Suppose the $ Suppose the $ collapses…collapses…

Who benefits from a $ Who benefits from a $ fall?fall?

Who loses?Who loses? When a currency depreciates When a currency depreciates (appreciates), domestic goods become (appreciates), domestic goods become relatively less (more) expensive relatively less (more) expensive compared to foreign goods.compared to foreign goods.

However, this is not always the case as However, this is not always the case as many exporting companies do not many exporting companies do not change their prices, when exchange change their prices, when exchange rates change, but instead absorb the rates change, but instead absorb the costs (or profits).costs (or profits).

For example, between Jan 1994 and April 1995, the For example, between Jan 1994 and April 1995, the Japanese yen appreciated by 34% against the dollar.Japanese yen appreciated by 34% against the dollar.

We would therefore expect the price of Japanese We would therefore expect the price of Japanese products sold in the US to be about 34% more products sold in the US to be about 34% more expensive as a result of the appreciation of the yen. expensive as a result of the appreciation of the yen. The price of Toyota Celica made in Japan increased The price of Toyota Celica made in Japan increased by only 2%…by only 2%…

The price of large-screen SONY Trinitron The price of large-screen SONY Trinitron fell fell by 15%by 15%……

What happened?What happened?

IntroductionIntroduction

BackgroundBackground Federal Reserve - Currency market dynamics mean the US could lower its trade Federal Reserve - Currency market dynamics mean the US could lower its trade

deficit more by boosting exports then cutting imports. Fluctuations in the U.S. deficit more by boosting exports then cutting imports. Fluctuations in the U.S. dollar have an "asymmetric " impact on the U.S. trade balance.” That means dollar have an "asymmetric " impact on the U.S. trade balance.” That means depreciation in the $ against other currencies does not pass through as strongly depreciation in the $ against other currencies does not pass through as strongly into the final price of goods imported into the US, as it does with the price of into the final price of goods imported into the US, as it does with the price of imports in other countries.imports in other countries.

"If U.S. import prices are less responsive to e, then you are not going to get much "If U.S. import prices are less responsive to e, then you are not going to get much of a decline in U.S. demand for imports from e movements. The trade balance of a decline in U.S. demand for imports from e movements. The trade balance effects from exchange rate movements gets shifted to the export side, Many effects from exchange rate movements gets shifted to the export side, Many economists have suggested the U.S. CA deficit, which has recently risen to near economists have suggested the U.S. CA deficit, which has recently risen to near 7% of GDP is unsustainably high and an adjustment is inevitable.7% of GDP is unsustainably high and an adjustment is inevitable.

““The sustainability of the U.S. CA deficit is much more precipitous now than it The sustainability of the U.S. CA deficit is much more precipitous now than it was in 1987 the last time the U.S. showed a sizable imbalance. That is due to the was in 1987 the last time the U.S. showed a sizable imbalance. That is due to the role of foreign CB as holders of $, as well as the ease with which capital flows role of foreign CB as holders of $, as well as the ease with which capital flows around the globe.” Among the CB that have announced their intention to make at around the globe.” Among the CB that have announced their intention to make at least a limited swing to euros from $ are China, South Korea, Sweden and Russia. least a limited swing to euros from $ are China, South Korea, Sweden and Russia.

The $ is still the dominant currency for global export and import invoicing, The $ is still the dominant currency for global export and import invoicing, although the advantages of using the $ have declined… The euro is on the rise as although the advantages of using the $ have declined… The euro is on the rise as an invoicing currency within the EU and Eastern Europe, but has made little an invoicing currency within the EU and Eastern Europe, but has made little inroads in Asia so far, However, transaction costs involving the euro, shown by inroads in Asia so far, However, transaction costs involving the euro, shown by bid-ask spreads in the London currency market, are in some cases cheaper than bid-ask spreads in the London currency market, are in some cases cheaper than for the $. "It's not the case that it is always cheaper to trade with the $. The world for the $. "It's not the case that it is always cheaper to trade with the $. The world is changing, and the euro is getting more important”.   is changing, and the euro is getting more important”.  

