Aug 27

Foreign Exchange: Price & Quantity Risk (2007 FRM)

by David Harper, CFA, FRM, CIPM

FRM | Risk |

 germanIntro

Learning Outcome

  • LO 19.8: Explain the interaction of price risk and quantity risk in terms of the additional challenges to hedging using examples of industries where the association between price and quantity of the risky factor is negative and where it is positive.

It's about demand elasticity

A company's foreign exchange exposure extends beyond currency movements. A company is also exposed to what Stulz calls quantity risk: the change in the quantity of the currency demanded that accompanies a foreign currency shift. To illustrate, consider a recent article in the Wall Street Journal about German auto makers and their plans to accelerate U.S.-based production operations. The WSJ reports that "German auto makers are accelerating plans to ramp up U.S. production and add jobs as a hedge against the dollar's persistent weakness against the euro, which has battered profits on vehicles exported from Europe." We can apply this real-world example to the Stulz reading on price/quantity risk and the above learning outcome.

The key issue is whether the price elasticity of demand in the United is relatively elastic or inelastic. If elastic, the German car maker cannot easily increase the U.S. dollar price of its cars; if inelastic, price increases do not imply dramatic drops in demand:

image

Two scenarios: positive or negative relationship

Let's illustrate with hypothetical assumptions. We will assume:

  • A German auto maker needs to collect 30,000 Euros per car to make a profit
  • The exchange rate is 0.75 Euros per dollar (I am rounding to simplify)
  • The German auto maker sells cars into the United States

Based on our assumptions, at the current (illustrative) exchange rate, the U.S. price of the German car is $40,000 dollar (30,000 Euros x 1.33 = $40,000. Or, you could divide by 0.75). 

germanPQ_intro

 

What happens when the exchange rate changes? From the Wall Street Journal:

Because expanding a factory can cost hundreds of millions of dollars, German car makers normally prefer to offset the strong euro by raising prices. But because of competition in the U.S., most companies -- even those with relatively affluent customers -- say they can't afford that option. Source: German Auto Makers Rev Up U.S. Output - WSJ.com

 

This suggests a positive relationship between price and quantity (of currency), to use Stulz's terminology. That is, if the foreign currency price drops (i.e., the dollar depreciates against the Euro), the quantity of dollars received also drops.

Two scenarios are illustrated below. In the green column, the dollar appreciates to 1 Euro per dollar. In the pink column, the dollar depreciates to 0.50 Euro per dollar.

germanPQ_scenario

 

The negative and positive relationships refer, respectively, to inelastic and elastic demand.

  • Under the "negative" scenario, if the dollar appreciates, the German auto maker can afford to lower the U.S. dollar price to $30,000. Due to the weaker Euro, the German company still earns 30,000 Euro. Similarly, if the Euro strengthens, the German company can afford to raise the U.S. dollar price to $60,000 and still earn 30,000 Euro per car ($60,000 x 0.5 Euro/$). This is awkwardly called a "negative relationship" because: if the price goes down (price = dollar/Euro exchange rate), the quantity of dollars received goes up.
  • The positive scenario is closer to reality, for German automakers, according to the Journal. Under the "positive" scenario, if the dollar depreciates, the German auto maker cannot really raise prices (that's competition and abundant substitutes), so they must still sell the car at $40,000 U.S. dollars. Under either a weak/strong Euro. So, if the Euro strengthens to 0.5, the German car maker only earns 20,000 Euros.

Two scenarios: positive or negative relationship

While these are extreme examples (e.g., the true elasticity is sure somewhere in between), the idea is that the German auto maker is not only exposed to currency movements (i.e., Stulz's price risk). The German company is also exposed to quantity risk: the risk that fewer U.S. dollars can be collected owing to the interplay between price and quantity on the demand curve.

EditGrid Spreadsheet

If you would like to explore this further, here is an EditGrid spreadsheet.

EditGrid Spreadsheet by bt/frm2007.

Comments

  1. mricho 03 Sep 2007

    Hi David

    I’m really keen on making an attempt at the FRM exams. I’ve only just received my Schweser reading material and ordered yours as well.
    Is there enough time to read, assimilate and master both sets of material as well as the GARP readings (the unchanged readings from 2006)?

    If I were to go with the GARP material and one other set from a service provider, should I go with Bionic or Schweser and why?

    Can you suggest a strategic focus, i.e should I use the GARP section weighting as a guide. Also, should the focus be more on sharpening my knowledge (I’m a financial analyst and an accountant) or testing and exam practise? how close to the exam do you suggest a shift towards exam focus? (I’ve alloted 1-2 hours Mon to Friday and 4-6 hours on Sat and Sunday each, too little?).

    Having just studied for the CFA level 2 exams, some material is relatively fresh, would that be sufficient groundwork in most areas. in your view how similar/dissimilar are the FRM and CFA level 2 exams. I did really well in the Fixed income sections and economics. Poorly in the quants and portfolio management.

    Can I reach you by phone?

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