Chapter 9: Measuring and managing
Real Exchange Risk
Power Points created by:
Joseph F. Greco Ph. D.
California State University, Fullerton
Mihaylo College of Business and Economics
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Chapter 9: Measuring and Managing
Real Exchange Risk
9.1
How Real Exchange Rates Affect Real
Profitability
9.2
Real Exchange Risk and the Profitability of
Domestic and Foreign Firms
9.3
Sharing the Real Exchange Risk: An Example
9.4
Pricing-to-Market Strategies
9.5
Evaluating the Performance of a Foreign
Subsidiary
9.6
Strategies for Managing Real Exchange Risk
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9.1 How Real Exchange Rates Affect
Real Profitability
• The Real Profitability of an Exporting Firm
• Real profitability: the purchasing power
of a firm’s nominal profits
• Firm’s Reaction to Exchange Rate
Changes:
• Exchange rate pass-through: what does the
management with its pricing when real
exchange rates change?
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9.2 Real Exchange Risk and the
Profitability of Domestic and Foreign Firms
Real Exchange Risk – Profitability of Domestic
and Foreign Firms: Overview
• Introduction
• The Real Exchange Rate Risk of a Net Exporter
• The Real Exchange Risk of a Net Importer
• The Real Exchange Risk of an Import Competitor
• Measuring Real Exchange Risk Exposure
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9.2 Real Exchange Risk and the
Profitability of Domestic and Foreign Firms
• Introduction
• Real exchange risk (operating exposure or
economic exposure)
• With respect to local currency in general:
• A real depreciation hurts importing firms
• A real appreciation hurts exporters
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9.2 Real Exchange Risk and the
Profitability of Domestic and Foreign Firms
• 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
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9.2 Real Exchange Risk and the
Profitability of Domestic and Foreign Firms
• The Real Exchange Risk of a Net Importer
• The Real Exchange Risk of an Import Competitor
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9.2 Real Exchange Risk and the
Profitability of Domestic and Foreign Firms
• Measuring Real Exchange Risk Exposure
• The present value of a firm’s profits
• Who doesn’t have real exchange risk?
• A completely domestic firm
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9.3 Sharing the Real Exchange Risk:
An Example
• Safe Air’s Situation
• Metallwerke A.G.’s Proposal
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9.3 Sharing the Real Exchange Risk:
An Example
•
The Indexing Formula allows for annual
changes in the base dollar price under the
following contingencies:
1.
The base dollar price will be increased at the annual rate of
inflation, as indicated by the U.S. producer price index
2.
If the dollar depreciates relative to the euro, the percentage
change in the base dollar price will equal the U.S. rate of
inflation plus an additional percentage equal to on-half the
rate of depreciation of the dollar relative to the euro
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9.3 Sharing the Real Exchange Risk:
An Example
• 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 = B10,$2 = $400 per tank
Safe Air’s other variable production costs = C10,$2 = $313 per tank
Safe Air’s retail sales price = T10,$2 = $820 per tank
Safe Air’s profit margin = M10,$2 = 15%
U.S. price level = P10,$2 = $50 per U.S. general good
Exchange rate = S10,€>$2 = €2>$
German price level = P10,€2 = €100 per German general good
Metallwerke’s profit margin M10,€2 = 15%
Metallwerke’s production cost = C10,€2 = €696 per tank
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Exhibit 9.1
Profitability When the Price per Tank is
Contractually Fixed
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Exhibit 9.2
Profitability Under Metallwerke’s Proposed
Contract
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Exhibit 9.3
Profitability Under a Contract That Shares
Real Exchange Risk
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9.3 Sharing the Real Exchange Risk:
An Example
• Analyzing contracts when inflation and real
exchange rates are changing:
– Profits with a constant real exchange rate
– Safe Air’s real cost per tank
– Safe Air’s real revenue per tank
– Metallwerke’s real cost per tank
– Evaluating Metallwerke’s proposal
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9.3 Sharing the Real Exchange Risk:
An Example
• Designing a contract that shares the real
exchange risk:
– A contract that shares the risk
– Understanding the contract
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9.3 Sharing the Real Exchange Risk:
An Example
• Would the redesigned contract be
adopted?
