Exchange Rates and the Firm: Strategies to Manage Exposure and the Impact of Emu

Exchange Rates and the Firm Strategies to Manage Exposure and the Impact of EMU Richard Friberg EXCHANGE RATES AND TH...

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Exchange Rates and the Firm Strategies to Manage Exposure and the Impact of EMU

Richard Friberg

EXCHANGE RATES AND THE FIRM

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Exchange Rates and the Firm Strategies to Manage Exposure and the Impact of EMU

Richard Friberg Research Associate Stockholm School of Economics Sweden

First published in Great Britain 1999 by

MACMILLAN PRESS LTD Houndmills, Basingstoke, Hampshire RG21 6XS and London Companies and representatives throughout the world A catalogue record for this book is available from the British Library. ISBN 0–333–74551–5 First published in the United States of America 1999 by ST. MARTIN’S PRESS, INC., Scholarly and Reference Division, 175 Fifth Avenue, New York, N.Y. 10010 ISBN 0–312–22024–3 Library of Congress Cataloging-in-Publication Data Friberg, Richard, 1967– Exchange rates and the firm : strategies to manage exposure and the impact of EMU / Richard Friberg. p. cm. Includes bibliographical references and index. ISBN 0–312–22024–3 (cloth) 1. Foreign exchange rates—European Union countries. 2. Economic and Monetary Union. 3. Monetary unions—European Union countries. 4. Monetary policy—European Union countries. 5. Business enterprises—European Union countries—Finance. I. Title. HG3942.F75 1999 332.4'566'094—dc21 98–54943 CIP © Richard Friberg 1999 All rights reserved. No reproduction, copy or transmission of this publication may be made without written permission. No paragraph of this publication may be reproduced, copied or transmitted save with written permission or in accordance with the provisions of the Copyright, Designs and Patents Act 1988, or under the terms of any licence permitting limited copying issued by the Copyright Licensing Agency, 90 Tottenham Court Road, London W1P 9HE. Any person who does any unauthorised act in relation to this publication may be liable to criminal prosecution and civil claims for damages. The author has asserted his right to be identified as the author of this work in accordance with the Copyright, Designs and Patents Act 1988. This book is printed on paper suitable for recycling and made from fully managed and sustained forest sources. 10 08

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Printed and bound in Great Britain by Antony Rowe Ltd, Chippenham, Wiltshire

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To Dick and Ruth Beesley, for their extraordinary hospitality

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Contents List of Figures

ix

Preface

x

1

Introduction and Scope of the Book

Part I

1

The Background

2

Setting the Stage

3

What are the Elements of Exposure?

20

4

Should a Firm Manage its Exposure?

23

5

The Instruments Commonly Used for Hedging

33

Part II

9

Economic Exposure

6

Economic Exposure

39

7

The Evidence

46

8

Contractual Exposure

54

9

The Mechanisms and What can be Done about Them – a Close Look

57

Part III 10

Accounting Exposure

Accounting Exposure

Part IV

103

EMU

11

A Brief Background

111

12

Accounting Exposure and EMU

116

13

Economic Exposure

119

vii

viii 14

Contents Macroeconomic Issues and their Implications for Exposure

141

Notes

153

References

161

Index

169

List of Figures 2.1 2.2 2.3 4.1 4.2 4.3 7.1 9.1 9.2 9.3 9.4 9.5 9.6 9.7

9.8 11.1 13.1 14.1 14.2

Pound price of one US dollar, 1993–8 Depreciation against relative inﬂation (against US$ 1973–96) Nominal and real effective exchange rates, United Kingdom, 1990–7 Value of the ﬁrm and the exchange rate, linear relationship Value of the ﬁrm and the exchange rate, concave realtionship Utility and wealth, concave relationship Operating proﬁts as a share of turnover in Swedish manufacturing and real exchange rate, 1975–93 Proﬁts and the exchange rate, examples of relationships Swiss franc price of one US dollar, 9-month forward rate, 1993–8 Real exchange rate, Switzerland/USA, 1973–97 A stylized international trade transaction Setting price in the importer’s currency Setting price in the exporter’s currency Deviation from the law of one price for Marlboro cigarettes (one carton of 200 cigarettes) in duty-free shop, 1990–6 Development of VAT-adjusted retail price of gasoline (RP) and costs, Sweden, fall 1995 French franc price of one dollar and one D-Mark, 1990–8 Price of Marlboro cigarettes (one carton of 200 cigarettes) in in-ﬂight shop, 1994–8 Nominal and real exchange rate, Sweden 1980–97 Long-term government bond yields, Italy, Netherlands and Spain, 1990–8

ix

10 14 16 24 26 29 49 58 62 62 67 70 72

74 76 112 127 144 146

Preface This book is the outcome of a large amount of research in the last few years focused on the connections between exchange rate variability and ﬁrm behavior. During these years, a great number of individuals have given comments at seminars, generously provided data, read and commented on work, and allowed me to use their time with questions and discussions. Unfortunately they are far too many to thank here. A couple of people nevertheless deserve special mention. The ﬁrst is Anders Vredin with whom I ﬁrst started working on these issues. We co-authored a background report for the Swedish Government Commission on EMU and this book bears a clear mark of the many discussions that we had and the issues that we wondered about then. Some of my work in the area covered in this book was done as part of my theses. I am grateful to Carsten Kowalczyk and Robert C. Feenstra for taking large slots of their time to act as discussants of my theses. A special thank you also to Bankforskningsinstitutet for ﬁnancial support. The book has beneﬁted greatly from comments and readings by Marcus Asplund, Stefan Nydahl, Mikael Sandström and by seminar participants at the Ministry of Finance. My greatest debt is to my wife Magda: partly for a careful reading of the manuscript but mostly for making life such a sweet experience. There are quite a number of references to internet sites in the book; links to these and others of relevance will be kept updated at my homepage http://www.hhs.se/personal/friberg.

