© 2018 Cambridge University Press 9-1
Michala Moravcová
Department of Finance, Masaryk University
International Finance
Measuring and Managing Real Exchange Risk
International Finance
© 2018 Cambridge University Press 9-2
• The real profitability of a firm - how changes in the real exchange rate affect a firm’s
profitability
• The real profitability of an exporting firm
• Real profitability: the purchasing power of a firm’s nominal profits (nominal profit/price level)
• 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑝𝑟𝑜𝑓𝑖𝑡 𝑓𝑜𝑟 𝑈𝑆 𝑓𝑖𝑟𝑚 = $ 𝑅𝑒𝑣𝑒𝑛𝑢𝑒!" + $ 𝑅𝑒𝑣𝑒𝑛𝑢𝑒!#– 𝐹𝑖𝑟𝑚’𝑠 $ 𝑐𝑜𝑠𝑡𝑠
• Example: Apples Galore (A = Apples)
• $ 𝑅𝑒𝑣𝑒𝑛𝑢𝑒!" = 𝑃(𝐴, $) × 𝑄(𝐴, 𝑈𝑆)
• $ 𝑅𝑒𝑣𝑒𝑛𝑢𝑒!# = 𝑆($/£)×𝑃(𝐴, £)×𝑄(𝐴, 𝑈𝐾)
• $ 𝐶𝑜𝑠𝑡𝑠 = 𝐶(𝐴, $)×[𝑄(𝐴, 𝑈𝑆) + 𝑄(𝐴, 𝑈𝐾)]
• Relative prices and components of real profit
• Divide nominal profit by price level in US: P($)
• 𝑅𝑒𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒!" = [𝑃(𝐴, $)/𝐏]×𝑄(𝐴, 𝑈𝑆)
• To keep the relative price of apples constant, the firm must ensure that the nominal price of the apples
increases at the U.S. rate of inflation.
• 𝑅𝑒𝑎𝑙 𝐶𝑜𝑠𝑡𝑠 = [𝐶(𝐴, $)/𝑃($)]×[𝑄(𝐴, 𝑈𝑆) + 𝑄(𝐴, 𝑈𝐾)]
• If its nominal average cost per apple increases at the U.S. rate of inflation, its real average costs are constant.
1. How Real Exchange Rates Affect Real Profitability
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© 2018 Cambridge University Press 9-3
• Revenue:
• To keep relative prices constant, the firm must ensure that the nominal price of apples
increases at the American interest rate.
• Costs:
• If the nominal average cost per unit increases at the American interest rate, the real average
costs are constant, and the total real costs are the same when the same amount is produced.
• Firm’s reaction to exchange rate changes:
• 𝑅𝑒𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒!" = [𝐒($/£)×𝑃(𝐴, £)×𝑄(𝐴, 𝑈𝐾)]/𝑃($)
• 𝑅𝑒𝑎𝑙 C𝑜𝑠𝑡𝑠 = 𝐶(𝐴, $)/𝑃($)×[𝑄(𝐴, 𝑈𝑆) + 𝑄(𝐴, 𝑈𝐾)]
• A real appreciation of the pound increases real revenue from the United Kingdom and allows the
firm to become more competitive there because it can lower its relative price of apples.
• Exchange rate pass-through - how the managers of the firm choose to respond with their relative
prices to changes in the real exchange rate.
1. How Real Exchange Rates Affect Real Profitability
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© 2018 Cambridge University Press 9-4
• Real exchange risk
• Profitability of a firm can change because of fluctuations in real exchange rates.
• Also known as operating or economic exposure.
• Real depreciation of the domestic currency hurts importing firms and helps exporting firms.
• Exactly how a firm is affected depends on the firm’s type of business—that is, it depends on
whether it is a net exporter, a net importer, or an import competitor.
