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  1. 1. Suppose the $ collapses… Who benefits from a $ fall? Who loses? <ul><li>When a currency depreciates (appreciates), domestic goods become relatively less (more) expensive compared to foreign goods. </li></ul><ul><li>However, this is not always the case as many exporting companies do not change their prices, when exchange rates change, but instead absorb the costs (or profits). </li></ul>
  2. 2. <ul><li>For example, between Jan 1994 and April 1995, the Japanese yen appreciated by 34% against the dollar. </li></ul><ul><li>We would therefore expect the price of Japanese products sold in the US to be about 34% more expensive as a result of the appreciation of the yen. The price of Toyota Celica made in Japan increased by only 2%… </li></ul><ul><li>The price of large-screen SONY Trinitron fell by 15%… </li></ul><ul><li>What happened? </li></ul>Introduction
  3. 3. Background <ul><li>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. dollar have an &quot;asymmetric &quot; impact on the U.S. trade balance.” That means 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 imports in other countries. </li></ul><ul><li>&quot;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 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 7% of GDP is unsustainably high and an adjustment is inevitable. </li></ul><ul><li>“ 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 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 least a limited swing to euros from $ are China, South Korea, Sweden and Russia. </li></ul><ul><li>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 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 bid-ask spreads in the London currency market, are in some cases cheaper than for the $. &quot;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”.   </li></ul>
  4. 4. Exchange Rate Pass Through <ul><li>The percentage change in local currency import prices resulting from a one percent change in the exchange rate between the exporting and importing countries </li></ul><ul><ul><li>In the language of ERPT, a theoretical one-for-one response of import prices to exchange rates is known as “full” or “complete” ERPT </li></ul></ul>
  5. 5. <ul><li>Full ERPT occurs when, </li></ul><ul><ul><ul><li>There are constant markups of price over cost </li></ul></ul></ul><ul><ul><ul><li>Constant marginal costs </li></ul></ul></ul><ul><ul><ul><li>Perfect competition </li></ul></ul></ul><ul><li>However, if market is monopolistically competitive, then ERPT isn’t complete. Some or all of the impact of the change in interest rates on prices is “swallowed” by producers’ pricing decisions. </li></ul>ERPT
  6. 6. <ul><li>Some research findings </li></ul><ul><li>Pass-through to U.S import prices = 65% during the 80s but has declined to 20% </li></ul><ul><li>Pass-through to Germany = 30% </li></ul><ul><li>ERPT in Ireland – 50% ERPT to Italy, 47% </li></ul><ul><li>ERPT in France is now 16% (used to be 50%) </li></ul><ul><li>Industry-specific estimates are different due to differentiated markup adjustment across industries. </li></ul><ul><li>Why would markup adjustments be different? </li></ul>Incomplete ERPT
  7. 7. Incomplete ERPT and Markup <ul><li>Industry-specific estimates are different due to differentiated markup adjustment across industries. </li></ul><ul><li>Why would markup adjustments be different? </li></ul>
  8. 10. <ul><li>Differences in demand curvatures explains the difference in markup adjustments in different industries. </li></ul><ul><li>Moreover, a change in the exporter’s exchange rate can affect the price charged in two ways: </li></ul><ul><ul><ul><li>By affecting marginal costs </li></ul></ul></ul><ul><ul><ul><li>By affecting the elasticity of demand </li></ul></ul></ul>Pricing to Market (PTM)
  9. 14. Pass-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/auto Complete Pass-through Invoicing? $20,000/auto ¥2,000,000/auto ¥100/$ No Pass-through Complete pass-through  Toyota maintains profit/unit in ¥
  10. 15. 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?
  11. 16. Theory of Incomplete Pass-Through 2. 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/$)( $20,000/auto) = ¥2,000,000 How could you arbitrage this? Impact on Prices? Why is this arbitrage not possible in practice? - tariffs at the border - different environmental and safety standards - warranties and service linked to location of purchase
  12. 17. Discussion Question You are a U.S. producer selling goods in Japan and the U.S. Originally E = 110 ¥/$. 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?