x

1 Introduction and Scope of the Book Exchange rates are often mentioned as a crucially important factor driving the proﬁtability of corporations. They are not seldom at the very top of the list when discussing past or future business performance. Examples of corporations having gone bankrupt due to large exchange rate changes, of ﬁrms losing market shares on a grand scale or running into bad proﬁtability in general abound. This is true also in relatively closed countries such as the United States. Recent events such as the EMU, the strength of the pound and the currency crisis in many East Asian countries have also put the spotlight on how ﬁrms can deal with exchange rate changes. A quick reading of The Financial Times for the last couple of months is just one way to get some views on the impact of exchange rates on the proﬁts and stock market valuation of ﬁrms. On 7 November 1997 one could read that ‘Mitsubishi Motors warned yesterday it would fall into loss this year because of foreign exchange losses related to its Thai manufacturing joint venture. The Japanese company said it was now forecasting a consolidated net loss of Y40bn (326m dollars), instead of a net proﬁt of Y11.6bn which it had expected.’1 On 10 December 1997, one could discover that ‘Kraft has been struggling for most of this year. In the third quarter it reported an 11 percent fall in operating proﬁts to 260m dollars, blaming lower coffee volumes, higher commodity costs and unfavourable exchange rates … The day before, shares in Coca-Cola tumbled by nearly 4 percent after some Wall Street analysts trimmed their 1998 earnings forecasts, citing the strong dollar.’ 2 On 29 January 1998 ‘The ﬁrmer dollar … sent ZURICH into record territory … PARIS … there were solid gains among dollar stocks.’3 In the same vein on could read that 3M claimed that the stronger dollar had knocked 12 percent off earnings4 and that operating proﬁt growth at Reed Elsevier had come to a halt because of the strong pound.5 The list could have been made much longer. In the present book we will assemble and assess the lessons that economics has to offer for how a ﬁrm should deal with exchange rate variability. What strategies can be employed to limit, or even beneﬁt 1

2

Exchange Rates and the Firm

from, the variability of exchange rates? We will draw on theory as well as empirical evidence. Let us discuss the relationship to previous work before returning to what we will do in this book. Given the potential importance of exchange rates for ﬁrm performance, one would believe that the present book would be only one among literally billions of articles and textbooks dealing with the issue of how ﬁrms can, and should, deal with variable exchange rates. In a way, a belief that this book was only one among many would certainly be correct: the amount of research and teaching done on how to protect earnings and the value of a ﬁrm from the effects of exchange rate variability with the aid of ﬁnancial instruments is enormous. Since the issue of how ﬁrms (should) deal with exchange rate variability has mainly been a concern of economists specializing in ﬁnancial economics, the focus of previous work has been on ﬁnancial hedging rather than on operating strategies. The typical article or textbook in this ﬁeld concludes by noting that the important issue is that of economic exposure (a concept that we will deﬁne later), but that is more encompassing than what is often considered to be at risk. Economic exposure of a ﬁrm will depend on how customers, competitors, and the ﬁrm itself behave in response to exchange rate changes. These are issues that go outside the scope of what is usually studied in ﬁnancial economics. A good example of a textbook in international ﬁnance is Sercu and Uppal (1995). They state in the introduction (p. vi), ‘This book is a text on international ﬁnance. Thus it does not address issues of multinational corporate strategy, and the discussion of international macroeconomics is kept to a minimum.’ The ﬁnancial literature covers the ground that it has decided to cover very well. But there are vast tracts of land that it does not cover. Say you were a British executive concerned with the strength of the pound. You wonder what strategies you should pursue to deal with the issue. Other examples are how you should adapt strategy to EMU – should you segment national markets? How should prices change when exchange rates change? There is little or no help coming from the ﬁnancial literature. Some articles6 and a few textbooks, most notably Shapiro (1992), do discuss strategies. They do so in a brief manner, however, and essentially without spelling out connections to either empirical results or theory. How about the people coming from another relevant ﬁeld within economics, ‘industrial organization’? Industrial organization, or its synonym industrial economics, is the name given to the study of ﬁrms

Introduction and Scope of the Book

3

and markets as we depart from the assumption of perfect competition. Remember that perfect competition is concerned with the case where each ﬁrm takes the prices it faces as given. For the assumptions of perfect competition to hold we require that all ﬁrms on the relevant market produce identical products, that resources are perfectly mobile and that there are no informational asymmetries – that we can hide no secrets from each other. Clearly industrial organization should contain some lessons for what strategies ﬁrms faced with exchange rate variability should pursue. Look in a textbook on industrial organization and you will ﬁnd that someone intelligent (usually) has given some thought to just about any imaginable issue. The role of advertising, how to prevent entry of competitors into your market, competition when there are ﬁxed costs, competition when there is this and competition when there is that. The word ‘exchange rates’ makes very few appearances. Nevertheless, many of the tools and results have bearing on the issues that we are here interested in. In their 1977 article ‘The Microeconomics of the Firm in an Open Economy’ Michael Adler and Bernard Dumas commence with the statement that ‘This paper undertakes to survey a largely nonexistent literature.’ A lot has happened since 1977, and the focus in that article is not in perfect correspondence with the focus of this book. Nevertheless their statement is not an inaccurate description of what the present book tries to accomplish. Industrial organization and other ﬁelds of economics contain many important lessons for how a ﬁrm should and can deal with exchange rate variability. Lessons that in many cases have not been spelled out or integrated previously. From our perspective, perhaps the biggest change relative to 1977 is the development of the analysis of how exchange rate changes affect prices in a world of imperfect competition. This large body of research originated in trying to explain the slow adjustment of the US current account and trade balance to the large swings of the dollar in the 1980s. The issue of to what extent exchange rate changes are reﬂected in prices has become known as the study of exchange rate passthrough. This line of research has rarely analyzed out the implications of price adjustment for ﬁrm value. In joint work from 1998 two of the grand old men in the study of exchange rates and their impact on the performance of ﬁrms (Bernard Dumas and Richard Marston), and one of the rising stars (Gordon Bodnar), claim to be the ﬁrst to integrate the issue of how sensitive a ﬁrm’s value is to exchange rate surprises with the issue of exchange rate pass-through, how prices respond to exchange rate changes.7

