GB540 Unit 9 Exchange Rate Exposure Paper Example

When the Krone Falls, Watch the Leader: A Unit 9 Exchange Rate Exposure Paper for an Outboard Maker

[Student Name]

Purdue University Global

GB540: Economics for Global Decision Makers

Unit 9 Exchange Rate Exposure Paper

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[Date]

Ruddiman Marine, its rivals and every rate and figure are composite and illustrative; the economics sources cited are real.

The Exposure

Ruddiman Marine builds every motor in Muskegon, pays its costs in dollars and sells about 40 percent of its motors abroad, in Norway and Australia, at prices set in local currency. When the dollar firms, each krone or Australian dollar of revenue buys fewer dollars, while costs do not change. The paper sets out three scenarios at current prices, before the Unit 6 changes take effect, so the currency effect can be seen on its own.

Scenario 1: The Krone Weakens 10 Percent

The krone moves from 10.60 to 11.66 per dollar. Ruddiman sells about 600 motors in Norway at NOK 49,900, with a delivered cost of $3,288 a motor. At the old rate each motor brings $4,707.50, and contribution is about $851,700.

Volume responds to the krone price, not the dollar price. Below the leader's price of NOK 52,900, the paper uses the US elasticity of minus 2.31 as a proxy. Above it, buyers can switch to the leader's better-known motor at a lower price, so the paper assumes a much higher elasticity, minus 4.0, for any part of a price above NOK 52,900. Both elasticities are assumptions, labeled as such.

Hold at NOK 49,900. Volume stays at 600. Each motor now brings $4,279.60. Contribution falls to about $595,000.

Full pass-through to NOK 54,890. The dollar price is restored to $4,707.50, but the krone price is now above the leader's. Volume falls to about 439. Contribution about $623,100.

Half pass-through to NOK 52,395. Volume about 531. Contribution about $639,800.

A cap just under the leader at NOK 52,500. Volume about 528. Contribution about $641,000.

No option restores the base. The best, pricing just under the leader, recovers about $46,000 of a $257,000 loss. Full pass-through recovers less because it pushes Ruddiman above the leader.

What If the Leader Moves Too?

The Norwegian leader is a European firm whose costs are mostly in euros. If the krone weakens against the euro as well as the dollar, the leader's own krone costs rise, and it may raise its price. Suppose it raises its price to NOK 55,500. Then full pass-through to NOK 54,890 keeps Ruddiman below the leader, volume falls only to about 461, and contribution recovers to about $655,000.

Ruddiman's Norwegian exposure is not a fixed number set by the currency, because the price it can charge depends on what the leader does with its own exposure.

This is why the answer depends more on the rival than on the currency. Gopinath et al. (2010) found that how much of an exchange rate change reaches import prices depends on the currency in which goods are priced, a choice their model ties to how strongly firms respond to rivals' prices, and Campa and Goldberg (2005) found that pass-through into import prices is incomplete in the short run in most industrial countries. A firm whose main rival prices in a different currency faces a market price that moves with the rival's costs, not only its own.

Scenario 2: The Australian Dollar Falls 8 Percent

The rate moves from 1.52 to about 1.652 Australian dollars per US dollar. Ruddiman sells about 808 motors in Australia at AUD 7,400, with a landed cost of $3,214. Base contribution is about $1.337 million. Australia has no dominant rival, and the measured elasticity from Unit 2 is minus 1.91.

Hold at AUD 7,400. Contribution falls to about $1.022 million.

Half pass-through to AUD 7,722. Volume about 741. Contribution about $1.082 million.

Full pass-through to AUD 8,043. Volume about 674. Contribution about $1.115 million, the best of the three.

In Australia, full pass-through is best, because demand there is less elastic and no leader caps the price. It recovers about $93,000 of a $315,000 loss.

Scenario 3: The Won Strengthens 5 Percent

Ruddiman buys its battery packs from South Korea, priced in won. A 5 percent stronger won raises each pack from $1,400 to $1,470. At 3,600 motors, the annual pack bill rises by about $252,000. This exposure falls on every motor, wherever it is sold, and raises marginal cost by $70, which would push the Unit 6 optimum prices up by about half that amount in each market.

Reading the Three Scenarios Together

The three scenarios differ in kind. The Norwegian exposure is competitive: the loss depends on what the leader does, and no price Ruddiman sets alone restores the base. The Australian exposure is closer to a pure price problem: with no leader capping the price and a moderate elasticity, Ruddiman can pass most of a currency fall to buyers and lose some volume. The won exposure is a cost problem that touches every market at once and cannot be passed through in one market without the others.

The three can also arrive together. When the dollar gains on Ruddiman's two sales currencies, the gain is often accompanied by movements against the won, since all three respond to the same changes in US interest rates. If the krone and the Australian dollar fell as assumed while the won held steady, the revenue losses would total about $571,000 before repricing and about $432,000 after the best response in each market. That figure, about 7 percent of current total contribution, is the size of the risk the treasury team should be asked to manage.

What Forward Contracts Can and Cannot Cover

Forward contracts can lock in the exchange rate on revenue Ruddiman already expects, such as the Norwegian and Australian distributors' spring orders, and on pack purchases already contracted. They protect a season's cash flows.

They cannot protect against the competitive effects described above. If the krone stays weak for several seasons, a forward contract covering one season only delays the problem. Allayannis et al. (2001) found that operational hedges, such as spreading production or sourcing across countries, were not an effective substitute for financial hedging, and that firms benefited when they combined the two. For Ruddiman, an operational response might be sourcing packs from a second supplier priced in dollars, which would reduce the won exposure, or assembling some Norwegian motors in Europe, which would put some costs in the same currency as the leader's.

Recommendation

Hedge one season of Norwegian and Australian revenue and contracted pack purchases with forwards. In Norway, if the krone weakens, price just under the leader and watch the leader's next price announcement before moving further. In Australia, pass a currency fall through in full. Begin pricing a second pack supplier in dollars.

References

Allayannis, G., Ihrig, J., & Weston, J. P. (2001). Exchange-rate hedging: Financial versus operational strategies. American Economic Review, 91(2), 391-395. https://doi.org/10.1257/aer.91.2.391

Campa, J. M., & Goldberg, L. S. (2005). Exchange rate pass-through into import prices. The Review of Economics and Statistics, 87(4), 679-690. https://doi.org/10.1162/003465305775098189

Gopinath, G., Itskhoki, O., & Rigobon, R. (2010). Currency choice and exchange rate pass-through. American Economic Review, 100(1), 304-336. https://doi.org/10.1257/aer.100.1.304