Suppose a bottle of French wine is priced in France at 1000 Euros. If the e = $1/€, the cost to an American is €1000 x ($1 / €) = $1000. Conclusion: __________________ . If the Euro appreciates ($ depreciates), will the French wine be more or less expensive? __________________ Proof: if e = $1. 20 / €, the cost to an American is €1000 x ($1. 20 / € ) = $1200. If the Euro depreciates ($ appreciates), will the French wine be more expensive or less? __________ Proof: if e = $. 80 / €, the cost to an American is €1000 x ($. 80 / €) = $800.
Therefore, the price could fluctuate between $800-$1200, depending on currency movements. POINT: if the dollar is strong (weak), French wine is cheaper (more expensive) for an American. The value of the $ in relation to the € will affect the price of foreign goods for an American. When the dollars appreciates, foreign goods/assets/services are CHEAPER. When the dollar depreciates, foreign goods/assets/services are MORE EXPENSIVE. SUMMARY of the Advantages/Disadvantages of a Strong/Weak Currency: 1. Strong dollar = Weak foreign currency: a.
Advantages: foreign goods and services are cheap, including foreign travel. Helps the import sector of the economy, companies that sell foreign goods (Toyota dealers). Helps U. S. companies buying foreign inputs. Helps U. S. consumers – imports are cheaper. b. Disadvantages: U. S. exports are expensive, including tourism in U. S. Hurts the export sector, companies that sell abroad, makes them less competitive. Hurts the import-competing sector – GM, for example (Toyotas from Japan are now cheaper). Domestic goods are less competitive overseas and here, because strong $ = weak foreign currency. . Weak dollar = Strong foreign currency: a. Advantages: Helps the U. S. export sector. Our goods and services are cheap overseas, including tourism in US. Helps the import-competing sector like GM, domestic goods are more competitive (Toyotas made in Japan are more expensive). b. Disadvantages: Hurts the import sector of the economy (BMW and Toyota dealers). Hurts US companies buying foreign inputs (50% of imports are inputs and NOT finished goods). Hurts U. S. consumers – imports are more expensive, e. g. il, coffee, bananas, German wine and beer, foreign travel, diamonds, for example. The examples above illustrate CURRENCY RISK – the possibility of an adverse exchange rate movement. Currency risk is an important consideration for almost all businesses because 1) most companies either buy foreign inputs or sell their output in other countries, 2) exchange rates are unpredictable and 3) contracts for purchases (imports, foreign inputs) and sales (export) are made far in advance. If a contract is stated in a foreign currency, one party is exposed to currency risk. Example: U.
S. computer manufacturer (importer) agrees by contract to buy computer parts in 6 months from a firm in Japan for ? 100,000 /unit. If the ex-rate ? 100 /$ in 6 months, the parts cost $1000. If the ex-rate is ? 80 / $ ($ weakens) the price is $1250/unit. Currency risk for the importer is that the dollar might depreciate over the next six months, meaning that it becomes more expensive to buy ? and more expensive to buy the foreign import. Risk can work both ways: if the ex-rate is 125? / $ (dollar appreciates, Yen depreciates) in 6 months, the cost is only $800.
In this case, the dollar got stronger, so it became cheaper to buy Yen, and the foreign product (priced in a fixed amount of Yen) became cheaper. Ex-rate volatility (currency risk) means the cost of parts could range between $800-1250 over the next 6 months for the U. S. manufacturer. Imagine if you were building a house, it would be complete in 6 months, and the range for the final cost was between $80,000-125,000! RISK FOR THE IMPORTER: They have to buy Yen 6 months from now to buy the imported product, they are worried that the $ will get weaker, making it more expensive to buy the foreign product.
If you have to pay a fixed amount of foreign currency in the future, you are worried about your domestic currency getting weaker in the future because it will cost you more money in dollars to buy the import. Example: U. S. Exporter agrees in a contract to sell beef to a buyer in Japan for ? 500 / lb. in 6 months. If the e = ? 100 / $, the U. S. exporter receives $5/lb. If e = ? 80 / $, (dollar weakens, Yen strengthens), the exporter gets $6. 25/lb. If e = 125Yen/$ (dollar strengthens, Yen weakens) he gets $4/lb. Range for the sales revenue is between $4. 00-6. 5/lb. Currency risk for the exporter is that the Yen could weaken over the next six months, dollar strengthen. RISK FOR EXPORTER: They are receiving a fixed amount of foreign currency in the future, they are worried about the foreign currency getting weaker in the future, meaning fewer dollars in the future for the sale of the exported product. What can importers/exporter do about currency risk? 1. Negotiate the contract in domestic currency ($). 2. Wait and see. Take the risk of using spot market at time of delivery, and hope for a favorable ex-rate movement. 3.
Lock in a forward ex-rate today with a forward contract, either for the entire amount (full hedge) or for a portion of the total (partial hedge). Example: Importer needs to buy Yen in six months. He/she can buy Yen forward today at the 6 month forward rate, and lock in a guaranteed ex-rate now for when the contract is due in 6 months. Locking in an ex-rate locks in a cost of the imported product in US dollars. If they will need ? 10m, they can buy ? 10m forward (full hedge) or just ? 5m for example (partial hedge). Exporter will receive ? in six months, and convert into (sell for) US dollars.
They can sell Yen forward now at the 6 month forward rate. Lock in a guaranteed ex-rate, and thereby lock in a fixed amount of revenue in US dollars. Full hedge or partial, sell ? 10m forward, or just ? 5m forward. Forward rates and forward contracts for currency allow companies doing intl. business to manage, control and predict costs and revenues by hedging to reduce or eliminate currency risk. EXCHANGE RATES IN THE LONG RUN: What determines Ex-rates? Basically, the Supply and Demand for currency determines ex-rates, market forces, like any commodity or asset.
We first look at ex-rates in the long-run (LR) and then ex-rates in the short-run (SR). LAW OF ONE PRICE (LOP): starting point for understanding ex-rates in the LR. Also called the “price equalization principle”: for homogeneous, identical goods, the price of the commodity should be the same (equalize) throughout the world, especially when barriers to trade, transactions costs and transportation costs are low. Says that foreign prices (Pf ), domestic prices (Pd) and ex-rates (e) are linked through the Law of One Price which says: Pd ($) = e * Pf (? ) , where e = $ / ?.
LOP says that similar products should sell for the same price in both countries, after converting the foreign price into dollars. Example: Price of gold in U. S. = $260 (Pd) , Price of gold in Canada = C$400 (Pf) and e = $0. 65 / C$. LOP holds: $260 = ($. 65/C$) x C$400, says that gold sells for the same price ($260/ounce) in both the U. S. and Canada, after converting the foreign price into $. The price of gold should equalize around the world and sell for about the same price everywhere: $260/ounce. What if somewhere in the world, P ; $260/oz, what would happen?
What if somewhere in the world, P ; $260, what would happen? ARBITRAGE: Riskless profits from exploiting price discrepancies. Example: What if gold was cheaper in Canada than in US? In U. S. , P=$260 and in Canada, P = $255? [Pd ($) ; e * Pf (C$)] Two effects: 1) People would _________ gold in Canada, __________ gold in U. S. Price in Canada would __________ and price in U. S. would _____________. 2) People would first buy __________ to buy Canadian gold, and would also sell _________ to buy Canadian dollars. Can $ would ________, US $ would ________, ex-rate ($/C$) would ___________.