4

Exchange Rates and the Firm

This book draws on what we know from different ﬁelds within economics and analyzes and synthesizes the lessons contained for how a ﬁrm should deal with variable exchange rates. I wish to present a structure for coherent thought on strategies to deal with exchange rate variability and to present the theoretical ideas and empirical studies that help us understand the issues. We then apply what we have learned to an analysis of the impact of the Economic and Monetary Union (EMU) on foreign exchange exposure and how strategy should be adopted. What the book tries to do is integrate a number of separate ﬁelds – present the evidence and bring out the intuition. We paint the broad picture with a speciﬁc focus on operating strategies. That is, we focus on the real side of decisions, such as production location, price setting strategy and market segmentation, rather than on the ﬁnancial side of decisions, such as how to hedge. It will be valuable as an additional textbook in an International Finance course at the upper undergraduate or MBA levels, or as a textbook in a course in multinational strategy. Practitioners, consultants, economic journalists, and ﬁnancial analysts should also ﬁnd the book of value. Hopefully it will also be valuable to fellow researchers who want a nontechnical and broad survey of the issues. At least I know that I would have wanted one when I started working in the ﬁeld. The target group deﬁnes what ground we will cover in this book and in which way we will cover it. The presentation is nontechnical even though much of the work that I survey does demand quite a background in economics. Extensive references are given for those who want to go back to the sources. An important aspect of the book is that I try to cover not only theory but also the practical experience. Where I am aware of serious empirical work dealing with an issue I will present those results. I will also use speciﬁc examples from ﬁrms or speciﬁc markets. Those examples will often be from Swedish ﬁrms. Sweden provides an excellent case if one is interested in exchange rate variability and ﬁrms. Like the UK it is part of the EU but will not be part of EMU from its start. Thus issues of how the ‘outs’ will be affected by the introduction of the euro are relevant. Sweden does have a ﬂoating and volatile exchange rate, is a small and very open country. Multinationals occupy a larger share of the economy than in any other country and there are also many smaller ﬁrms that trade intensively. Experiences from the last few years include both major devaluations of the Swedish krona, having a ﬁxed exchange rate to a basket of currencies of Sweden’s major trade partners, and later a ﬁxed exchange rate against the ecu. 1992 saw 500 percent overnight interest rates to defend the ﬁxed

Introduction and Scope of the Book

5

exchange rate. Sweden now has a ﬂoating exchange rate and an independent central bank with a price stability target. As opposed to, for instance, the British pound and the Swiss franc, the krona is a ‘small’ currency, something that might increasingly be the case also for the pound and the Swiss franc post-EMU. Sweden thus provides an excellent laboratory to learn about exchange rate variability and its impact on ﬁrms. The focus in this book is on ﬁrms that produce goods or services, not on portfolio management. Nevertheless, it will also be crucial for a portfolio manager to understand the mechanisms behind the exposure of individual assets. How a ﬁrm is affected by exchange rates depends not only on which industry or industries it is active in, but also on its main role – exporters, importers, and subsidiaries will each have their speciﬁc issues. In this book I will typically focus on the case of an exporter of goods, mainly for ease of exposition; the same analytical tools are applicable to the case of an importer. We should note that the book is brief on a number of more technical issues such as the pricing of options. There is an abundance of good textbooks spelling out the foundations of international ﬁnancial management.8 More speciﬁcally we will proceed as follows. We start by a review of exchange rate determination, real exchange rates, and the relation between the exchange rate and other macroeconomic variables (Chapter 2). Chapter 3 introduces the categorization of exchange rate exposure and the sensitivity in the value of the ﬁrm and its assets to exchange rate surprises. Should a ﬁrm manage this exposure? We study that issue in Chapter 4. Chapter 5 gives a concise overview of the instruments available on the ﬁnancial markets for hedging purposes. Part II (Chapters 6–9) provides an analysis of the sensitivity of cash ﬂows and the value of the ﬁrm to exchange rate surprises (so-called economic exposure). This is the central part of the book. Part III (Chapter 10) analyzes the issue of the exposure of accounting statements to exchange rates. Part IV (Chapters 11–14) discusses the impact of EMU on exchange rate exposure and how strategy could be adjusted to meet the new institutional framework.

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Part I The Background

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2 Setting the Stage 2.1

NOMINAL EXCHANGE RATES

A ﬂoating exchange rate typically exhibits wild gyrations. Let us illustrate with a few examples. During the period from 1 August 1997 to 30 March 1998 the yen weakened by some 12 percent against the US dollar. During the same period the Swiss franc weakened by some 5 percent against the Canadian dollar. Exchange rates also exhibit pretty radical swings over longer time periods. From 1 August 1996 until the end of March 1998 the British pound had strengthened by more than 25 percent against the D-mark. The classic example of a massive shift in exchange rates is the path of the dollar. From February 1985 to January 1988 the US dollar price of D-marks and yen more than doubled. These gains and losses are typically no smooth process, rather they take place in leaps and bounds. Figure 2.1 exempliﬁes with the exchange rate between British pounds and US dollars between August 1993 and March 1998. The focus of this book is on how swings in exchange rates like the above affect a corporation. Both the shorter day-to-day or week-toweek movements, and the longer swings over a couple of years, are discussed in the book. This chapter will mention a few facts that are of relevance for how this transition takes place. We start with a discussion of why the pattern that we see in Figure 2.1 looks the way it does. What drives nominal exchange rates? The most important thing for managers to know is that we are really bad at predicting exchange rates based on fundamentals. Fundamentals here means things such as money supply in the different countries, interest rate differentials between countries, rate of growth in the consumer price indexes, and changes in the level of real activity in the respective countries (for instance industrial production) – variables that we on theoretical grounds believe to be important for the nominal exchange rate. In a survey, for the Handbook of International Economics, Frankel and Rose (1995, p. 1690) describe the present state of affairs: ‘The most profound negative result was produced by Meese and Rogoff, who compared the predictive abilities of a variety of exchange rate models. Their key result was that no existing structural exchange rate model could reliably out-predict the naive alternative of a random walk at short- and medium-run horizons. This extremely negative ﬁnding has 9