• 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
• Firm’s competitive situation
2. Real Exchange Risk at Exporters, Importers and
Domestic Firms
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© 2018 Cambridge University Press 9-5
• Olympia Communication Exporters (OCE) manufactures cell phones in Greece
• Sells them in the US at $79, and sells 2M phones per year
• S = $1.25/€
• 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 € = $79 (𝑝𝑒𝑟 𝑝ℎ𝑜𝑛𝑒)×2𝑀×€1/$1.25 = €126.4𝑀
• InflationUS forecasted @ 5.5%
• InflationEUR forecasted @ 1%
• Following interest rate parity formula - USD is expected to weaken (EUR strengthen):
• L
#!/#
$!/#
= L
(&'(!)
(&'(#)
• 𝐹*/, = 𝑆*/,× L
(&'(!)
(&'(#)
• $𝟏. 𝟑𝟎𝟓𝟕/€ = $1.25/€ × 1.055/1.01
• This change just offsets the inflation differential and leaves the real exchange rate unchanged.
2. Real Exchange Risk at Exporters, Importers and
Domestic Firms
International Finance
© 2018 Cambridge University Press 9-6
• The change offsets the inflation differential and leaves the real exchange rate unchanged
• If the demand curve is constant in the US, what $ price should OCE charge to earn the same
real revenue and sell the same quantity of phones in the United States considering the
inflation?
• The price should increase by US inflation 5.5%:
• $79/𝑝ℎ𝑜𝑛𝑒×1.055 = $83.35/𝑝ℎ𝑜𝑛𝑒
• Revenue would increase to:
• $83.35×2𝑀×€1/$1.3057 = €127,670,981
• € 127,670,981 is 1% higher than € 126,400,000. An increase of 1% in nominal revenue is required to
keep the firm’s real revenue constant.
2. Real Exchange Risk at Exporters, Importers and
Domestic Firms
International Finance
© 2018 Cambridge University Press 9-7
• Any increase in the exchange rate above $1.3057/€ creates dilemma for OCE
• Increase the price of cell phones above $ 83.35?
• NO – EUR value of revenue will decrease
• YES – price will rise above US inflation – firm will sell less phones
= OCE is less profitable after a real depreciation of the dollar
• BY how much?
• Elasticity of demand
2. Real Exchange Risk at Exporters, Importers and
Domestic Firms
International Finance
© 2018 Cambridge University Press 9-8
• Trans-Malaysian Airlines (TMA) flies mostly domestic routes
• It imports its fuel from Singapore @ $3.50/gallon
• Last year TMA imported 250M gallons (S=MYR4/$) or MYR3.5B, while its revenue net of other costs was
MYR4B, with profit of MYR0.5B
• TMA is regulated and cannot raise prices above inflation rate (15%)
• If fuel cost increases by the US 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/$
• New costs: $3.64×250𝑀 𝑔𝑎𝑙𝑙𝑜𝑛𝑠×𝑀𝑌𝑅4.8654/$ = 𝑀𝑌𝑅4.428𝐵
• New profit: 𝑀𝑌𝑅4𝐵×(1.15) − 𝑀𝑌𝑅4.428𝐵 = 𝑀𝑌𝑅0.172𝐵
• Instead of profits 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%
• A real appreciation of the dollar clearly has a severe effect on the real profitability of TMA because it
increases TMA’s costs, and the regulation prevents the company from passing any of its increased costs
due to a change in the exchange rate on to its customers in the form of higher prices.
