Economic Theories about How Exchange

Rates are Determined: Summary

 Supply and Demand: Foreign exchange rates reflect the demand
and supply of one currency relative to the demand and supply of
another. The demand and supply of currencies is fueled by the
supply and demand of goods and services.
 What can affect supply and demand of goods and services?

 Changes in Income: generally increase in income tends to

cause depreciation of domestic currency against the currency
of a country whose income is not increasing as rapidly.
 Changes in Prices (due to inflation): generally a country
with high inflation should expect its currency to depreciate
against the currency of a country with a lower inflation rate.
 Changes in Interest Rates: currency of a country with a
higher interest rate will initially see an appreciation of its
currency against the currency of a country with a lower
interest rate. Over time, interest rates may equalize and the
International Fisher Effect (IFE) applies.
Economic Theories about How Exchange
Rates are Determined: Summary
 Investor psychology and “bandwagon” effects:
people can influence exchange rates through their
involvement in the foreign exchange market
(speculative actions, capital flight).

 Actions of government: actions to influence

international trade and investment and monetary and
fiscal policies which will impact employment, income
growth, inflation, and interest rates.
 Foreign Exchange
Issues: International
Trade and FDI
Selected topics in lecture and selected topics
from Chapter 10 (pages 357-361) Foreign
Exchange Chapter 19 (pages 650-660)
Accounting Chapter 20 (pages 681-682)
International Financial Management
Forex Issues: International
Trade
& Foreign Direct Investment
Recall→
 International Trade occurs when a company in one
country sells its goods or services to consumers in
another country.
 Foreign Direct Investment occurs when a company
invests money, resources, time, etc. in productive
business operations in another country.
 Companies will convert one currency into another
currency using the foreign exchange market in order to
execute transactions of paying or receiving payments
involved in international trade and foreign direct
investment.
 Foreign exchange risk is the likelihood that unpredictable
or unexpected changes will adversely affect the value of
transactions involved in international trade and foreign
direct investment.
 One method to hedge against uncertainty, especially if
home currency is expected to depreciate, is to secure
forward contracts to lock in exchange rates for currencies
required in future transactions.
 Your bid of US $10,000 for one of the two Maseratis for sale
EXAMPLE: FORWARD was accepted by CSUEBAY. You can take delivery now or in
EXCHANGE thirty days. You check both Spot and the Forward exchange

CSUEBAY
rates to decide when you want to take delivery. What will you
do?

Recall→ Forward exchange contract: An

agreement to buy/sell a foreign currency
for future delivery at a price set now (the
"forward exchange rate").
Purpose: to hedge against the possibility
that future exchange movements will
make a transaction unprofitable by the
time that transaction has been executed.
 Discount on forward: the spot
rate is stronger than the forward
NOW rate (the target currency as
valued by the forward rate is
weaker than the spot rate); the
30 DAYS expectation is that the currency is
depreciating.
 Premium on forward: the spot
rate is weaker than the forward
rate (the target currency as valued
by the forward rate is stronger
than the spot rate);the expectation
is that the currency is appreciating.
Selected Issues in Foreign
Exchange and International
Trade

Export Pricing
Strategies to Manage
International Trade in the face
of changing exchange rates
Level of Pass-Through
Impacts on Consumers
Forex and Export Pricing
 Export pricing, as one of the fundamental
components in International Trade, can be
impacted by exchange rate fluctuations.
 One of the most basic and major decisions in
International trade is how to price products and
services. Examples of basic questions:
 Should a company price products and require payment
in domestic currency or foreign currency?
 When there are exchange range fluctuations, how do
you manage your international trade?