  13. 18. Profit or Loss? <ul><li>Suppose US exporter interested in China. Currently, you can produce CDs that cost 640 Yuan and goal is to sell it at $10 as this is market rate. </li></ul><ul><li>At 8 Y/$, …. Profit? </li></ul><ul><li>Suppose Yuan appreciates 20%...Profit? </li></ul><ul><li>Suppose goal is to sell it to export to other county, does the $ depreciation still hurt? </li></ul>
  14. 19. Monopoly Pricing D MR MC q* p* To maximize profit, the monopolist chooses q where MR = MC. $ quantity
  15. 20. Standard Monopoly Pricing Example Demand: p = 100 - 4 q Cost: TC = 100 + 10q TR = p*q = (100 - 4q)*q = 100q - 4q 2 MR = (dTR/dq) = 100 - 8q MC = (dTC/dq) = 10 MR = MC ----> 100 - 8q = 10 ---> q = (90/8) = 11.25
  16. 21. Deriving the Home Currency Foreign 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.
  17. 22. Foreign Demand in the Exporter’s Currency quantity $ price Japanese demand at E = 110 ¥en/$ p = 20 - q 20
  18. 23. Foreign Demand Response to an Appreciation of the Exporter’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.
  19. 24. Foreign Demand Response to an Appreciation of the Exporter’s Currency quantity 20 $ Japanese demand in $ terms rotates in due to $ appreciation : p = 18.3 - 0.917 q 18.3
  20. 25. Foreign Demand Response to an Appreciation of the Exporter’s Currency quantity $ MC MR 1 q 1 p 1 optimal price and quantity fall as a result of appreciation of the exporter’s currency for a given MC MR 2 q 2 p 2
  21. 26. Response to $ appreciation <ul><li>Cut $ price (profit margin) to Japanese buyers to offset some of the currency swing. </li></ul><ul><li>Reduce quantity sold (market share). </li></ul><ul><li>Profits fall. </li></ul><ul><li>Yen price faced by Japanese buyers still increases, unless you absorb 100% of currency change in margins. </li></ul>
  22. 27. Optimal Price Adjustment <ul><li>Profit maximization usually implies export price reduction (increase) to offset part of export currency appreciation (depreciation). </li></ul><ul><li>The optimal adjustment must tradeoff market share and profit margins. Precise mix depends on market structure and demand. </li></ul><ul><li>Even with optimal adjustment, operating profits will be affected by a change in the exchange rate, all else equal. </li></ul>
  23. 28. International Price Discrimination <ul><li>When possible, firms should segment buyers in different markets and charge optimal prices to each group. </li></ul><ul><li>If demand conditions vary by market, then optimal prices will vary by market. </li></ul><ul><li>In some cases, wide differentials can be maintained. Example--drugs. </li></ul><ul><li>Arbitrage may limit discrimination. </li></ul>
  24. 29. Key Issues for Int’l Price Adjustment <ul><li>What determines the desired mix of margin and share adjustments? </li></ul><ul><ul><li>Demand characteristics... </li></ul></ul><ul><ul><li>Can the markets be segmented? </li></ul></ul><ul><ul><li>Are there long term consequences of changing prices? </li></ul></ul><ul><ul><li>How will competitors respond? </li></ul></ul><ul><ul><li>Is the exchange rate change likely to be reversed? </li></ul></ul>
  25. 30. Discussion Question Honda Motor claims that “every ¥en the dollar rises against the Japanese currency adds about $40 million to its profits.” Why is Honda’s profit related to the strength of the dollar? Is this a big deal or a small deal?
  26. 31. Price and Output Response to a Depreciation of the Exporter’s Currency quantity ¥en MC MR 1 q 1 p 1 optimal price and quantity rise as a result of depreciation of the exporter’s currency for a given MC MR 2 q 2 p 2
  27. 32. Profit Response to a Depreciation of the Exporter’s Currency quantity ¥en MC q 2 q 1 p 2 p 1 depreciation of exporter’s currency increases price, quantity, and profit
  28. 33. Is this a big deal for Honda??
