Aug 29

Foreign Exchange: Adding Competition (2007 FRM)

by David Harper, CFA, FRM, CIPM

FRM | Risk |

supplyDemandCurveIntro2

Learning Outcome

  • LO 19.11: Using supply (marginal cost) and demand analysis, illustrate the competitive exposure to exchange rate risk for an exporting firm, considering changes in (i) exchange rates between the firm's currency and the currency of the importing country and (ii) exchange rates between the currency of a third country (that has exporters that compete with the firm) and the currency of the importing country.

To price and quantity risk, add competition

In the two previous posts, we showed that foreign exposure includes not only the price risk (i.e., the more familiar risk that the exchange rate will move against a company) but also quantity risk (i.e., the risk that demand for the currency drops as a result of the currency movement).

This above learning outcome is illustrated in Rene Stulz's Risk Management & Derivatives (Chapter 8). It adds the impact of competition. The assumptions:

  • A British car maker exports to the United States (selling cars in U.S. dollars, therefore exposed to foreign exchange price and quantity risk)
  • The dollar depreciates over the period (or, the pound sterling appreciates)
  • Two scenarios: markets are competitive or not competitive. If competitive, we say they are perfectly elastic: demand is a horizontal line because the firm cannot increase prices (it is the opposite of perfectly inelastic, such as a true necessity, where the demand curve is vertical because the quantity demanded is not impacted by price increases). If not competitive, we mean a more normal demand curve: price increases tend to lower quantity demanded.

With limited (or no) competition

The economic truism throughout supply/demand scenarios is a firm should produce to the point where its marginal revenue (MR) equals (=) its marginal cost (MC). That's because MR - MC = marginal profit. So, if MR>MC, it makes sense to produce another car. But if MR>MC, it is not worthwhile (implicit here is an assumption of diseconomies of scale).

Maybe the hardest part about the supply/demand curve below is that the y-axis shows the pound price of cars sold in the United States. As the dollar depreciates, there is no impact on the demand curve in dollars. (If you are buying a car in the U.S., all other things being equal, a stronger pound sterling does not immediately impact your dollar price tag.) Consider a car that costs $10,000 (5,000 GBP). If the dollar depreciates, maybe the pound price of the car becomes 4,000 GBP. Under GBP appreciation (dollar depreciation), the demand curve in pounds drops.

In this way, the demand curve in pounds falls by the amount that the dollar depreciates against the pound. The downward shift in the demand curve leads to a reduction in price and quantity demanded. That's true for the supply/demand curve where price is the pound price of cars sold in the U.S.

 

With competition

In a highly competitive economy, marginal revenue (MR) equals the demand curve. In this case, the company has a problem. The firm's marginal cost is static. But because it cannot lower prices, the pound price of U.S. cars sold forces the marginal revenue down if the domestic currency (GBP) strengthens against the foreign currency ($USD). It may not be profitable to sell these cars.

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