of purchasing power parity), national
economic growth rates, and interest rates help
explain long-term exchange rate movements.

Slide 2
 Competitiveness and Exchange Rates
• The international competitiveness of products is affected by
exchange rates.
• If the US exports a Jeep Grand Cherokee that sells for $30,000, the
price of the same car in Europe is vastly different
» In 2000, $/€ = $.86/€. If that car costs $30,000, then in Euros that is $30,000 /
$.860/€ or €34,884.
• When $/€ = $.86/€, then €/$ = 1/ $.86/€ = €1.163/$
» In 2004, $/€ = $1.20/€. If that same car costs $30,000, then in Euros that is
$30,000 / $1.20/€ or €25,000.
• When $/€ = $1.20/€, then €/$ = 1/ $1.20/€ = €.833/$
» Clearly, more Jeeps are likely to be sold in Europe at the lower than the higher
price.

Slide 3
 Foreign Exchange Risk Exposure
• Translation Risk Exposure – occurs when foreign
assets or liabilities are affected by exchange rates.
» Disney owns a park near Paris. When the Euro rises against the dollar, the
value of the land rises in terms of dollars. This is primarily an accounting
adjustment.
• Transaction Risk Exposure – occurs when a purchase
or sale is made in the future, which involves a foreign
currency.
» When Cummins Engine sells equipment to Japan in Yen, but they give 60
days before the payment is due, there is a risk that the Yen will fall in
value.
• Operating Risk Exposure – occurs when cash flows of
the firm are impacted by exchange rates.
» When Jeep sells more Grand Cherokees when the value of the
dollar is low, and less when it is high, this is operating risk
exposure. This is the most important risk. Slide 4
 The Market for US Dollars as Foreign Exchange
• Jeep, BMW, and Cummins Engine are buying and
selling foreign exchange in the market.
• Governments also intervene by buying or selling currencies
• Spot Price for foreign exchange is current price
(2 day delivery) can appear in different terms
» The $/€ is the direct quote in the US, but the indirect
quote in Europe
» The €/$ is the indirect quote in the US, but the direct
quote in the Europe
• Forward Price is the price of a foreign currency for
delivery at a future date agreed by contract today
Slide 5
 Canadian Dollar
Spot and Forward Rates
June 21, 2004 from
http://www.bmo.com/economic/regular/fxrates.html
Country US $ equivalent Per US $

Canada (C$) .7331 1.3631

1-month forward .7327 1.3648
2-months forward .7322 1.3657
3-months forward .7320 1.3661
6-months forward .7312 1.3676
12-months forward .7298 1.3702

What does the market think will happen to the C$

based on the forward rates?
Slide 6
 Cross Rates (June 22, 2004)
USD EUR JPY GBP CHF CAD AUD HKD

HKD 7.7993 9.4387 0.0713 14.1904 6.2337 5.7449 5.3569  

AUD 1.4559 1.762 0.0133 2.649 1.1637 1.0724   0.1867

CAD 1.3576 1.643 0.0124 2.4701 1.0851   0.9325 0.1741

CHF 1.2512 1.5141 0.0114 2.2764   0.9216 0.8594 0.1604

GBP 0.5496 0.6651 0.005   0.4393 0.4048 0.3775 0.0705

JPY 109.325 132.305   198.911 87.3796 80.528 75.0899 14.0173

EUR 0.8263   0.0076 1.5034 0.6604 0.6087 0.5676 0.1059

USD   1.2102 0.0091 1.8194 0.7993 0.7366 0.6868 0.1282

Source: http://www.bloomberg.com/markets/currencies/fxc.html
USD: U.S. Dollar GBP: British Pound CAD: Canadian Dollar
EUR: Euro CHF: Swiss Franc AUD: Australian Dollar
HKD: Hong Kong Dollar JPY: Japanese Yen
Slide 7
 Supply & Demand Model of
Exchange Rates
• Foreign Exchange is used
$/SFr
for trade and investment.
Use a supply & demand
model to explore FX rates
• Demand for Swiss Francs
(SFr): Demand is associated 1,000 SFr
with US demand for imports
from Switzerland and
purchase of Swiss financial D
securities

SFr
Slide 8
 Supply of SFr
• Supply of SFr -- Supply
is associated with S
SWISS demand for US
exports and US
financial investments.
• Market Clears-- no
excess demand or excess
$/SFr $.7993

supply of SF D
• In Flexible Markets, buying
& selling through
international banks
SFr
Slide 9
 Suppose that there is a rise in the
Inflation Rate in the US S'
• Both Supply & Demand of SFr
Shift
S
• SWISS products appear
cheaper, so D shifts to D’ $2/SFr
• US exports appear more
$1/SFr
expensive, so S shifts
from S to S’ D'
• The SFr appreciates, and the D
dollar depreciates