  29. 34. ¥en/$ in the 1990s: Implications for 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) = +$1.4 billion
  30. 35. Profit Response to a Depreciation of the Exporter’s Currency <ul><li>Honda’s profit is positively related to the value of the dollar. </li></ul><ul><li>This effect is conditional on all else equal. In particular, other prices and wages in the U.S. and Japan are held fixed. </li></ul><ul><li>It is not clear what assumption Honda is making in their claim… </li></ul>
  31. 36. Firm That Imports Inputs <ul><li>Suppose your firm only sells in domestic markets. </li></ul><ul><li>But your inputs are priced in foreign currency. </li></ul><ul><li>You buy inputs priced in yen, and sell in U.S. market. The exchange rate rises from E = 110 ¥en/$, to E = 120 ¥en/$. </li></ul><ul><li>The dollar price of your imported inputs falls. This leads to a decline in the marginal cost. </li></ul><ul><li>Your firm should lower price and increase quantity sold. </li></ul>
  32. 37. quantity $ p p ′ MC MC ′ Q ′ Q Depreciation of yen lowers dollar marginal cost. Margin increases and market share increases.
  33. 38. Discussion 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?
  34. 39. Market Value and Currency Fluctuations <ul><li>A one-yen depreciation raises current period profit by $40 million. </li></ul><ul><li>If it persists, it must raise next period’s profit by a similar amount, all else equal . </li></ul><ul><li>Market value should equal pdv of expected future free cash flow. </li></ul><ul><li>Thus, the market value effect will exceed the current period profit effect. </li></ul>
  35. 40. Discussion of “Weak Greenback” <ul><li>How are MacDonald’s profits affected by a weakening of the dollar? </li></ul><ul><li>What do you predict will happen to euro prices of Big Macs? </li></ul><ul><li>How might a Wisconsin manufacturer who does no international trade benefit from a weaker dollar? </li></ul>
  36. 41. How important is the Yen/$ for Kodak?
  37. 42. Hedging FX Risk <ul><li>Should Honda consider hedging currency risk? What kind of financial policies could help Honda hedge its currency risk? </li></ul><ul><li>Honda’s profit and market value are positively related to the value of the dollar. </li></ul><ul><li>The value of the dollar is outside Honda’s control. </li></ul><ul><li>Financial policies or investment decisions could reduce the sensitivity of Honda’s cash flows to currency changes. </li></ul>
  38. 43. Should companies hedge FX 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.
  39. 44. Arguments against hedging <ul><li>Shareholders can diversify risk themselves. </li></ul><ul><li>Hedging is costly. Bid-ask spreads can be wide and it requires managerial attention. </li></ul><ul><li>Hedging equity risk can be very complex and require large positions. </li></ul><ul><li>Hedging equity risk may appear to be speculation. </li></ul>
  40. 45. Arguments for hedging <ul><li>It is more costly for shareholders to diversify risk than it is firms. </li></ul><ul><li>Asymmetries in the tax code favor stable profits. </li></ul><ul><li>Hedging can lower the expected costs of financial distress. </li></ul><ul><li>Hedging can affect future investment decisions in R&D intensive industries. </li></ul>
  41. 46. What could Honda do to hedge FX risk? <ul><li>Honda’s core business benefits from a strong dollar. How to offset? </li></ul><ul><ul><li>Short the dollar in forward market. </li></ul></ul><ul><ul><li>Borrow in U.S. dollars rather than Yen. </li></ul></ul><ul><ul><li>Incur more costs in the U.S. to reduce net exposure ( real hedging). </li></ul></ul>
  42. 47. Hedging FX risk <ul><li>The general idea is that when your firm has an asset denominated in foreign currency, it is wise to acquire a liability in foreign currency. </li></ul><ul><li>The asset may be some future cash flow in foreign currency. </li></ul><ul><li>The liability may be costs of production or debt. </li></ul><ul><li>It is important to match the timing of the payoffs on the assets and liabilities. </li></ul>
  43. 48. The Wrap <ul><li>Currency fluctuations create a need for export price and output adjustment. </li></ul><ul><li>Even with optimal adjustment, profits and market value are affected by a currency change, all else equal. </li></ul><ul><li>In cases where exposure to currency risk is large, firms may want to hedge in order to reduce tax liability, avoid costs of financial distress, or maintain R&D spending. </li></ul>