Foreign exchange and relative costs

• Objectives of this session– Learn how exchange rates affect international

cost comparisons and the values of overseas investments

– Understand different exchange rate systems– Acquire knowledge of managing exchange

rate risk

Exchange rate variability

Asian Currency Indexes Jan 1 1997 =100

Exchange rates: Why we care

• Exchange rates affect:– value of payables, receivables– international cost competitiveness – value of overseas assets/liabilities

Evaluate the effect of a foreign currency (¥) devaluation on

$ profits for cases A, B, C, and D

Production

Home ($)Foreign

(¥)Sale

Home ($) A BForeign (¥)

C D

Cost comparisons

• You want to buy the DVD movie Serenity– amazon.ca: 25.96 CAD– amazon.com: 17.99 USD– amazon.co.uk: 13.99 GBP

• Exchange rates are 1.16 CAD/USD, 1.76 USD/GBP

• What is the CAD/GBP exchange rate?

• Which is the best buy?

Exchange rate regimes

• Freely Floating exchange rates: These move freely according to supply and demand although government central banks may buy and sell currency to influence values.

• Pegged exchange rates: A currency that has a fixed value against another currency or basket of currencies.

• Managed float: Currencies that have some flexibility to move against other currencies. Some governments try to maintain exchange rates within a certain "band" around, say, the U.S. dollar.

Exchange rate regimes

China/HK

Can we predict future exchange rates?

• Not very accurately.– Floating exchange rates move a lot, but—in

the short run—are about as likely to go up as to go down.

– Fixed exchange rates usually eventually fall, but the timing of the collapse is hard to predict.

• Fundamentals do matter, sometimes:

“Over-valued” currencies fall and “under-valued” currencies rise in the long run.

Two Fundamental Standards

• Parity (price): A country’s exchange rate is over-valued when prices in that country are too high.

• Equilibrium (quantity): A country’s exchange rate is over-valued when it runs chronic current account deficits

Parity Standards

• A “parity” exchange rate is a hypothetical rate that would equalize price levels in the home and foreign country.– Pc(eppp) = Pus eppp = Pus/Pc

• Parity exchange rates can be defined for– individual goods, such as a Big Mac or Latte– Overall consumption bundles, such as

Consumer Price Index (CPI Parity)

Parity calculations: an example

• Price of Big Mac in Mexico: 23 MXP• Price of Big Mac in Canada: 3.20 CAD• Price of Big Mac in USA: 2.71 USD• Big Mac Parity: relative prices in own

currencies– Mexico: 23/2.71 = 8.49 MXP/USD or .118

USD/MXP– Canada: 3.2/2.71 = 1.18 CAD/USD or .85

USD/CAD

Over/under-valuation

• Market exchange rate on April 22nd, 2003– Canada: 1.45 CAD/USD or 0.69 USD/CAD– Mexico: 10.53 MXP/USD or .095 USD/MXP

• Overvaluation = (Market –Parity)/Parity – Both rates expressed as foreign c.u./local c.u.– Canada: (.69-.85)/.85 = -.19 19%

undervaluation– Mexico: (.095-.118)/.118 = -.19 19%

underval.

Cost comparisons

• You want to buy the DVD movie Serenity– amazon.ca: 25.96 CAD– amazon.com: 17.99 USD– amazon.co.uk: 13.99 GBP

• Exchange rates are 1.16 CAD/USD, 1.76 USD/GBP

• According to DVD purchasing power parity, how much are the Canadian dollar and British pound over or under valued relative to the U.S. dollar? How about the pound relative to the Canadian dollar?

Big Max IndexJuly 13, 2009

Why might PPP not hold?

Why might PPP not hold?

• trade costs

• unobserved quality differences

• retailing cost differences (non-tradables)

• tax differences

Equilibrium Standard

• Equilibrium in the foreign exchange market occurs when the supply of a currency equals the demand for that currency. In a world with no international lending, supply and demand derives from imports and exports

– If, at a given exchange rate, a country wants to import (supply home currency) more than it is able to export (foreigners’ demand home currency), then the home currency must depreciate.

– equilibrium in the foreign exchange market occurs when imports equal exports (balanced trade).