Exchange Rate Pass Exchange Rate Pass ThroughThrough

The percentage change in local currency The percentage change in local currency import prices resulting from a one import prices resulting from a one percent change in the exchange rate percent change in the exchange rate between the exporting and importing between the exporting and importing countriescountries

• In the language of ERPT, a theoretical one-In the language of ERPT, a theoretical one-for-one response of import prices to for-one response of import prices to exchange rates is known as “full” or exchange rates is known as “full” or “complete” ERPT“complete” ERPT

Full ERPTFull ERPT occurs when, occurs when, There are There are constant markupsconstant markups of price over of price over cost cost

Constant marginal costsConstant marginal costs Perfect competitionPerfect competition

However, if market is monopolistically However, if market is monopolistically competitive, then ERPT isn’t complete. Some competitive, then ERPT isn’t complete. Some or all of the impact of the change in interest or all of the impact of the change in interest rates on prices is “swallowed” by producers’ rates on prices is “swallowed” by producers’ pricing decisions. pricing decisions.

ERPTERPT

Some research findingsSome research findings Pass-through to U.S import prices = 65% Pass-through to U.S import prices = 65%

during the 80s but has declined to 20%during the 80s but has declined to 20% Pass-through to Germany = 30%Pass-through to Germany = 30% ERPT in Ireland – 50% ERPT to Italy, 47% ERPT in Ireland – 50% ERPT to Italy, 47% ERPT in France is now 16% (used to be 50%)ERPT in France is now 16% (used to be 50%)Industry-specific estimates are different due to Industry-specific estimates are different due to

differentiated differentiated markup adjustment markup adjustment across across industries. industries.

Why would markup adjustments be Why would markup adjustments be different?different?

Incomplete ERPTIncomplete ERPT

Incomplete ERPT and Incomplete ERPT and MarkupMarkup

Industry-specific estimates are Industry-specific estimates are different due to differentiated different due to differentiated markup markup adjustment adjustment across industries. across industries.

Why would markup adjustments be Why would markup adjustments be different?different?

Differences in demand curvatures Differences in demand curvatures explains the difference in markup explains the difference in markup adjustments in different industries.adjustments in different industries.

Moreover, a change in the exporter’s Moreover, a change in the exporter’s exchange rate can affect the price exchange rate can affect the price charged in two ways:charged in two ways:

o By affecting marginal costsBy affecting marginal costso By affecting the elasticity of demandBy affecting the elasticity of demand

Pricing to Market (PTM)Pricing to Market (PTM)

Pass-ThroughPass-Through

How do changes in exchange rates affect prices charged by foreign in the domestic market?

Exchange Rate

$ Price of Japanese Cars Sold in U.S. Revenue in ¥

¥150/$

¥100/$

$20,000/auto ¥3,000,000/auto

$30,000/auto ¥3,000,000/autoComplete Pass-through

Invoicing?

$20,000/auto ¥2,000,000/auto¥100/$ No Pass-through

Complete pass-through Toyota maintains profit/unit in ¥

How complete is pass-through?How complete is pass-through?

1991-95: $ prices of imports from Japan rose by 20% while the Yen appreciated by 60%

1995-98: same elasticity during yen depreciation

Why is pass-through so incomplete?

Theory of Incomplete Pass-ThroughTheory of Incomplete Pass-Through2. Segmented Markets (not integrated)

Resale across markets is limited so that nearly identical products sell for different prices in two markets without inducing profitable third-party arbitrage.

¥ price of Celicas in Japan = ¥3,000,000¥ price of Celicas in U.S. = (¥100/$)($20,000/auto)

= ¥2,000,000

How could you arbitrage this? Impact on Prices?

Why is this arbitrage not possible in practice?

- tariffs at the border- different environmental and safety standards- warranties and service linked to location of purchase

Discussion QuestionDiscussion Question

You are a U.S. producer selling goods in Japan and the U.S.

Originally E = 110 ¥/$. Price was $1 per unit of output in both markets.

Now, E = 120 ¥/$. Your ($) costs remain the same.

What qualitative suggestion (increase or decrease dollar prices) would you make about how to change prices in the two markets?