Or ?
Impacts of Forex on
International Trade
 Recall→ whatthe impact of the current value of a
domestic currency is on International Trade:
 Domestic currency is appreciating: imports increase
because foreign goods are less expensive and exports
decrease because they cost more to foreigners.
(country’s exports are less competitive)
 Domestic currency is depreciating: exports increase
because domestic goods cost less for foreigners and
imports decrease because they cost more to local
consumers in the domestic market. (country’s exports
are more competitive)
 Export Management & Price Strategies in
relation to Foreign Exchange
 When Domestic currency is  When Domestic Currency is
weak (depreciating) strong (appreciating)
 Emphasize price benefits.  In order to remain competitive,
 Expand product line and emphasize non price product
more-costly features. characteristics, such as quality,
 Shift sourcing and delivery, after sale service, etc.
manufacturing to domestic  Seek vigorous cost reductions
market. through more efficient
 Exploit export opportunities operations and distribution
in all markets. systems.
 Use conventional cash-for-
goods trade.
 Shift sourcing and
 Use full-costing approach
manufacturing overseas.
but marginal cost approach  Deal in counter trade with
to penetrate weak-currency countries or
new/competitive markets. accept payments in foreign
currencies.
 Accept lower profit margins and
use marginal-cost pricing when
possible.
Extracted and restated from: Chapter 71 Levy, Frerichs, and Gordon, eds.
Marketing Manager’s Handbook, Dartnell Corporation, Chicago, IL. Fig 2.
M2 CALLS IN:
PASS THROUGH OR NO PASS?
M2: Hello, HQ 4670? This is M2. We have a situation you need
to follow-up on. I am at our diamond supplier in Randia (a
country in Africa) inspecting samples of the diamonds we
have purchased under contract with payment and pricing in
randos at time of delivery.” A big shipment of those special
“blue” diamonds is coming in to the U.S. so that our
company can sell them for Valentine’s Day. The exchange
rate of Randian randos (RO) to US $ has appreciated since
our last meeting where we talked about these special
“blue” diamonds. As you might recall, we wanted to hit the
mass market with these blue diamonds and price these out
competitively to get more market penetration/recognition
in order to set up the market for our big June diamond
wedding ring promotion. Our Marketing people need to
determine what % of Pass-Through we are going to allow.
Are we going to Pass-through or not?
Pricing Issues in International Trade:
Exchange Rate Pass-Through
 Pass-through: the degree to which the prices
of imported and exported goods change as a
result of exchange rate changes. (Will prices
be changed to include or reflect exchange
rate changes?)
Pass-through? Or no Pass-through?
 The degree to which exchange rates
fluctuations are “passed through” to product
pricing depends on the price elasticity of a
given product.
Pricing Issues in International Trade:
Exchange Rate Pass-Through
 Remember that a price is considered elastic
if the quantity of demand for a product
changes significantly when there are price
changes.

 Remember that a price is considered

inelastic if the quantity of demand for a
product does not change significantly when
there are price changes.
Pricing Issues in International Trade:
Exchange Rate Pass-Through
 Generally speaking, if a product is relatively price
inelastic, it may often have a high degree of pass-
through. The higher price of certain products may
not have any noticeable impact on the quantity
demanded by consumers, so a company can “pass-
through” (passing on to the consumer the burden of
the foreign exchange rate fluctuation) the increase
(or decrease) in price.
 If, however, products do have price elasticity, their
demand may be impacted by changes in prices due
to foreign currency fluctuation. The degree of pass-
through may be considerably less, depending on how
much the consumer market can sustain.
Other Factors impacting Pricing and
Pass-Through Decisions
 Government actions and regulations
 Productivity and production capacity
of a county
 Sophistication of product
development and quality of marketing
techniques
 Unique characteristics of a particular
industry
Pricing Issues in International Trade:
Exchange Rate Pass-Through
 Example: Blue diamonds from Randia
When blue diamonds from Randia are
exported from Randia to the U.S., the price
should be:
P ROBDR x S = P$BDR

where P$BDR is the price of Blue diamonds from Randia in

dollars, P RO
BDR is the price of Blue diamonds from Randia in
randos and S is the current spot exchange of the
number of U.S. dollars per Rando.
Pricing Issues in International Trade:
Exchange Rate Pass-Through
 Example: Blue diamonds from Randia
Let’s assume that the price of the Blue Diamond in dollars is as
follows based on exchange rate of US$ 2 /rando:
P ROBDR x S = P$BDR

