Revision lecture 6

Hedging Economic Exposure

Change in real exchange rate

• Suppose inflation in Australia (UK) over the next year is 4% (8%). Also, the nominal exchange rate changes in line with Relative PPP predictions.

$$s_{t+1}=s_{t}\cdot \frac{1+\pi _{\$}}{1+\pi _{\pounds}}=1.30\cdot \frac{1.04}{1.08}=\$1.2519 / \pounds$$

• The £ weakens by 3.7%
  • What is the new Real Exchange Rate?
• New price levels are $15,600 (=15,000×1.04) and £12,960 (= £12,960×1.08) in Australia and the UK respectively

$$E_{t+1} = \frac{\$1.2519/\pounds}{\frac{\$15600}{\pounds 129600}} = 1.04$$

• Notice, the real exchange rate has not changed. This is because relative PPP holds. This keeps deviations from absolute PPP constant.

Real exchange rate change

• Real exchange rate, E, can change over time. This is given as

$$\Delta E = \frac{E^{A/B}_{t+1}-E^{A/B}_{t}}{E^{A/B}_{t}} = \frac{E^{A/B}_{t+1}}{E^{A/B}_{t}} -1$$

$$1+\Delta E = \frac{(1+\Delta s_{t+1})\cdot (1+\pi_{B,t+1})}{1+\pi_{A,t+1}}$$

• If the % change in E is positive, we have real appreciation of B.
• If the % change in E is negative, we have real depreciation of B.

Real exchange rates and Profitability

• Real Exchange Rates affect real profitability which is the nominal profits divided by the price level.
  • Why is real profitability important?
• Consider the case of an Australian exporter of mangoes (M). His costs are incurred in AUD.

Revenue from sales:

$$P(M, \$) \cdot Q(M, Aus)$$

Revenue from French Sales

$$P(M, €) \cdot Q(M, Fr) \cdot S(\$ /€)$$

Cost of Production

$$C(M, \$) \cdot [Q(M, Fr) + Q(M, Aus)]$$

• The exporter's real export revenue from sales to France is

$$\frac{P(M, €) \cdot Q(M, Fr) \cdot S(\$ /€)}{P(\$)}$$

$$= \frac{S(\$ /€) \cdot P(€)}{P(\$)} \cdot \frac{P(M, €)}{P(€)} \cdot Q(M, Fr)$$

• The exporter’s real export revenue depends on three factors

1. The real exchange rate;
2. The relative price of mangoes in France; and
3. The quantity of mangoes sold in France

The Source of Economic Exposure

• Economic exposure arises when the value of the firm is affected by changes in the Real exchange rate. Exchange rates affect the value of the firm through their impact on
  • Revenues;
  • Costs; and
  • Competitive position
• It is the extent of sensitivity of the Value of a firm to an unexpected exchange to real exchange rates.

A Real-World Example: Honda Motors

• Honda used to manufacture all its automobiles in Japan and ship them to the U.S.

• U.S. demand declined with yen appreciation

• In January 1993, exchange rate was about 125 ¥/$. By April, it fell to 113-114 ¥/$ range

  • ~$11,602

• NY Times says that Japanese manufacturers would have to “take stern measures to reduce their costs and improve their efficiency.”

• June 1993 dollar fell to about 110 ¥/$

  • ~$11,364

• End of summer of 1993, 100 ¥/$

  • ~$12,500

• In July 1993, Japanese auto exports were 14% below previous year’s level.

• The New York Times reported Japanese manufacturers were shifting production to U.S.

• Honda posted a 55% drop in pre-tax profit for quarter ending June 30, 1993.

• Honda has built manufacturing plants in the U.S. to produce automobiles for sale there.

Impact of Economic Exposure

• A strong dollar can make imports look cheap to Australian purchasers.
  • Can bring new competition for Australian producers.
• Exchange rates can affect the price a firm pays for inputs imported from foreign countries.
  • Raise prices (lower demand) or earn lower profits?
• Exchange rates can affect the foreign demand for a firm’s product.
  • Weak dollar can make Australian exports attractive.
  • Increase in foreign demand can also increase Australian prices if production doesn’t adjust fast enough.

Quantifying Economic Exposure

• PV of firms profits/CFs is given as

$$V = \sum ^{T} _{j=1} \frac{CF_{j}}{(1+r)^{j}}$$

• It measures the marginal impact on firm value by an unexpected change in the (AUD/FC) real exchange rate.

Natural Hedges

• Ford shifting production to Asia

• Toyota has insulated itself to some extent against dollar fluctuations
  • It builds 60% of the cars sold in North America in North America
• Michelin, the world’s largest tire maker, has 40% of its annual sales in North America.
  • Most of the imported raw materials used by Michelin are also priced in dollars

Exchange rate Changes and Profit Margins

• Another way to state the findings is: Foreign customers do observe exchange-rate driven changes in prices, but the Japanese firms moderate the extent of these changes by altering their profit margins.

Why would this make sense?

• A firm that has found its profit-maximizing price in each market and will attempt to keep its goods at that price. (Cares about maintaining market share.)
• Thus, firms are inclined to absorb currency swings into their profit margins to stabilize prices seen by foreign customers.