Profit or Loss?Profit or Loss? Suppose US exporter interested in Suppose US exporter interested in

China. Currently, you can produce CDs China. Currently, you can produce CDs that cost 640 Yuan and goal is to sell it that cost 640 Yuan and goal is to sell it at $10 as this is market rate.at $10 as this is market rate.

At 8 Y/$, …. Profit?At 8 Y/$, …. Profit? Suppose Yuan appreciates 20%...Profit?Suppose Yuan appreciates 20%...Profit? Suppose goal is to sell it to export to Suppose goal is to sell it to export to

other county, does the $ depreciation other county, does the $ depreciation still hurt?still hurt?

Monopoly PricingMonopoly Pricing

DMR

MC

q*

p*

To maximize profit,the monopolist chooses q where MR = MC.

$

quantity

Standard Monopoly Pricing Standard Monopoly Pricing ExampleExample

Demand: p = 100 - 4 q

Cost: TC = 100 + 10q

TR = p*q = (100 - 4q)*q = 100q - 4q2

MR = (dTR/dq) = 100 - 8q

MC = (dTC/dq) = 10

MR = MC ----> 100 - 8q = 10 ---> q = (90/8) = 11.25

Deriving the Home Currency Deriving the Home Currency Foreign Demand CurveForeign Demand Curve

Assume demand in Japan in ¥en is:

p¥ = 2200 - 110 q

At E = 110 ¥en/$, demand in $ is given by:

p$ = (2200/110) - (110/110) q = 20 - q

Once we get demand and cost in a common currency, this becomes a standard monopoly pricing problem.

Foreign Demand in the Foreign Demand in the Exporter’s CurrencyExporter’s Currency

quantity

$ price

Japanese demandat E = 110 ¥en/$p = 20 - q

20

Foreign Demand Response to Foreign Demand Response to an Appreciation of the an Appreciation of the Exporter’s CurrencyExporter’s Currency

At E = 110 ¥en/$, demand in $ is given by:

p$ = (2200/110) - (110/110) q = 20 - q

At E = 120 ¥en/$, demand in $ is given by:

p$ = (2200/120) - (110/120) q = 18.3 - 0.917 q

Demand in the exporter’s currency rotates inward from the x-intercept.

Foreign Demand Response to Foreign Demand Response to an Appreciation of the an Appreciation of the Exporter’s CurrencyExporter’s Currency

quantity

20

Japanese demand in $ terms rotates in due to $ appreciation:p = 18.3 - 0.917 q

18.3

$

Foreign Demand Response to Foreign Demand Response to an Appreciation of the an Appreciation of the Exporter’s CurrencyExporter’s Currency

quantity

$

MC

MR1

q1

p1

optimal price and quantityfall as a result of appreciationof the exporter’s currencyfor a given MC

MR2

q2

p2

Response to $ appreciationResponse to $ appreciation

Cut $ price (profit margin) to Cut $ price (profit margin) to Japanese buyers to offset Japanese buyers to offset somesome of of the currency swing.the currency swing.

Reduce quantity sold (market share).Reduce quantity sold (market share). Profits fall.Profits fall. Yen price faced by Japanese buyers Yen price faced by Japanese buyers

still increases, unless you absorb still increases, unless you absorb 100% of currency change in margins.100% of currency change in margins.

Optimal Price AdjustmentOptimal Price Adjustment

Profit maximization usually implies export Profit maximization usually implies export price reduction (increase) to offset price reduction (increase) to offset partpart of of export currency appreciation (depreciation). export currency appreciation (depreciation).

The optimal adjustment must tradeoff market The optimal adjustment must tradeoff market share and profit margins. Precise mix share and profit margins. Precise mix depends on market structure and demand.depends on market structure and demand.

Even with optimal adjustment, operating Even with optimal adjustment, operating profits will be affected by a change in the profits will be affected by a change in the exchange rate, all else equal.exchange rate, all else equal.

International Price International Price DiscriminationDiscrimination

When possible, firms should segment When possible, firms should segment buyers in different markets and buyers in different markets and charge optimal prices to each group. charge optimal prices to each group.

