Real Exchange Risk

Definition: the phenomenon whereby the profitability of a firm can change because of fluctuations in the real exchange rate. (= operating exposure or economic exposure)

Value of a firm is represented by the present value of its expected future profitability, thus could affect a firm's cash flows, either through changes in demand or costs.

Pricing to market: producer charges different prices for the same good in different markets.

Depreciation of local currency: hurts net importer but benefits net exporter.

Strategies for managing real exchange risk: 

• Production scheduling: use changes in inventory to meet firm's transitory fluctuations in demand.
• Input sourcing: when domestic currency is strong, domestic firms should use foreign inputs.
• Plant locations: shifting production among existing locations (firm should increase production in countries whose depreciated in currency)
• Pricing policies: when a currency depreciates, exporter to that country face a trade off (profits vs market share). If firm increase price -- they will lose market share, but if the product is inelastic, the exporter could increase its prices by a greater amount.
• The frequency of price adjustment: consumer hates it, thus company should build boundaries that will not trigger a change in price.
• Market entry decision: introducing new product in foreign markets when the foreign currencies are strong -- set up a comparatively low price for product.
• Brand loyalty -- consumer hardly to switch to other competitor's product.

The fisher hypothesis: nominal interest rates should reflect expectations of the rate of inflation. Real rates of return - measures how much your purchasing power has increased over time.

Fundamental exchange rate forecasting: econometric models (money supply, inflation, productivity, growth rates); judgment of future macroeconomic relationships; concerned with multiyear forecasts.

Technical analysis: short term forecasts; using historical data to find pattern; information about the future exchange rate is assumed to be present in past trading behaviour.

The asset market approach: the exchange rate as an asset price, just like stocks -- based on current and future cash flows; fluctuate randomly by people's willingness to hold this particular currencies; the exchange rate as a weighted average of current fundamental and its expected future values; changes as news come out or good/bad expectations.

The monetary approach: real money balance; concerned with the real value of the nominal money; function of money supplies and income levels in two countries; supply money in domestic currency increases--weaken in domestic currency; supply money in foreign currency increases--domestic strengthen; if domestic real income falls--the foreign income rises; or news expected lower domestic growth or faster foreign growth--domestic currency weakens.

Balance of Payments (BOP) = Current Account (export and import) + Capital Account (foreign investment inflows and outflows) + central bank's reserve account = 0
Ex: strong domestic currencies -- foreign goods cheaper -- increase of imports relative to exports -- current account deficit.
Higher interest rates -- increase savings and decrease real investment -- capital account deficit (losing net foreign investment).
Equilibrium: supply and demand force an equilibrium price and quantity of the real exchange rate on the current account through a "goods" channel and a "savings and investment" channel.

Potential spurious pattern: chartist rely on graphs to detect trends rather than on statistics.

Filter rules: provide signals on investors as to when to buy and sell currencies.
x% rules -- buy the currencies if it appreciates by x% above its support level and sell the currencies when it falls x% below its resistance level.
moving average cross-over rules: the average value of an exchange rate over a set of period. Buy (go long)-- short term (y days) moving average crosses the long-term (z days) moving average from below. Sell (go short) if it crosses from above. But, simple moving average rules works better.

Ex-post: correct the nominal interest rate with the realised or ex post rate of inflation; Ex-ante: correct the nominal interest rate with expected inflation.

Higher nominal interest rate -- higher expected rate of inflation -- country's currency expected to depreciate relative to dollar -- trade in forward discount relative to dollar.

Large increase in domestic money supply -- a depreciation of the currency. But it could be offset the money supply effect, if an increase in real income that increase the demand for money.

An increase in government spending or a decrease in taxes that causes a budget deficit should increase the real exchange rate -- increase aggregate demand which causes the real interest rates to rise.