RO 200 x US$ 2 = US$400

What happens to the price of the Blue Diamonds in dollars if the
Rando appreciates by 20%? (i.e. U.S.$ depreciates by 20%). What
happens to the price of the Blue Diamonds in dollars? The exchange
rate is now US$2.40/rando.
RO 200 x US$2.40 = US$480
The company must decide if it can pass the change in the dollar/rando
exchange rate on to the consumer or if it can absorb it in costs. If the
company decides that it can only ask customers to pay a price of
US$460, what is the rate of pass-through?
Pricing Issues in International Trade:
Exchange Rate Pass-Through
 Example: Blue diamonds from Randia, with
20% appreciation of rando price:
P ROBDR x S = P$BDR
200 x US$2.40 = US$480
The company will price at US$ 460. What is the Rate of
pass-through?
1) Determine Rate of increase in price in country doing the
importing: P$BDR2/ P$BDR1
US$460 ÷ US$400 = 1.15 or, in other words a 15%
increase in the U.S. price of Blue Diamonds from Randia.
2) Compare percentage increase of new price of import is to %
increase (or decrease) of exporting country currency.
15% ÷ 20% = .75 or a Pass-through of 75%
Example of Pricing decision due to
foreign exchange rate
PASS-THROUGH
WITH A REDUCTION IN PRICE
Examples of Pass-Through Levels
 Levels of Pass-Through
vary by industry, product,
country, etc.
 If you are a company and
must face changes in exchange
rates, you must consider what
is going on in specific product
markets and industry trends,
not as much what is going on
in the overall economy.

c. 1988 Source: Exchange Rates and Pass-Through

To Pass-Through or Not Pass-
Through—that is the question
 The Impacts of Pass-Through decisions
 If a company changes prices in response to
fluctuations in the exchange rate, the decision
can have a big impact on price competitive and
effectiveness (depending on elasticity or
inelasticity of the product or services being
traded)
 If a company does not change prices in
response to fluctuations in the exchange rate,
the decision can have a big impact on the
profitability of a product line, export sales, etc.
Other Impacts of Forex
fluctuation
Fluctuations in Forex can impact markets/consumers in other ways.
An error in accounting.
 Foreign Exchange Issues in
Foreign Direct Investment
 Foreign Exchange Issues in Foreign Direct
Investment involve issues related to the foreign
exchange risk which can affect the value of
normal transactions of making or receiving
payments (as in international trade), change the
effect of transferring cash and profits among
subsidiaries, and change the long-term value of
these investments.
 Selected Foreign Exchange Issues in FDI include:
 Foreign Exchange Exposures
 Transfer Pricing
 Budgeting and Control systems
 Issues in Foreign Direct Investment:
Types of Foreign Exchange Risk (Chapter 10)
 Managing Foreign Exchange Issues
 Risk that future unpredictable changes in a country’s
exchange rate will hurt the firm.
 Transaction exposure: extent to which income

from transactions is affected by currency

fluctuations.
 Translation exposure: impact of currency

exchange rates on consolidated results and balance

sheet.
 Economic exposure: extent to which a firm’s

future international earning power (from future

prices, sales and costs, etc ) is impacted by
currency fluctuations.
Transaction Exposure
 Transaction exposure: risk of gain or losses in cash
flows which come from contractual obligations due
to changes in foreign exchange rates. (critical issue
in both International Trade and Foreign Direct
Investment)
 Buying goods or services whose prices are in foreign
currencies
 Selling goods or services whose prices are in foreign
currencies
 Borrowing or lending funds requiring payment in foreign
currencies
 Translation Exposure
 Translation Exposure ( also known as Accounting
Exposure): Risk that the conversion of financial
statements expressed in foreign currency to
parent’s reporting currency for consolidation
purposes will result in an adverse change in a
parent’s net worth and reported net income.
 Subsidiaries of multinationals are separate legal entities
but not separate economic entities. Accounting
information about a group of companies that recognizes
economic interdependence (subsidiaries) must be
“translated” into a common currency to generate
consolidated statements.
 Translation Exposure
 Management of FDI’s is also made more complicated due
to national differences in accounting systems and
methods. Comparability of financial reports is made more
difficult as a result.
 The International Accounting Standards Board (IASB) is
working on harmonizing accounting standards across
countries. Current estimate is that no new major
standards will be effective before 2009.
 Preparing consolidated financial statements is the norm
for multinational corporations. It is necessary to get an
overall “big picture” of how the MNC is doing as a
business entity.
 Translation Exposure