If demand conditions vary by market, If demand conditions vary by market, then optimal prices will vary by then optimal prices will vary by market.market.

In some cases, wide differentials can In some cases, wide differentials can be maintained. Example--drugs.be maintained. Example--drugs.

Arbitrage may limit discrimination.Arbitrage may limit discrimination.

Key Issues for Int’l Price Key Issues for Int’l Price AdjustmentAdjustment

What determines the desired mix of What determines the desired mix of margin and share adjustments? margin and share adjustments? • Demand characteristics... Demand characteristics... • Can the markets be segmented?Can the markets be segmented?• Are there long term consequences of Are there long term consequences of

changing prices?changing prices?• How will competitors respond? How will competitors respond? • Is the exchange rate change likely to be Is the exchange rate change likely to be

reversed?reversed?

Discussion QuestionDiscussion Question

Honda Motor claims that “every ¥en the dollar rises against the Japanese currency adds about $40 million to its profits.” Why is Honda’s profit related to the strength of the dollar?

Is this a big deal or a small deal?

Price and Output Response to a Price and Output Response to a Depreciation of the Exporter’s Depreciation of the Exporter’s

CurrencyCurrency

quantity

¥en

MC

MR1

q1

p1

optimal price and quantityrise as a result of depreciationof the exporter’s currencyfor a given MC

MR2

q2

p2

Profit Response to a Profit Response to a Depreciation of the Exporter’s Depreciation of the Exporter’s

CurrencyCurrency

quantity

¥en

MC

q2q1

p2

p1

depreciation of exporter’scurrency increases price, quantity, and profit

Yen/$, Monthly 1990-99

60.0090.00

120.00150.00180.00

19

90

M1

19

90

M1

19

91

M7

19

92

M4

19

93

M1

19

93

M1

19

94

M7

19

95

M4

19

96

M1

19

96

M1

19

97

M7

19

98

M4

19

99

M1

19

99

M1

Is this a big deal for Honda??

¥en/$ in the 1990s: Implications ¥en/$ in the 1990s: Implications for Honda’s Profitsfor Honda’s Profits

1990 to 1995: 150 ¥en/$ to 90 ¥en/$

Profit change = ($40 mill)*(-60) = -$2.4 billion

1995 to 97: 90 ¥en/$ to 125 ¥en/$

Profit change = ($40 mill)*(35) = +$1.4 billion

Profit Response to a Profit Response to a Depreciation of the Exporter’s Depreciation of the Exporter’s

CurrencyCurrency Honda’s profit is positively related to Honda’s profit is positively related to

the value of the dollar.the value of the dollar. This effect is conditional on all else This effect is conditional on all else

equal. In particular, other prices and equal. In particular, other prices and wages in the U.S. and Japan are held wages in the U.S. and Japan are held fixed. fixed.

It is not clear what assumption It is not clear what assumption Honda is making in their claim…Honda is making in their claim…

Firm That Imports InputsFirm That Imports Inputs

•Suppose your firm only sells in domestic markets.

•But your inputs are priced in foreign currency.

•You buy inputs priced in yen, and sell in U.S. market. The exchange rate rises from E = 110 ¥en/$, to E = 120 ¥en/$.

•The dollar price of your imported inputs falls. This leads to a decline in the marginal cost.

•Your firm should lower price and increase quantity sold.

quantity

$

p

p′

MC

MC′

Q′Q

Depreciation of yen lowers dollar marginal cost. Margin increases and market share increases.

Discussion QuestionDiscussion Question

Do you think a “one-yen rise in the value of the dollar” has an impact on the market value of Honda that is greater than or less than $40 million?

Market Value and Currency Market Value and Currency FluctuationsFluctuations

A one-yen depreciation raises current A one-yen depreciation raises current period profit by $40 million.period profit by $40 million.

If it persists, it must raise next period’s If it persists, it must raise next period’s profit by a similar amount, profit by a similar amount, all else all else equalequal..

Market value should equal pdv of Market value should equal pdv of expected future free cash flow.expected future free cash flow.

