Class Notes 10

Foreign Exchange

Momo Deretic
Sauder School of Business
 Main points

1. How exchange rates affect international

price and cost comparisons and the values
of overseas investments

2. Different exchange rate systems

3. How to manage exchange rate risk

 Exchange rates: Why we care

Exchange rates affect:

value of payables, receivables, profits
value of overseas assets/liabilities
international cost competitiveness
 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.
 Two Fundamental Standards
Parity (price): A countrys exchange rate is
over-valued when prices in that country
are too high.
Equilibrium (quantity): A countrys
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. It is based on
Law of One Price
Pc(eppp) = Pus eppp = Pus/Pc

Parity exchange rates can be defined for

individual goods, such as a Big Mac, or
Overall consumption bundles, such as
Consumer Price Index (CPI Parity)
 Parity calculations: an example
(January 2015)
Price of Big Mac in Mexico: 49 MXP
Price of Big Mac in Canada: 5.70 CAD
Price of Big Mac in USA: 4.79 USD
Big Mac Parity: relative prices in own
currencies
Mexico: 49/4.79 = 10.22 MXP/USD or .097
USD/MXP
Canada: 5.70/4.79 = 1.19 CAD/USD or .84
USD/CAD
 Over/under-valuation
Market exchange rate January, 2015
Canada: 1.27 CAD/USD or 0.79 USD/CAD
Mexico: 15.33 MXP/USD or .065 USD/MXP
Overvaluation = (Market Parity)/Parity
Both rates expressed as foreign c.u./local c.u.
Canada: (.79-.84)/.84 = -.06 6%
undervaluation
Mexico: (.065-.097)/.97 = -.33 33%
undervaluation
 Why might PPP not hold?

trade costs
unobserved quality differences
retailing cost differences
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
and 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 equilibrium:
current 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, 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 home
currency)
Ration currency: restrict people from
converting home currency into foreign
currency (restrict people from converting
foreign currency into home currency)
Note: if the currency is free floating, the
government cannot do much.
 Major types of exchange rate risks
Transaction exposure

Translation exposure

Relative cost (economic) exposure

 Transaction 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 to Korea Telecom at current exchange rates.
However, if the Canada dollar depreciates to 600W/$, the value
of the sale falls 25% to 600 million won.
Strategies for lowering risk for Korea Telecom: use
forward/future contract to eliminate risk. (purchase a
contract @800W/$).
 Translation ( accounting) exposure
This measures the impact of currency changes on the
balance sheet or income statement of a company.
Take for example a company that has $1M in losses in
home country and $1M in profits in foreign country. If
exchange rate changes from current 1:1 to 1:0.5 (50%
depreciation), then the profits in foreign country will fall to
$0.5M and the company will experience overall loss in
consolidated accounts.
The same goes for assets denominated in foreign
currency.
The solution is to either buy a future/forward contract for
a particular date in the future, or (in case of balance
sheet items),set up a currency swap (a combination of
spot purchase and a repurchase at some future date).
 Relative cost (economic) exposure

The risk that exchange rate fluctuations

affect your: (1) sales volume (2) price (3)
cost competitiveness relative to your
international competitors.
It depends on the real exchange rate
 Real exchange rate
Real exchange rate: nominal exchange rate adjusted for
changes in 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 rise in Korea by 10% and Canadian prices rise
by 5% but the nominal exchange rate remains unchanged. In
this case, the relative price of Korean goods rises 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.
 Real exchange rate and
economic exposure in terms of costs
Consider a Korean firm exporting into the Canada and
consider the unit labour costs (ULC) of the Korean firm
relative to a Canadian firm. ULC = W/K, where W is
wages and K is productivity (output/worker).
ULCK/ULCC = [en*WK/WC)]*Kk/ Kc]
Suppose that relative wages reflect relative prices
(WK/WC=PK/PC). Then relative unit labour costs depend
on the real exchange rate (e*PK/PC) and relative
productivity (Kc/ Kk).
A real appreciation of the won (i.e., en*PK/PC is rising),
implies that relative unit labour costs are rising for
Korean companies.
 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
Produce differentiated product from those of your rivals
so that competition does not depend so much on relative
costs. If a real appreciation forces you to raise prices in
another market, you will not lose all your demand.
 Key Takeaways - Managing Foreign
Exchange Risk
Accounting Exposure Economic Exposure

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

Financial items at risk Translation: debt/assets Relative costs

Transaction:
payables/receivables

Items to evaluate Accounting statements Price elasticity of demand,

location of production (own
and rival's)

Management response Translation: balance Enhance ability to respond

foreign currency to relative exchange rate
debt/assets, hedges changes: eg, invest in
Transactions: forward excess capacity, outsource,
contracts etc.
Differentiate