 Transactions among members of a corporate family not

included in consolidated financial statements. Only
assets, liabilities, revenue and expenses statements with
external trade parties are shown.

 If financial statements of a subsidiary’s activities are

prepared in the local currency, they have to be converted
into the currency of Multinational’s home country in order
to be included in the consolidated accounts of the
Multinational Corporation.

 Basic question: Is foreign affiliate an integrated entity

(uses parent company currency as currency of operation
[functional currency] ) or is it a self-sustaining entity
which uses local currency as currency of operation
[functional currency]?
Translation Exposure
 If a different exchange rate is used for different
items on an individual financial statement, an
imbalance may result.
 Translation methods identify what exchange rate
is to be used to remeasure each individual
balance sheet and income statement item and
also indicate where any imbalances are to be
recorded.
 Companies can use two main methods (there are
others) to determine what exchange rate should
be used when translating financial statements:
Current Rate Method
Temporal Method
Currency Translation
 The current rate method:
 Exchange rate at the date on the balance sheet is
used to translate foreign subsidiary financial
statements into home country currency.
 Incompatible with ‘historic cost principle’, used in
U.S., Germany, Japan, and other countries. This
principle assumes that currency unit used in
reporting is not losing/gaining value due to inflation.
(e.g. purchase of land)
 Gains or losses due to currency translation
adjustments are not included in consolidated net
income but are accumulated in a separate equity
account (CTA = cumulated translation adjustment)
Currency Translation
 The temporal method:
 Translates foreign subsidiary assets into home-country
currency at the time of purchase of the asset.
 Changing exchange rates may mean the balance sheet
may not balance.
 Translation adjustments are carried in the current
consolidated income, not to equity reserves, thus
introducing more volatility into income statements.
Current U.S. Practice
 Statement 52 “Foreign Currency Translation”
 Self-sustaining autonomous subsidiary:
 Functional currency is local currency.
 Balance sheet uses exchange rate at end of financial year.
 Income statement is financial year average.
 Integral subsidiary:
 Functional currency is US currency.
 Financial statements use the temporal method.
 Dangling credit or debit increases or decreases
consolidated earnings for the period.
 Current U.S. Practice

SOURCE: Eitman, David K.,

Stonehill, Arthur L., Moffet, Michael
H. MULTINATIONAL
BUSINESS FINANCE.
Addison Westley: New York,
2001. p.92
Reducing Transaction &
Translation Exposure
 Secure Forward Exchange contracts and currency
swaps
 Apply lead and lag strategies: accelerate outflows
from weak-currency to strong currency countries
and delay inflows from strong-currency to weak
countries.
 Lead strategy: collecting foreign currency receivables
early when currency devaluation is anticipated and
paying foreign currency payables early when
currency may appreciate.
 Lag strategy: delaying foreign currency receivable
collection when anticipating currency appreciation and
delaying foreign currency payables when currency
depreciation is expected.
 Example: Lead & Lag
Companies tries to minimize foreign exchange problems through
Lead [early] and Lag [late] strategies.
LEAD:
 If U.S. company has a receivable in foreign currency (100 FX) and that foreign
currency is expected to depreciate:
current rate: 2 FX/1US$ = US$50.00
expected rate: 5FX/1US$ = US$20.00
 If U.S. company has a payable in foreign currency (100 FX) and that foreign
currency is expected to appreciate:
current rate: 5FX/1US$ = US$20.00
expected rate:2FX/1US$ = US$50.00
LAG:
 If U.S. company has a receivable in foreign currency (100 FX) and that foreign
currency is expected to appreciate:
current rate: 5FX/1US$ = US$20.00
expected rate:2FX/1US$ = US$50.00