2. Real Exchange Risk at Exporters, Importers and
Domestic Firms
© 2018 Cambridge University Press 9-9
• Measuring real exchange risk exposure
• Change in the present value of a firm’s future after-tax profits
• Who does not 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
2. Real Exchange Risk at Exporters, Importers and
Domestic Firms
International Finance
© 2018 Cambridge University Press 9-10
• Safe Air’s (SA) situation
• Small US 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
3. Sharing the Real Exchange Risk: An Example
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© 2018 Cambridge University Press 9-11
• Designing a contract that shares the real exchange risk:
• Sharing the real exchange risk equally between two parties
• Let the base dollar price of the product increase one for one with the US 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
3. Sharing the Real Exchange Risk: An Example
International Finance
© 2018 Cambridge University Press 9-12
• Understanding the contract
a) If euro appreciates relative to the dollar by more than is warranted by the differential rates of
inflation, Metallwerke’s real revenue falls
• Redesigned contract increases nominal base price in USD, such that Safe Air bears part of the
losses
• If euro weakens relative to the dollar by more than the inflation differential, Metallwerke’s
real revenue rises
• Redesigned contract lowers the rate at which the dollar base price increases, such that the gains
are shared with Safe Air
3. Sharing the Real Exchange Risk: An Example
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© 2018 Cambridge University Press 9-13
• 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
Sharing the Real Exchange Risk: An Example
International Finance
© 2018 Cambridge University Press 9-14
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
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© 2018 Cambridge University Press 9-15
• 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
3. Sharing the Real Exchange Risk: An Example
International Finance
© 2018 Cambridge University Press 9-16
• Pricing to market
• Occurs when a producer charges different prices for the same good in different markets
• Example of pricing-to-market strategies
• French handbags: Louis Vuitton bags cost 40% more in Japan than in Europe
4. Pricing-to-Market Strategies
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A Monopolistic Exporter
The real exchange rate is initially equal to 1.
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A Monopolistic Exporter When RS=1.2
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A Monopolist with Imported Costs
20% Real depreciation of foreign currency
Monopolist will want to produce more in foreign market
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• 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 net importer – ThaiComp imports personal computer parts from Japan, assembles and
sells mostly in Thailand. its costs increase more than its revenues when there is a real
depreciation of the baht. The Japanese owners of ThaiComp then experience an additional
loss in real terms when they convert baht profit into yen.
• The net exporter – WeRToys produces and mostly exports toys from Japan to Thailand. its
operating performance improves with a real depreciation of the baht, but its Japanese
owners experience less of this increase in real profitability when the yen strengthens.
• The neutral firm – RiceNoodle serves the Thai market with no export revenues or foreign
costs but has Japanese owners. real depreciation of the baht relative to the yen does
adversely affect the real value of RiceNoodle’s profits for the company’s Japanese owners.
5. Evaluating the Performance of a Foreign Subsidiary
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© 2018 Cambridge University Press 9-21
Operating Profit with a One-to-One Real Exchange Rate
Between the Baht and the Yen
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© 2018 Cambridge University Press 9-22
Actual Operating Profit After a 10% Real Appreciation of
the Yen
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Operating Profit After a 10% Real Appreciation of the
Yen: No Response by Managers
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Operating Profit After a 10% Real Appreciation of the
Yen: Managers Respond Optimally
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Actual Versus Optimal Operating Profit After a 10% Real
Appreciation of the Yen
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Operating Profit After a 10% Real Depreciation of the
Yen: Managers Respond Optimally
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© 2018 Cambridge University Press 9-27
• 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
6. Strategies for Managing Real Exchange Risk
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© 2018 Cambridge University Press 9-28
• Marketing management
• Pricing policies (with respect to price elasticity)
• The frequency of price adjustments (customers like price stability)
• Market entry decisions
• Brand loyalty
6. Strategies for Managing Real Exchange Risk
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© 2018 Cambridge University Press 9-29
A Checklist for Managers of Real Exchange Risk
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© 2018 Cambridge University Press 9-30
• Given that real exchange rates fluctuate, when would be the best time to enter the
market of a foreign country as an exporter to that market?
• You have been asked to evaluate possible sites for an Asian production facility that will
manufacture your firm’s products and sell them to the Asian market. What real exchange
rate considerations should you entertain in your evaluation?
• Why is it important for an exporter to understand the distinction between a temporary
change in the exchange rate and a permanent change in determining whether to respond
to a real depreciation of the home currency with increased production or sales out of
inventories?
• What do economists mean by pricing-to-market?
Questions:
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