• Countries can run trade deficits only if foreigners are willing to lend them money.

Equilibrium Standard

Balance of payments equilibriumcurrent account + financial account = reserves– where the current account equals goods trade, service trade,

and income (payments for borrowing/lending), the financial account reflects portfolio and direct investment, and reserves is change in central government (foreign) reserves.

• A current account deficit must be financed by foreign lending (a surplus in the financial account) or changes in government reserves.

• Since we do not expect foreigners to lend money to countries indefinitely and government reserves are finite, a country running a chronic current account deficit is likely to have its currency depreciate until its current account is in balance.

Defending your currency

• What can government do to keep its currency from depreciating (appreciating)?– Raise interest rates (lower interest rates)– Buy home currency using reserves (sell local

currency)– Ration currency: restrict people from

converting home currency into foreign currency (restrict people from converting foreign currency into local)

Managing exchange rates riskTransaction exposure: • This is the extent that short-term cash flows are affected

by fluctuations in foreign exchange. These can include payments associated with lending, borrowing, purchases, or sales.– Example: Suppose a Canadian client of Korea Telecom will pay

$1 million next month for telecommunication services and the current exchange rate is 800W/$. This means the sale is worth 800 million won at current exchange rates. However, if the Canada dollar depreciates to 600W/$, the value of the sale falls 25% to 600 million won.

• Strategies for lowering risk: use forward contracts to eliminate risk.

Translation exposure• This measures the impact of currency changes on the

balance sheet of a company. – Suppose a Canadian company owns a factory in Mexico valued

at 3 million pesos and the exchange rate in 3P/$, implying an asset of $1 million for the Canadian company. Now suppose the peso falls to 5P/$. Now the factory is worth only $600,000 in the home currency.

• Strategies for lowering risk: match the levels of liabilities and assets that are denominated in the same currency. A Korean firm wishing to build a $1 million factory in Canada could borrow $1 million in Canada to build the factory. That way it will have a $1 million dollar asset and a $1 million liability. Any changes in nominal exchange rates will have offsetting effects on the balance sheet.

Relative cost (economic) exposure

• The risk that exchange rate fluctuations affect your cost competitiveness relative to your international competitors.

• It depends on the real exchange rate

Real exchange rate• Real exchange rate: nominal exchange rates adjusted

for price levels. The real exchange rate should be interpreted as being a measure of relative prices (in a common currency) er = en(PK/PC)where en is nominal exchange rate expressed as $/won, er is real exchange rate, and PC,PK are prices in Canada, Korea.– Suppose prices/wages rise in Korea by 10% and Canadian

prices/wages rise by 5% but the nominal exchange rate remains unchanged. In this case, the relative price of Korean wage costs rise or Korea has experienced a real appreciation of its currency (even though its nominal exchange rate has not changed).

– Purchasing power parity implies that the real exchange rate is constant and equal to one and that nominal exchange rates changes reflect differences in inflation rates.

Strategies for reducing risk of economic exposure

• Outsource from multiple countries and adjust purchases according to changes in the real exchange rate (i.e., increase sourcing from countries experiencing real depreciation.)

• Operate factories in multiple countries and maintain excess capacity. Shift production towards countries experiencing real depreciation (Black and Decker example).

Managing Foreign Exchange Risk

Accounting Exposure Economic Exposure

Key exchange rate Nominal (e) Real (eP*/P)

Financial items at risk Translation: debt/assetsTransaction: payables/receivables

Relative costs

Items to evaluate Accounting statements Location of production (own and rival's)

Management response Translation: balance foreign currency debt/assetsTransactions: forward contracts

Enhance ability to respond to relative exchange rate changes: eg, invest in excess capacity, outsource, etc.

“When Currencies Collapse”“On a won and a prayer”

“The dollar is dandy again”

• For each article, what happened to relevant currency? Why?

• For the following firms that appear in the articles, discuss the consequences of the exchange rate change on revenues, costs, and assets/liabilities.– Korean Air– Delta Electronics and Thai Petrochemical Industries – Google and Yahoo, Philip Morris, Caterpillar,

Manpower