SFr
Slide 10
 Suppose US interest rates rise.
• Demand for Swiss
investments declines, from
S
D to D’
• Supply of Swiss francs rises S’
as Swiss seek to invest in
the US from S to S’ $1/SFr
• Swiss francs fall in value and
the dollar rises in value $2/SFr
• What happens when D
Greenspan CUTS interest D'
rates?
Slide 11
 Governmental Intervention in
Foreign Exchange Markets
• Governments can and do intervene in markets
» Directly by buying and selling foreign currencies
» And indirectly by altering interest rates or inflation rates
• Sterilized Interventions involve offsetting an
indirect move (like an increase in short term
interest rates) through direct action in the
foreign currency markets
• Coordinated Interventions involve several
countries all agreeing to intervene to raise or
lower the exchange rate of some country.
Slide 12
 Foreign Exchange Risk Management
• Internal hedges – multinational firms buy and sell within
the firm in any currency that they select.
» BMW could use sale of its cars in $ payables to buy US car parts
• Hedges using forward contracts – firms can offset
exposure in foreign currency by buying or selling that amount of
currency in a forward contract.
» This is a typical way to reduce transaction risk exposure
• Hedges using future or options contracts – firm
may offset risk with a futures contract in that currency.
» Foreign currency futures and options are limited to the major currencies
• Hedges using currency swaps – firms may agree to
exchange (swap) streams of payments in different currencies,
with adjustments at each settlement date.

Slide 13
 Determinants of Long-Run Trends
in Exchange Rates
1. Countries that have high growth rates in GDP tend to have
rising currency values.
2. Countries tend to have a declining value of their currency when
they run trade deficits, and tend to have rising currency values
if they run trade surpluses.
3.Long-run trends in exchange rates are affected by differences in
inflation-adjusted interest rates. High relative interest rates
attract investors, tending to raise the value of the currency.
4.Countries with high inflation tend to depreciate; countries with
low relative inflation appreciate.

Slide 14
 Purchasing Power Parity (PPP)
• Purchasing power parity says that the price of traded
goods tends to be equal around the world. This is: the law
of one price.
» if exchange rates are flexible and there are no significant costs
or barriers to trade, then:
S1 = ( 1 + h )
S0 ( 1 + f )
S1/S0 shows the expected change in the direct quote of a currency. The right
side of the equation is the ratio of home and foreign inflation rates. If the
foreign inflation rises (f), then the domestic expected future spot rates S 1
declines.

Slide 15
 PPP Example
• Suppose inflation in the US is 3%
• Suppose that inflation in Canada is 4%
• The currency price of the Canadian dollar is
$.74/C$.
• What is the expected price of the Canadian
dollar in one year?
• Answer:
S1 = ( 1 + h ) = 1.03 = .9903 = S1
S0 ( 1 + f ) 1.04 .74

• Hence, S1 = .74*.9903 = $.732822 /C$, a slight

decline from $.74.
Slide 16
 Qualifications of PPP
• PPP is sensitive to the starting point, S0. The base time
period may not in equilibrium
• Differences in the traded goods, or cross-cultural
differences, may prevent the law of one price to equilibrate
price differences.
• The inflation rate used may include some non-traded
goods.
• PPP tends to work better in the long run than in short run
changes in inflationary expectations.

Slide 17
 Trade-Weighted Exchange Rate Index
• With many countries and many exchange rates, whether a
currency rose or fell is complex. We tend to combine the
cost of foreign currency into an index based on the amount
of trade to each country.
• The trade-weighted exchange rate index is a measure of the
value of the dollar.
• The index, EER, is weighted by the amount of trade with
other countries, wit. An index of the change in value of pairs
of currencies since a base year, eI$it.
• If £.40/$ is the exchange rate in the base year and is now
£.60/$, then the index is (£.60/$) /(£.40/$) · 100 = 150.
• This means that the dollar is 50% more expensive to the
British. The index is:

EER  t eI wit
t
$ $
it
Slide 18
International Trade and Trading Blocs
• With no barriers to trade in a free trade block, such
as we have in North America because of NAFTA,
trade expands
• In 1980, 33% of US trade was in North American.
In 1999, that number is 47%.
• In 1980, 57% of European trade was in Europe. In
1999, that percentage rose to 61%
• In 1980, 13% of trade in South America in the bloc
know as MERCOSUR was within that region. In
1999, that percentage rose to 22%
» In each case, freer trade within the region led to more
intraregional trade. See Table 6.3 on page 263.

Slide 19
 Real Terms of Trade
Example: page 265 Table 6.4
Absolute Cost US Absolute Cost Japan

Carburetors $120 ¥10,000

Memory Chips $300 ¥ 8,000

The question is: Which country should make

carburetors and which should make chips?

Slide 20
 Comparative Advantage
• Countries or firms should produce more of those
goods for which they have lower relative cost.

Relative Cost in US Relative Cost in Japan

Carburetors .4 Chips = $120/$300 1.25 Chips
Computer Chips 2.5 Carb = $300/$120 .8 Carburetors

• It costs $120 in the US to make a carburetor and $300 to make

chips, the “cost” of a carburetor is the .4 chips foregone (take the
ratio $120/$300 to find .4 chips).
• The US relative cost of carburetors is much lower than that of the
Japanese (1.25 Chips), whereas the Japanese relative cost of chips
(.8 Carburetors) is much lower than that of the US.
• Japan should make chips and US should make carburetors.
Slide 21
 Gains from Comparative Advantage
• In this example, suppose that both countries currently
make 1 carburetor and 1 chip.
• World production is 2 carburetors and 2 memory chips
before trade.
• Now, let the US make all of the carburetors. Since
each chip given up is 2.5 carburetors, the US now
makes 3.5 carburetors (the one they were making and
the 2.5 extra ones made).
• Let also Japan specialize in memory chips. They stop
making the carburetor and make instead 1.25 chips.
Along with the original chip, they make 2.25 chips.
• World production rose to 3.5 carburetors and 2.25
chips through comparative advantage.
• Both countries will be richer by this trade.
Slide 22
 Restrictions Attempts to
on Free Trade Expand Free Trade
• Tariffs • Larger free trade
» Expands domestic regions called trading
production blocs
» But raises the price for
consumers
• European Community
and the Euro
• Import quotas
» Raises the price for • NAFTA
consumers • Expansion of NAFTA
• Exchange rate controls with Latin America
» Reduces trade and MERCOSUR

Slide 23
Supply and Demand Analysis of Trade
• Situation without a tariff
• Small Country -- imports oil at Pw

DOMESTIC
SUPPLY

Pw
DOMESTIC DEMAND

Sd Qd Dd Quantity of Oil

Amount of oil imported is Dd - Sd

Slide 24
Impact of Tariffs with S&D Curves
• Situation where PT is the price with a tariff
DOMESTIC
SUPPLY

PT
Pw
DOMESTIC DEMAND

Sd S’d D’d Dd Quantity of Oil

•Domestic production increases to S’d
•Domestic consumption decreases to D’d Slide 25
 Other Protectionist Measures:
Quotas & Voluntary Export Restraints

}
• Quotas -- limit number of imports P
• Voluntary restraints are quotas
• Non-tariff regulations are barriers
» safety rules, pollution rules
D
» Metric / non-metric standards
» ISO 9000, quality rules, and the CE Q
quota
Mark
added
P W’
costs
PW
Q
Slide 26
 Optimal Currency Areas
• The Optimal Currency Area involves the question of
how many different currencies are best.
• If all of Europe has only one currency, trade is quite
easy.
• But if Italy needs assistance, for example, reducing the
value of the Euro for the whole group of countries
doesn't target the single ailing region.
• Hence, it is an open question as to how many currencies
Europe should have.
• It is expected that the Euro will help the participating
countries, but it makes helping the poorest countries
harder.
Slide 27
One Currency for North America?
• Should the US, Canada, and Mexico consider having
one united currency, the Peso-Dollar?
• The US has the same currency in all 50 states, and this
has helped the US. All states have open borders, so
Ohio workers can move to Missouri if they want to find
work.
» But one currency makes helping poorer states harder.
» If problems arise in Mexico, they would not
be able to depreciate the peso to help.
» Also, open borders within North America does
not exactly exist. $
Slide 28
 Trade Deficits and Balance of Payments
• The current account reflects goods and service trade flows, receipts
and payments US assets abroad and foreign assets in the US, and
unilateral governmental and private transfers (such as foreign aid or
gifts to foreign family members).
• The capital account reflects capital inflows and outflows of foreign
assets. The capital account includes transfers in and out of
securities, bonds, and financial claims on other assets and liabilities,
as well as official reserves, International Monetary Fund balances
and gold.
• If there is a current account deficit, the needed funds come from
borrowing from abroad (a capital account inflow).
• The current account (deficit or surplus) comes from a capital
account (surplus or deficit) to balance payments. This is the idea
behind the accounting identity of the balance of payments.
Slide 29
 Guide Questions
1. If the Peso (PHP) depreciates by 25%, how
does this affect the manufacturers that
import raw materials?
2. If the Peso (PHP) appreciates by 30%,
what will be the impact to exporter traders
and manufacturers of export goods?

Slide 30
 TO DO:
Research on an Follow the outline below.
international trade A.Background
agreement. Select one B.Members
from the following : C.Advantages
» NAFTA D.Disadvantages
» Eurozone Reminders:
» ASEAN Font: Arial Size: 11
» Spacing: 1.15; 1 page short bond
APEC
Save your research in the Trade
Agreement folder in the
Managerial Economics google
drive

Slide 31