Thus, the market value effect will Thus, the market value effect will exceed the current period profit effect.exceed the current period profit effect.

Discussion of “Weak Discussion of “Weak Greenback”Greenback”

How are MacDonald’s profits affected How are MacDonald’s profits affected by a weakening of the dollar?by a weakening of the dollar?

What do you predict will happen to What do you predict will happen to euro prices of Big Macs?euro prices of Big Macs?

How might a Wisconsin manufacturer How might a Wisconsin manufacturer who does no international trade who does no international trade benefit from a weaker dollar?benefit from a weaker dollar?

Kodak/S&P500 vs. Real Yen/$

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

Jan-

88

Jan-

89

Jan-

90

Jan-

91

Jan-

92

Jan-

93

Jan-

94

Jan-

95

Jan-

96

Jan-

97

time

log

sc

ale

LJPX2

Kodak

How important is the Yen/$ for Kodak?

Hedging FX RiskHedging FX RiskShould Honda consider hedging currency

risk? What kind of financial policies could help Honda hedge its currency risk?

Honda’s profit and market value are Honda’s profit and market value are positively related to the value of the positively related to the value of the dollar.dollar.

The value of the dollar is outside Honda’s The value of the dollar is outside Honda’s control.control.

Financial policies or investment decisions Financial policies or investment decisions could reduce the sensitivity of Honda’s could reduce the sensitivity of Honda’s cash flows to currencycash flows to currency changes. changes.

Should companies hedge FX Should companies hedge FX risk?risk?

Hedging makes sense only if it can improve the value of the firm.

If capital markets are perfect, there may be no reason to hedge risk.

Arguments against hedgingArguments against hedging

Shareholders can diversify risk Shareholders can diversify risk themselves.themselves.

Hedging is costly. Bid-ask spreads Hedging is costly. Bid-ask spreads can be wide and it requires can be wide and it requires managerial attention.managerial attention.

Hedging equity risk can be very Hedging equity risk can be very complex and require large positions.complex and require large positions.

Hedging equity risk may appear to Hedging equity risk may appear to be speculation.be speculation.

Arguments for hedgingArguments for hedging

It is more costly for shareholders to It is more costly for shareholders to diversify risk than it is firms.diversify risk than it is firms.

Asymmetries in the tax code favor Asymmetries in the tax code favor stable profits.stable profits.

Hedging can lower the expected Hedging can lower the expected costs of financial distress.costs of financial distress.

Hedging can affect future investment Hedging can affect future investment decisions in R&D intensive industries.decisions in R&D intensive industries.

What could Honda do to hedge What could Honda do to hedge FX risk?FX risk?

Honda’s core business benefits from Honda’s core business benefits from a strong dollar. How to offset?a strong dollar. How to offset?• Short the dollar in forward market.Short the dollar in forward market.• Borrow in U.S. dollars rather than Yen.Borrow in U.S. dollars rather than Yen.• Incur more costs in the U.S. to reduce Incur more costs in the U.S. to reduce

net exposure (net exposure (realreal hedging). hedging).

Hedging FX riskHedging FX risk

The general idea is that when your firm has The general idea is that when your firm has an asset denominated in foreign currency, it is an asset denominated in foreign currency, it is wise to acquire a liability in foreign currency.wise to acquire a liability in foreign currency.

The asset may be some future cash flow in The asset may be some future cash flow in foreign currency.foreign currency.

The liability may be costs of production or The liability may be costs of production or debt.debt.

It is important to match the timing of the It is important to match the timing of the payoffs on the assets and liabilities.payoffs on the assets and liabilities.

The WrapThe Wrap

Currency fluctuations create a need for Currency fluctuations create a need for export price and output adjustment. export price and output adjustment.

Even with optimal adjustment, profits and Even with optimal adjustment, profits and market value are affected by a currency market value are affected by a currency change, all else equal.change, all else equal.

In cases where exposure to currency risk is In cases where exposure to currency risk is large, firms may want to hedge in order to large, firms may want to hedge in order to reduce tax liability, avoid costs of financial reduce tax liability, avoid costs of financial distress, or maintain R&D spending.distress, or maintain R&D spending.