– Other factors affecting costs
– Competitiveness and pricing ability
– Relative bargaining strength
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9.4 Pricing-to-Market Strategies
Pricing-to-Market Strategies: Overview
• Pricing to Market
• Some Examples of Pricing-to-Market Strategies
• Pricing to Market by a Monopolist
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9.4 Pricing-to-Market Strategies
• Pricing to Market
• Occurs when a producer charges different prices
for the same good in different markets
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9.4 Pricing-to-Market Strategies
• Some Examples of Pricing-to-Market Strategies
• Luxury cars in the 1980s
• Japanese consumer electronics
• French handbags
• The concept of pricing-to-market
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9.4 Pricing-to-Market Strategies
• Pricing to Market by a Monopolist
• A monopolistic exporter
• A monopolistic net importer
• Empirical Evidence on Pricing-to-Market
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Exhibit 9.4
A Monopolistic Exporter
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Exhibit 9.5
A Monopolistic Exporter When RS=1.2
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Exhibit 9.6
A Monopolist with Imported Costs
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9.5 Evaluating the Performance of a
Foreign Subsidiary
Evaluating the Performance of a Foreign
Subsidiary: Overview
• Three Types of Subsidiaries
• Initial Operating Profitability
• Actual Versus Forecasted Operating Results
• Comparisons the Optimal Response with No
Response by Managers
• Who Deserves a Bonus?
• Assessing the Long-Run Viability of a Subsidiary
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9.5 Evaluating the Performance of a
Foreign Subsidiary
• Three Types of Subsidiaries
• The net importer
• The net exporter
• The neutral firm
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9.5 Evaluating the Performance of a
Foreign Subsidiary
• Initial Operating Profitability:
• Because real exchange rate changes affect
profitability, it complicates the process of
evaluating performance
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Exhibit 9.7
Operating Profit with a One-to-One Real Exchange
Rate Between the Baht and the Yen
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9.5 Evaluating the Performance of a
Foreign Subsidiary
• Actual Versus Forecasted Operating Results
• What did the manager forecast?
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Exhibit 9.8
Actual Operating Profit After a 10% Real
Appreciation of the Yen
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9.5 Evaluating the Performance of a
Foreign Subsidiary
• Comparisons the Optimal Response with No
Response by Managers
• Comparisons with no operating responses
• Comparisons with optimal responses
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Exhibit 9.9
Operating Profit After a 10% Real Appreciation of
the Yen: No Response by Managers
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Exhibit 9.10
Operating Profit After a 10% Real Appreciation of
the Yen: Managers Respond Optimally
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9.5 Evaluating the Performance of a
Foreign Subsidiary
• Who Deserves a Bonus?
• Does real profit exceed the forecast?
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Exhibit 9.11
Actual versus Optimal Operating Profit After a 10%
Real Appreciation of the Yen
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9.5 Evaluating the Performance of a
Foreign Subsidiary
• Assessing the Long-Run Viability of a Subsidiary
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Exhibit 9.12
Operating Profit After a 10% Real Depreciation of
the Yen: Managers Respond Optimally
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9.6 Strategies for Managing Real
Exchange Risk
Strategies for Managing Real Exchange Risk:
Overview
• Transitory Versus Permanent Changes in Real
Exchange Rates
• Production Management
• Marketing Management
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9.6 Strategies for Managing Real
Exchange Risk
• Transitory Versus Permanent Changes in Real
Exchange Rates
• Key element influencing a firm: length of time
the exchange rate is expected to persist
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9.6 Strategies for Managing Real
Exchange Risk
• Production Management
• Production scheduling
• Input sourcing
• Plant location decisions
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Exhibit 9.13
A Production Manager’s Responses to Real
Exchange Rates
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9.6 Strategies for Managing Real
Exchange Risk
• Marketing Management
• Pricing policies
• The frequency of price adjustments
• Market entry decisions
• Brand loyalty
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Exhibit 9.14
A Checklist for Managers of Real Exchange Risk
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