10 Figure 2.1

Exchange Rates and the Firm Pound price of one US dollar, 1993–8

never been entirely convincingly overturned despite many attempts. The simple random walk model of the exchange rate has become the standard benchmark for empirical exchange rate performance, no matter how uninteresting it is per se.’ It is worth taking half a minute to refresh our memories on the properties of a random walk. A variable following a random walk is one where the value in the next period is equal to the value in the present period plus a random, stochastic component. There is no correlation between the shocks in different periods. This leads a variable which follows a random walk to behave as a drunkard staggering around in a ﬁeld, with equal chances of stumbling to the left or to the right and with no tendency to move back towards the path. It is of no help for predicting where he will stumble next to know how he has stumbled before; all that information is contained in his current position. The current value of a variable contains all the relevant information for predicting its future value given that you know the variance of the error term. Why do Frankel and Rose ﬁnd the random walk uninteresting? Well, ask an analyst what the future expectations are for a variable following a random walk – the answer you receive will read something along the lines of ‘Well, it can move up, it can move down, I do not know which. My best prediction is today’s value.’ I can agree that it might seem uninteresting. Random walks (and their continuous time equivalent of Brownian motions/Wiener processes) do occupy a central position in the theory of ﬁnance. If the market is efﬁcient, all known information has been

Setting the Stage

11

incorporated in the price of an asset. The asset price will only change as news arrives, news that will be random.1 Since it takes no great leap of faith to view currencies as assets, it should come as no surprise that the prices of foreign currency behave as random walks in the short to medium run. Before we get too dismal as to the predictive power of models we should emphasize that as economists we usually have a presumption about what will broadly happen to the exchange rate when there are large policy shifts. A monetary tightening will normally lead to an appreciating exchange rate (foreign currency becoming cheaper). The US combination of tight monetary policy and expansive ﬁscal policy in the early 1980s led to what most economists would have predicted, an appreciation of the dollar. The magnitude surprised many but the general tendency did not. That a similar combination of policies implied a need for appreciation of the D-mark vis-à-vis the other EMS countries in 1992 was also what many economists predicted – at least ex post. In characteristic language Paul Krugman (1993c, p. 3) states ‘So the policy debacle of 1992 was intellectually reassuring. I was certainly not the only economist who, behind his serious expressions of concern was thinking “Ha! Told you so!’’’ We are not always totally in the dark about the determinants of exchange rates, but any predictions will deﬁnitely be guess-work. Before we go on we should make a quick aside on the notation for exchange rates that we will use in the book. We adopt standard convention and express exchange rates as the domestic currency price of foreign currency. The exchange rate, e, for instance says that I have to pay 0.1 pounds to buy one franc. A higher value of e thus implies that foreign currency has become more expensive, the home currency has depreciated (or devalued, if it has changed from a ﬁxed exchange rate). In other words it has weakened. This is the case if the price of franc has gone up to, for instance, 0.15 pounds. The somewhat counter-intuitive result that a higher value of the exchange rate represents a weaker currency has led to an increasing use of the inverse deﬁnition, but in this book we will stick to the traditional one. A lower value of e, the way we deﬁne it, thus implies that foreign currency becomes cheaper, the home currency appreciates – strengthens.

2.2

REAL EXCHANGE RATES

It should be apparent that a key issue for how the nominal exchange rate inﬂuences a ﬁrm is how prices are affected by exchange rate

12

Exchange Rates and the Firm

changes such as the above. Let us illustrate with a simple example – that of a one-person ﬁrm in the book writing business. Macmillan ﬁrst contacted me on 22 September 1997. From that time until 30 March, the Swedish krona depreciated some 8 percent against the British pound. 10,000 pounds would have been worth 123,000 kronor on the ﬁrst date whereas they were worth 133,000 kronor at the end of March. Since Sweden has had virtually no inﬂation during this time period, 10,000 pounds was quite another thing in September than what it was in March for someone who like me has most of their consumption in Swedish kronor. The depreciation had expanded the range of goods that I could buy by 10,000 kronor. To take a speciﬁc example, this would be enough to buy a cheap used car such as a 15year-old Mazda 626. The fact that some prices change (prices expressed in foreign currency), whereas others do not (prices expressed in domestic currency), clearly has implications for my buying, or purchasing, power. If all prices changed in unison so that relative prices and incomes were unaffected, an exchange rate change would have no real effects. What could force prices to move in unison? If there were no costs associated with searching for the best deals on goods, if there were no trade barriers and we more generally lived in what we can call a frictionless world, the buying of goods where they were cheaper would bring prices into line. In a frictionless world, arbitrage would ensure that a good had the same price irrespective of the currency in which it was priced. The price of a used Swedish Mazda 626 has fallen substantially versus a used British Mazda 626 as a consequence of the weakening of the Swedish krona. If trade were frictionless this would cause an upward pressure on the price of a Mazda 626 in Sweden and my real purchasing power would be affected less than what is the case today. I would have 10,000 kronor more but all goods would also be more expensive. If we followed the time-honored assumption of ‘a small open economy’ all prices would be given in foreign currency and there would be a world market price of used Mazda 626s – the price in Sweden would then rise by the full amount of the depreciation. In a frictionless world the law of one price would hold, that is, the price of a good would be the same no matter where it was sold. The price of the good in the home country (p) would adjust so that it were equal to the foreign price (p*) translated at the current exchange rate e, expressed as the units of home currency needed to buy one unit of foreign currency. With these building blocks, Equation 2.1 spells out the law of one price – that the price of a good, expressed in the same

Setting the Stage

13

currency, is equal no matter were it is traded. If the law of one price holds, a book that costs 20 dollars in the US will cost the local currency equivalent of 20 dollars in Chile, Sweden, and Thailand as well. p = ep*

(2.1)

On 31 March 1998 you needed 39.25 Thai baht to buy one US dollar. Consequently the price of the book had to be 20 39.25 = 785 baht for the law of one price to hold. Similarly if the law of one price holds, a used Mazda 626 of the same quality will cost the local currency equivalent of 10,000 kronor no matter if it is sold in Cape Town, St. Petersburg, Tokyo, or Stockholm. Now, if the law of one price holds for all goods, we then have purchasing power parity (PPP). If the law of one price holds for all goods, the price of a basket of goods in the home country (P) is equal to the price of that same basket in a foreign country (P*) when prices are compared using the nominal exchange rate e. Just replace p with P, and p* with P* in 2.1 and you have the PPP relation, 2.2. P = eP*

(2.2)

A somewhat less stringent demand on prices is that relative purchasing power parity should hold. That is, that changes in price levels should correct for nominal exchange rate changes. If Italy had a higher rate of inﬂation than the US, the nominal exchange rate would change to compensate for this, if relative PPP held. How does this hold in the real world? It typically holds reasonably well in the long run, as exempliﬁed by Figure 2.2, which plots on the horizontal axis the depreciation of the G7 country currencies and a few others as well against the US dollar for the period 1973–96. The vertical axis gives the inﬂation of the respective countries relative to the United States for the same period.2 If the slope of the relationship is equal to one, relative PPP holds, so that the exchange rate has changed over the period to correct for inﬂation differentials. As indicated by the ﬁgure, over a period of some 20 years relative PPP is a reasonable approximation. We will return to the issue of why relative PPP is interesting for managers – for now we note that for many decisions managers will typically be concerned with shorter time periods than two decades. In the short run, (relative) PPP fails miserably. Prices tend to be sluggish in the local currency and exchange rates behave as the asset prices that they are, driven not only by fun-

14 Figure 2.2

Exchange Rates and the Firm Depreciation versus relative inﬂation (against the US$, 1973–96)

damentals but also by news and expectations (about fundamentals as well as beliefs of other market participants’ behavior). One reason why (relative) PPP does not hold is that in a consumption basket there are many goods that are nontradable. The prime example are services – you would typically not travel from London to Paris to get your hair cut or go to the shrink. No trade implies that there will be no equalizing pressure on prices coming about from arbitrage. So one reason why PPP can break down is the presence of nontraded goods. The other reason why PPP does not hold is that prices on tradable goods are not equal across countries either. Prices of goods such as cars are not equal across countries and they do not move sufﬁciently to offset exchange rate changes in the medium run. Partly this is because there is a nontraded component to many goods prices: if that book that we looked at earlier does not cost 20 dollars irrespective of where we buy it, part of the reason is that local wages will make up part of the cost of selling the book. To a large extent, however, this is not the most likely explanation for why the law of one price fails for traded goods. We return later to the issue of why for traded goods British prices tend to be sticky in pounds and French prices sticky in francs. The law

Setting the Stage

15

of one price holds to a reasonable extent on commodities or assets traded on exchanges. The price of gold is roughly equal across the planet. Similarly the price of a stock traded on several stock exchanges will have the same price when expressed in common currency. If the stock of Ericsson or Volvo traded for another price on Nasdaq (the US) than in Stockholm it would not take long for someone to beneﬁt from the money machine that buying in the cheap market and reselling in the dear market would imply. For other goods, however, the law of one price typically fails fairly dramatically at shorter horizons. We will return to the case studies that exist in Chapter 9. For now just note that the fact that the realization that PPP does not hold because the law of one price does not hold may be new – but the fact that the law of one price does not hold may not necessarily be a new phenomenon. In an entertaining paper, using 700 years (!) of agricultural goods prices from Britain and Holland, Froot, Kim, and Rogoff (1995, p. 2) ﬁnd that ‘Several alternative measures all suggest that with the possible exception of the late nineteenth and early twentieth centuries, the volatility of law of one price deviations has generally been remarkably stable by century over the second millennium.’ After having noted the reasons for why PPP may not hold, we rewrite the PPP relation as r = eP*/P

(2.3)

where r then is the real exchange rate. If PPP holds, r = 1; otherwise the real exchange rate will ﬂuctuate. If prices are sluggish, a depreciation of the home currency (higher e, the price of foreign currency going up) will be associated with a real depreciation. That is, it will be cheaper in the home country relative to abroad. This is then what is meant by calling a currency over- or undervalued. If prices are lower at home than abroad the currency is undervalued. The Economist publishes what they call the Big Mac index each year. The basket of goods that is used is, surprise, a Big Mac. The beauty of the Big Mac is that it is very much the same good, no matter where on the globe that you buy it. The price of this hamburger varied in 1998 from US dollars 1.16 in Indonesia and Malaysia to US dollars 3.87 in Switzerland. The average US price was 2.56 dollars. With this measure of the basket of goods, the Indonesian rupiah was undervalued by some 50 percent and the Swiss franc overvalued by some 50 percent.3 The Big Mac is of course a pretty particular basket of goods, and inputs are largely agricultural, a sector in which trade restrictions are abundant (leading to

16

Exchange Rates and the Firm

potential failure of the law of one price on inputs), while the ﬁnished product itself is essentially nontradable. People buying Big Macs in Kuala Lumpur, taking a plane to Geneva and then reselling them on the street there is not liable to put a large equalizing pressure on prices. The Big Mac PPP is thus not to be taken too seriously; it is, however, a good pedagogic exercise. If PPP held perfectly there would be no reason for a ﬁrm to worry about exchange rates affecting their competitiveness. A British manager of recent years would have had no reason to be concerned about the price of foreign currency going down, since real relative prices would have been unchanged. As we know, managers of many exporting ﬁrms have been concerned. Figure 2.3 indicates why they were often right to be so. PPP has not held and the real exchange rate has followed the nominal exchange rate closely. Figure 2.3 plots the (trade weighted) British nominal and real exchange rate indexes for the 1990s. The picture painted is typical of a ﬂoating exchange rate – real and nominal exchange rates follow each other closely, consumer prices being sticky in the respective currencies and only slowly reﬂecting exchange rate (monetary) changes to produce the pattern that we observed in Figure 2.2. When a nominal strengthening of the pound is not associated with compensating movements in UK input prices and wages, it will clearly affect the competitive situation of a ﬁrm by raising its costs in relation to the costs of foreign competitors. Figure 2.3

Nominal and real effective exchange rates, UK, 1990–7

Setting the Stage

17

If PPP does not hold in the short run, at what range does it hold? There are a number of econometric issues involved in the estimation of how real exchange rates have behaved. For a long time it seemed as if one could not reject the hypotheses that real exchange rates followed a random walk. If the real exchange rate follows a random walk (without drift), there is no tendency for it to return to 1 as it is subjected to shocks. PPP would then give no guidance whatsoever as to the behavior of the real exchange rate. Newer tests do indicate that there is a tendency for the real exchange rate to return to 1, to PPP. In their recent survey for the Handbook of International Economics, Froot and Rogoff (1995, p. 1648) summarize the evidence: ‘Consensus estimates put the half-life of deviations from PPP at about 4 years for exchange rates among major industrialized countries.’ That is, after 4 years about half of the deviation from PPP will have been adjusted for by price movements. The discussion clearly indicates that issues of exchange rates and the ﬁrm are important for prolonged periods. So the point about raising issues of real exchange rates is that one is right to worry about (nominal) exchange rates. Because prices are sticky in the domestic currency in each country, nominal exchange rate changes will be associated with changes in the competitiveness of ﬁrms. Summing up the main points of our overview so far, we have found that the nominal exchange rate is pretty much unpredictable and behaves more or less like a random walk. Prices tend to be sluggish in local currencies and this implies that real exchange rates follow nominal exchange rates closely. It typically takes several years for shocks to wash out. It would be surprising if this did not affect the cash ﬂows and accounting value of a ﬁrm. Which ﬁrms will be affected strongly by exchange rate changes? This is what we turn to in the rest of the book, after a discussion on the relationship between macroeconomics and exchange rates and the connection to the analysis of risks faced by ﬁrms.

2.3

MACROECONOMICS

That the exchange rate is ultimately related to fundamentals implies that exchange rate risk is part of some more general concept of macroeconomic risk. That is, other risks such as interest rate risk, inﬂation risk, and political risks are all entwined. A monetary tightening will in conventional wisdom lead to lower inﬂation, an appreciating exchange rate, squeezed domestic demand, higher real interest

18

Exchange Rates and the Firm

rates, and potentially the default of some of one’s counter-parties as well as a change of government. In this sense the approach of focusing only on the exchange rate risk is somewhat sloppy. For instance, funding risks can be associated with exchange rates, while defending a ﬁxed exchange rate can hurt liquidity in the ﬁnancial system – loans can be recalled and access to new credit severely hampered.4 Let us illustrate with a stylized view of Sweden’s development from the late 1980s and forward to the early 1990s. The late 1980s saw Sweden with high inﬂation (up to 10 percent), newly deregulated ﬁnancial markets, and an overheated domestic economy. Higher inﬂation than our major trading partners and a ﬁxed exchange rate implied a strong krona and problems for exporters. A slowdown of the economy came as the 1980s turned to 1990s – partly this was through external shocks such as the Kuwait crisis and partly it was due to homemade policies such as a monetary tightening. A new tax system that favored savings more than had previously been the case contributed to the eventual collapse of domestic demand. During 1992 the krona came under pressure, as did many other European currencies, as the German policy mix to accommodate Reuniﬁcation put an upward strain on the D-mark relative to other European currencies. Interest rates were raised and these factors together saw Swedish property values collapse and banks drowning in bad debt. 1992–3 saw a full-ﬂedged banking crisis, and bank runs probably only avoided because of government guarantees. These were no happy days for a highly leveraged ﬁrm. An indicator of the severity of the situation is that unemployment went from 2.5 percent in 1990 to 10 percent in 1993. The krona was ﬂoated in November 1992, and has been ﬂoating since. These are all developments that affected the value of ﬁrms – how can one look at exchange rate exposure in isolation? Another recent example comes from Asian economies under stress lately, such as Malaysia, South Korea, and Indonesia. A ﬁnancial crisis with tumbling property prices partly preceded the exchange rate collapses. Clearly the collapses of the exchange rates were no independent events, totally unrelated to anything else going on in the economy. A great number of things are intertwined and interest rates, domestic demand, and politics all interact. Exactly to what extent and in what ways they interact is often hard to discern.5 One alibi for the focus of this book is that it is important to realize that exchange rates, though ultimately dependent on policy, are an important channel for how ﬁrms are affected by policy and other shocks. Understanding how that channel works is important – no

Setting the Stage

19

matter that there are many other variables that also matter for the ﬁrm, that in complex ways partly depend on the same factors. For example, on page 23 in the ‘Companies and Finance’ section of The Financial Times on 30 April 1998 one ﬁnds a clearcut example of this from Indonesia. Many exporters have seen huge boosts in proﬁts as a result of the collapse of the rupiah: for instance, ‘Aneka Tambang, the privatized Indonesian nickel and gold mining group, doubled 1997 net proﬁts, demonstrating how several of the country’s mining companies have proﬁted from the crash that has left the rest of the economy in tatters.’ An example of the opposite type of ﬁrm, focused on the domestic market and dependent on imported inputs, is provided on the same page in another article: ‘Indocement Tungal Prakarsa … in the red … gross proﬁts fell 3.9 percent because of high inﬂation and a sharp rise in dollar-denominated costs. Off-shore debt stood at $546m, … With the domestic cement market in tatters, Sudwikatmono, president director, said 1998 would be “difﬁcult.’’’ Despite the huge macroeconomic and political turmoil the conventional exchange rate exposure is important enough not be swamped by other factors. Furthermore, the strategic choices discussed in Chapter 9 will be relevant for dealing with any variability – the lessons are not limited solely to the exchange rate turf. As noted previously, we know that exchange rates do depend on policies, at home and abroad, but we as economists are not very impressive at connecting the movements of exchange rates to our models. If one is to discuss the real world rather than a stylized version with a number of international parity conditions holding (for instance, purchasing parity or a relationship known as uncovered interest parity), such an analysis becomes very complex indeed and will have to remain outside the scope of the present book. In Part IV we will, however, analyze the changing macroeconomic environment following upon the introduction of EMU and how it will affect exchange rate exposure. A discussion of the broader concept of macro risk and exposure can be found in, for instance, Oxelheim and Wihlborg (1997).

3 What are the Elements of Exposure? We follow established tradition in using the concept of exchange rate exposure around which to build our analysis of how ﬁrms are affected by exchange rate variability. Exposure measures what one has at risk. The most commonly accepted deﬁnition stems from Adler and Dumas (1984). A good summary of their deﬁnition is found in Levi (1990, p. 187). The deﬁnition runs as follows: ‘Foreign exchange exposure is the sensitivity of real domestic currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates.’ Sercu and Uppal’s (1995) way of stating Adler and Dumas’ deﬁnition of exposure is: Exposure of ﬁrm to ei = (Total unexpected change in the ﬁnancial position of the ﬁrm as measured in the home currency)/ unexpected change in ei, where ‘ﬁnancial position’ includes ﬁnancial statements as well as cash ﬂows and ei is the exchange rate against a speciﬁc currency which we denote i (for instance D-marks, Hong Kong dollars, or what have you). To take a very simplistic example of exposure, assume that my ﬁrm is expecting payment of 500 US dollars. My domestic currency is the kronor, this is where I spend my money. What is my exposure against the dollar if I, for the sake of this example, assume that all my other incomes and net asset holdings are unaffected by the dollar exchange rate? The simplest way to think about it is to remember that exposure is concerned with what I have at risk – what do I have at risk? Easy: 500 dollars. A longer way to see this is the following: today I need 7.54 kronor (SEK) to buy one US dollar (USD), so the expected domestic currency value is 500 USD 7.54 (SEK/USD) = 3770 SEK. What is the sensitivity of this to a surprise in the dollar exchange rate of, say, 0.1 kronor? The unexpected change in the value is 500 USD 0.1 (SEK/USD) = 50 SEK. To get the exposure we relate this to the change in the exchange rate, 0.1 (SEK/USD) as in the expression above. The exposure will thus be 50 SEK/(0.1 (SEK/USD)). My ﬁnancial position strengthens by 50 kronor when the 20

What are the Elements of Exposure?

21

price of dollars increases by 0.1 kronor. The SEK cancel so that we can rewrite the expression as (50/0.1) USD = 500 USD. In this example the exposure was trivial since the dollar amount was ﬁxed. In Chapter 7 we will see how one can operationalize this deﬁnition of exposure with the aid of econometric techniques when the cash ﬂow is not a ﬁxed amount in foreign currency. As noted in the last chapter, the random walk behavior of exchange rates implies that basically all exchange rate changes are surprises. Exchange rate exposure is normally divided into different parts. There is little controversy as to the overall deﬁnition of exchange rate exposure. But when one discusses the different elements of exposure this unanimity disappears.1 The deﬁnitions that I will use are the same as those in Sercu and Uppal (1995). I will return with a few more words on different categorizations before concluding this chapter. The most relevant concept for exchange rate exposure is that of economic exposure. This is deﬁned as the expected sensitivity in the value of the ﬁrm, measured as the discounted expected future cash ﬂows, to exchange rate surprises. It thus comprises on the one hand cash-ﬂows that are due to past contractual undertakings: contractual exposure. This is the net of accounts receivable or payable or loan payments that are denominated in foreign currency. Take a very simple example – we are now in May and I represent a Swedish ﬁrm. In March my ﬁrm sold consulting services to a British ﬁrm for 10,000 pounds. These are to be paid on 1 July. On 1 July I also have to pay the 3,000 pounds that were my costs for the project. On the same date a loan payment of 1,000 pounds is due. What is my contractual exposure? The net of my obligations in pounds is of course 10,000 – 3,000 – 1,000 = 6,000 pounds. It is ﬁxed in pounds but exposed to exchange rates since I am interested in its worth in Swedish kronor. This is where I live and take my wife out to dinner. The other element of economic exposure is operating exposure – the change in future operating incomes because of changes in the exchange rate. It relates to how future cash ﬂows will be affected since prices, costs, demand, and other factors may change in response to the exchange rate change. To return to the little consulting example from above, the question now is how will my future consulting revenue be affected by a sudden strengthening of the Swedish krona? Well, I consult for that large exporter, they will probably demand less; and then this Dutch lady that’s in the same line of business will probably be quoting a cheaper price. On the other hand some inputs may become cheaper …

22

Exchange Rates and the Firm

Lastly there is accounting exposure. Accounting exposure is deﬁned as the change in a ﬁrm’s consolidated balance sheet and income statement due to exchange rate surprises. Foreign subsidiaries of a ﬁrm will typically maintain their accounts in local currency. The parent ﬁrm has to translate the net ﬁnancial position of the subsidiary into the parent’s currency in order to prepare consolidated ﬁnancial statements. As suggested by the name, it deals only with accounting values, and any effect on cash ﬂows is only indirect, for instance through taxes. If taxes are levied on the basis of the accounting value of proﬁts, or assets, a change in the accounting values will have implications for the amount of tax paid. So these were the elements of exposure. There was accounting exposure and economic exposure. Economic exposure in its turn consisted of contractual exposure and operating exposure. As mentioned at the beginning of this chapter, this is not the only possible rubric for the elements of exposure. Accounting exposure is often referred to as ‘translation’ exposure. This is the case in, for instance, Levi (1990). Contractual exposure is often named ‘transaction’ exposure (for instance in Eiteman, Stonehill, and Moffett (1995), Levi (1990), and Shapiro (1992)). Operating exposure in its turn has been called ‘competitive’ exposure, ‘strategic’ exposure, and even ‘economic’ exposure. Until the industry settles on a common categorization you will unfortunately have to keep track of how the particular author categorizes. We will return to each part of exposure later on in the book. First we will take a look at the more basic question of whether you should manage exposure at all.

4 Should a Firm Manage its Exposure? Exchange rate variability will cause the proﬁts, and the value, of an exposed ﬁrm sometimes to be higher, sometimes lower. Is this a problem – should you as manager worry about this at all? In this chapter we will discuss if economic exposure should be hedged. Economic exposure is, as noted in the last chapter, concerned with the sensitivity of cash ﬂows to exchange rates. Here we will concentrate on management of exposure using ﬁnancial instruments. That is, we take the exposure of cash ﬂows in themselves as given, and discuss reasons for limiting the ultimate effect on ﬁrm value and cash ﬂows by creating offsetting exposure from ﬁnancial contracts. The ﬁnancial contracts used for management of exposure will be discussed in Chapter 5. The other way of managing exposure would be to modify the commercial cash ﬂows themselves. Crudely put, one way for an exporter to manage its exposure is to cease being an exporter. Those kinds of issues will be discussed in Chapter 9. For now take the commercial cash ﬂows as given. Should a ﬁrm strive to lower exposure by the use of ﬁnancial instruments? There are some relevant reasons for doing this. Most observers agree that hedging of accounting exposure is not relevant – we postpone that discussion until Chapter 10. It should be stressed that it is not at all obvious that a ﬁrm should try to limit exposure. By ﬁnancial contracts you limit the downside of exchange rate variability but you also take away some upside potential. If you use up resources in the process of hedging you will furthermore lower cash ﬂows over time. Limiting variability will then be associated with lower returns. Let us try to attack the problem systematically. The ﬁrst observation that should be made is that in a perfectly frictionless world ﬁnancial hedging could not add value to the ﬁrm. Why should owners of ﬁrms pay the ﬁrms to do something that they can do equally well themselves – manage risk? Why not let ﬁrm value be risky and let the owners put together a portfolio of investments reﬂecting their preferences towards risk? This goes back to work by Franco Modigliani and Merton Miller from 1958 and 1963. Their results have become known as the Modigliani–Miller theorem. It states that in a stylized world without such things as taxes or transaction costs (and 23

24

Exchange Rates and the Firm

some other imperfections), the ﬁnancial structure of the ﬁrm should not affect its value. For instance, the proportions in which the ﬁrm ﬁnances itself with debt or with equity do not matter for the valuation of the ﬁrm in the stylized world of Modigliani–Miller. Similarly, in this kind of world, there is no reason why a ﬁnancial contract, a hedge, which owners could equally well undertake, should add value to the ﬁrm. The real world that we live in is, however, rife with transaction costs, taxes, and asymmetric information – all of which opens up the possibility of risk management being a good idea.1 Let us discuss the background intuitively before going into the speciﬁc reasons. Think of a ﬁrm whose value is affected by the exchange rate in a linear fashion as shown in Figure 4.1. Here think of the value only as the discounted stream of future cash ﬂows. In a one-period setting, value and cash ﬂow/proﬁts would be equal. What do we mean by linear? Only that cash ﬂows increase by the same amount when the exchange rate depreciates as cash ﬂows Figure 4.1

Value of the ﬁrm and the exchange rate, linear relationship

Should a Firm Manage its Exposure?

25

decrease when the exchange rate appreciates. So what would variability do to the expected proﬁt in this case? Nothing. The expected value of cash ﬂows under variable exchange rates is the same as the value of cash ﬂows would be if the exchange rate were constant and equal to its mean. To take a simple illustration, assume that you are about to receive 10,000 D-marks. You know the amount in D-marks but since you have not yet received it and since the value of the exchange rate is uncertain it is exposed (contractual exposure). Make a simpliﬁcation and say that the current exchange rate against the D-mark for your country is 1, so that the amount is worth 10,000 in your currency. Linear exposure then means that if your currency depreciates by 10 percent it will be worth 11,000, whereas if your currency appreciates by an equal amount it will be worth 9,000. For equal size exchange rate changes you will gain or lose equally much. A 10 percent appreciation will lead to cash ﬂows that are 1,000 less, whereas a 10 percent depreciation will lead to an increase in cash ﬂows of 1,000. In this case variability of the exchange rate does not affect the expected value of proﬁts. Assume that there is a 50 percent chance that the exchange rate will strengthen by 10 percent and a 50 percent chance that it will weaken by 10 percent. The expected value is then 0.5 9,000 + 0.5 11,000 = 10,000. This is the same as the realized value if the exchange rate would not ﬂuctuate and be equal to 1, and also the same as if there were equal chances of the exchange rate being 5,000 or 15,000. Variability thus does not affect the expected value and we can take what is called a ‘mean-preserving spread’. