Chapter 9 Measuring and Managing Real Exchange Risk

1. Chapter 9Measuring and Managing Real Exchange Risk

2. The real profitability of an exporting firm Real profitability: the purchasing power of a firm’s nominal profits U.S. firm’s nominal profit = $ revenueU.S. + $ revenueU.K. – Firm’s $ costs Example: Apples Galore (A = Apples) $ RevenueU.S.= P(A,$) * Q(A,U.S.) $ RevenueU.K.= S($/£) * P(A,£) * Q(A,U.K.) $ Costs = C(A,$) * [Q(A,U.S.) + Q(A,U.K.)] Relative prices and components of real profit Divide nominal profit by price level in U.S.: P($) Real RevenueU.S.= Real Costs = [C(A,$)/P($)] * [Q(A,U.S.) + Q(A,U.K.)] 9.1 How Real Exchange Rates Affect Real Profitability

3. Revenue: to keep relative prices constant, the firm must ensure that the nominal price of apples increases at the IU.S. Costs: if its nominal average cost per unit increases at IU.S., its real average costs are constant and the Apples Galore’s total real costs are the same when the same amount is produced Firm’s reaction to exchange rate changes: Real revenueU.K.= Real costs = C(A,$)/P($) * [Q(A,U.S.) + Q(A,U.K.)] Exchange rate pass-through: how do management respond with regard to its pricing when real exchange rates change? 9.1 How Real Exchange Rates Affect Real Profitability

4. 9.2 Real Exchange Risk at Exporters, Importers and Domestic Firms Real exchange risk – profitability of a firm can change because of fluctuations in real exchange rates The real exchange rate risk of a net exporter A competitive dilemma: Raise prices – lose market share Lower prices – lose profits Major factor that determines a firm’s response: Price elasticity of demand for its product

5. 9.2 Real Exchange Risk at Exporters, Importers and Domestic Firms Olympia Communication Exporters (OCE) manufactures cell phones in Greece and sells them in the U.S. at $79. The company is selling 2M phones per year. S = $1.25/€. Revenue€=$79 (per phone) * 2M * €1/$1.25 = €126,400,000 InflationU.S. forecasted @ 5.5% InflationU.K. forecasted @ 1% $1.3057/€ = $1.25/€ * 1.055/1.01 The change just offsets the inflation differential and leaves the real exchange rate unchanged. If demand curve is constant in U.S., what $ price should OCE charge to earn same real revenue? The price should increase by 5.5%: $79/phone * 1.055 = $83.35/phone Revenue would increase to: $83.35 * 2M * €1/$1.3057 = €127,670,981 Interest Rate Parity Formula Fh/f = (1 + ih) Sh/f (1 + if)

6. 9.2 Real Exchange Risk at Exporters, Importers and Domestic Firms Trans-Malaysian Airlines (TMA) flies mostly domestic routes (Malaysia). It imports its fuel from Singapore @ $3.50/gallon. Last year TMA imported 250M gallons (S=MYR4/$) or MYR3.5B. Its revenue net of other costs was MYR4B. Profit was therefore MYR0.5B. TMA is regulated and cannot raise prices above inflation rate (15% this yr). What if fuel cost increases by U.S. inflation rate – 4%. By how much will real profits fall if there is a 10% real appreciation of the dollar relative to the ringgit (i.e., causing their costs to increase)? New price of fuel: $3.50/gallon * 1.04 = $3.64/gallon New spot rate: (MYR4/$ * 1.10) * (1.15/1.04) = MYR4.8654/$ IRP FORMULA $3.64 * 250M gallons * MYR4.8654/$ = MYR4.428B New Profit = MYR4B * (1.15) - MYR4.428B = MYR0.172B Instead of increasing by 15%, which they would have if there was no real appreciation in the value of the $ (or equivalently, depreciation in the ringgit), nominal profits have fallen by 65.6%!

7. Measuring real exchange risk exposure The present value of a firm’s profits Who doesn’t have real exchange risk? A completely domestic firm? Well, sort of – these firms may not face forex risk in the short-term, but may very well in the longer-term. Example: a restaurant in Miami that does not deal with foreign currency could suffer a drop in customers if the value of the Euro is weak. 9.2 Real Exchange Risk at Exporters, Importers and Domestic Firms

8. 9.3 Sharing the Real Exchange Risk:An Example Safe Air’s (SA) situation Small U.S. company that sells air tanks with “safe” air to fire departments CEO needs to prove leadership since earnings are declining Metallwerke A.G.’s proposal German firm that manufactures similar product prepared to manufacture tanks for SA Same or better quality of current supplier Lock in low dollar price Want a TEN year contract with indexing formula!

9. 9.3 Sharing the Real Exchange Risk:An Example The indexing formula allows for annual changes in the base dollar price under the following contingencies: The base dollar price will be increased at the U.S. annual rate of inflation, as indicated by the U.S. producer price index If the dollar depreciates relative to the euro, the percentage change in the base dollar price will equal the U.S. rate of inflation plus an additional percentage equal to on-half the rate of depreciation of the dollar relative to the euro

10. 9.3 Sharing the Real Exchange Risk:An Example Basic data an analysis Some basic prices and notations (the zeros indicate current-period values) related to the deal proposed by Metallwerke: Safe Air’s contractual base purchase price = B(0,$) = $400 per tank Safe Air’s other variable production costs = C(0,$) = $313 per tank Safe Air’s retail sales price = T(0,$) = $856 per tank Safe Air’s profit margin = M(0,$) = 20% U.S. price level = P(0,$) = $140 per U.S. general good Exchange rate = S(0,€/$) = €1.40/$ German price level = P(0,€) = €100 per German general good Metallwerke’s profit margin M(0,€) = 20% Metallwerke’s production cost = C(0,€) = €238 per tank

11. Exhibit 9.1 Profitability When the Price per Tank Is Contractually Fixed

12. Exhibit 9.2 Profitability Under Metallwerke’s Proposed Contract

13. Exhibit 9.3 Profitability Under a Contract That Shares Real Exchange Risk Safe Air loses some if $ falls but gains some if $ rises Metallwerke trades off some profit when $ rises for a higher profit when $ falls

14. 9.3 Sharing the Real Exchange Risk:An Example Analyzing contracts when inflation and real exchange rates are changing: Profits with a constant real exchange rate Real cost per tank – increases in the base price that are larger (smaller) than the U.S. rate of inflation increase (decrease) real imported part costs Safe Air’s real revenue per tank Will remain the same only if SA is able to raise prices by rate of inflation Metallwerke’s real revenue per tank This is written in the contract as constant (but they would like this changed!) Metallwerke’s real cost per tank This is constant as long as the cost of production rises at the German rate of inflation

15. 9.3 Sharing the Real Exchange Risk:An Example If relative PPP does NOT hold (likely), both parties are exposed to real exchange rate risk Designing a contract that shares the real exchange risk Let the base dollar price of the product increase one for one with the U.S. inflation rate Adjust for changes in real exchange rate Increase base price by one-half of any real depreciation of the dollar relative to the euro Decrease base price by one-half of any real appreciation of the dollar relative to the euro

16. 9.3 Sharing the Real Exchange Risk: An Example Evaluating the proposal If relative PPP holds and IU.S.>IGermany (e.g., 10% and 5%, respectively, the $ will depreciate relative to the € [1-d(€/$)] = [1+I(€)]/[1+I($)] = 1.05/1.1 = 0.0455 Proposal suggests that the change in price be adjusted by inflation plus half of the depreciation ∆Base price = 1 + (IU.S.+0.5d) = 1.1228 or an increase of 12.28% SA’s per tank cost: increase by 2.07% (=1.1228/1.10) M’s real per tank revenue: increase by 2.07% (=[(1-0.0455) * (1+0.1228)]/(1+0.05))

17. 9.3 Sharing the Real Exchange Risk: An Example Should the redesigned contract be adopted? Other factors affecting costs Wage pressure when the buying power of employees at SA is squeezed (i.e., when domestic currency is weak in real terms relative to foreign currency) Solution: smaller increase in base price when $ is weak and smaller decrease when the dollar is strong Competitiveness and pricing ability Demand is fairly elastic given budgets of fire departments! This means SA is not able to increase prices above inflation Foreign competitors complicate matters in that they become aggressive when $ is strong. Could fix this by allowing SA to receive >50% of benefit when $ is strong Relative bargaining strength – who gets what has a lot to do with who has more bargaining power

18. 9.4 Pricing-to-Market Strategies Pricing to market Occurs when a producer charges different prices for the same good in different markets Some examples of pricing-to-market strategies Luxury cars in the 1980s - $ very strong; European manufacturers chose to keep prices high and fatten profits instead of gaining market share Japanese consumer electronics - $ weak; Japanese manufactures kept prices low to maintain market share French handbags: Louis Vuitton bags cost 40% more in Japan than in Europe

19. Exhibit 9.4 A Monopolistic Exporter 20% real appreciation of foreign currency Monopolist will want to sell more in foreign market

20. Exhibit 9.5 A Monopolistic Exporter When RS=1.2 20% real appreciation of foreign currency Monopolist will want to sell more in foreign market

21. Exhibit 9.6 A Monopolist with Imported Costs 20% Real depreciation of foreign currency Monopolist will want to produce more in foreign market

22. 9.5 Evaluating the Performance of a Foreign Subsidiary Evaluation the performance of a foreign subsidiary – tough because of the effect of real changes in forex! Example: three Japanese subsidiaries operating in Thailand The neutral firm – RiceNoodle serves the Thai market with no export revenues or foreign costs but has Japanese owners The net importer – ThaiComp imports personal computer parts from Japan, assembles and sells mostly in Thailand The net exporter – WeRToys produces and mostly exports toys from Japan to Thailand

23. Exhibit 9.7 Operating Profit with a One-to-One Real Exchange Rate Between the Baht and the Yen THB1=JPY1

24. Exhibit 9.8 Actual Operating Profit After a 10% Real Appreciation of the Yen

25. Exhibit 9.9 Operating Profit After a 10% Real Appreciation of the Yen: No Response by Managers THB1.1=JPY1

26. Exhibit 9.10 Operating Profit After a 10% Real Appreciation of the Yen: Managers Respond Optimally *arrows indicate direction of change from levels in Exhibit 9.7

27. Exhibit 9.11 Actual Versus Optimal Operating Profit After a 10% Real Appreciation of the Yen

28. Exhibit 9.12 Operating Profit After a 10% Real Depreciation of the Yen: Managers Respond Optimally

29. 9.6 Strategies for Managing Real Exchange Risk Transitory versus permanent changes in real exchange rates – how long is change supposed to persist? Production management Production scheduling – use inventory to avoid paying employees overtime to meet excess demand Input sourcing – weighing ability to switch back and forth between domestic/foreign suppliers and the value of long-term relationships Plant location Expand locations Shift production among existing locations

30. 9.6 Strategies for Managing Real Exchange Risk Marketing management Pricing policies The frequency of price adjustments Market entry decisions Brand loyalty

31. Exhibit 9.13 A Checklist for Managers of Real Exchange Risk