 If U.S. company has a payable in foreign currency (100 FX) and that foreign
currency is expected to depreciate:
current rate: 2 FX/1US$ = US$50.00
expected rate: 5FX/1US$ = US$20.00
Reducing Economic
Exposure
 Economic exposure (also known as economic,
competitive, strategic exposure): more long term,
has to do with the risk of change in the present
value of the firm resulting from changes in future
operation cash flows.
 Reduce Economic exposure:
 Implement operating policies which serve to protect the
company.
 e.g. Establish re-invoicing centers which function as a
management center for all currency exposure
 Seek diversification in strategy: distribute productive
assets to various locations so firm is not severely
affected by exchange rate changes.
 e.g. Japanese automobile makers shift in production
locations
Reducing Economic
Exposure
 Reduce Economic exposure:
 Seek diversification in financing and
investment:
 e.g. Seek out financing in global capital markets to
take advantage of different exchange rates and
interest rates;
 e.g. Retain earnings in different currencies and

repatriate when conditions are most favorable.

FOREX & FDI: Transfer Pricing

 Transfer price is the price set for goods

and services “transferred” intracompany.
 Transfer prices can introduce significant
distortions into the control process.
 Transfer price must be taken into account
when setting budgets and evaluating a
subsidiary’s performance.
FOREX & FDI :Transfer Pricing

 The manipulation of transfer pricing can be used to

gain advantage for multinational corporation. Transfer
pricing is a way of positioning funds within a multinational
company.
 Move founds out of country by setting high transfer fees
or into a country by setting low transfer fees
 Movement can be within subsidiaries or between the
parent and its subsidiaries
 There are several areas in which companies can gain
advantage:
 Reduce tax liabilities by using transfer fees to shift from a high-
tax country to a low-tax country.
 Reduce foreign exchange risk exposure to expected currency
devaluation by transferring funds.
 Use to move funds out of a foreign country where dividends are
restricted or blocked by host-government policy.
 Reduce import duties (ad valorem) by reducing transfer prices
and the value of the goods.
FOREX & FDI :Transfer Pricing
 Few governments like it.
 Believe (rightly) that they are losing
revenue.
 Has an impact on management incentives and
performance evaluations.
 Inconsistent with a ‘profit center’.
 Managers can hide inefficiencies.
 FOREX & FDI:
Budget and Control Systems
 Most multinational businesses require that their foreign
units submit budgets and performance goals which are
expressed in the corporate currency, normally the
home currency of the company. This brings up several
issues:
 Which exchange rates should be used to prepare the
budgets and compare actual to budgeted results?
 Transfer prices must be taken into account when setting
budgets and evaluating a subsidiary’s performance.
 How do you evaluate performance of foreign subsidiaries
when there is large volatility in exchange rates which can
impact financial performance numbers being reported.
General Guidelines for Policies
to Manage Forex Exposure
 Enforce a valid annual budget process which includes:
 Joint determination and agreement by Head office
and subunit management about subunit goals for the
coming year.
 Continual monitoring of subunit performance against
agreed goals.
 If goals not met, analysis, identification of reasons
for shortfall and determination and implementation
of corrective actions when appropriate.
 Make a distinction between valuation of a subsidiary and the
evaluation of the subsidiary manager. Manager’s evaluation
should take into consideration how hostile or benign the
country’s environment is for business and make allowances over
items for which the manager has no control, e.g. inflation or
interest rates, exchange rates.
General Guidelines for Policies
to Manage Forex Exposure
Multinational Corporations with foreign units should
follow basic guidelines.
 Maintain central control of exposure.

 Distinguish between transaction, translation

exposure and economic exposure.

 Forecast future exchange rate movements.

 Establish good reporting systems to monitor

firm’s exposure to exchange rate changes.

 Produce monthly foreign exchange exposure

reports.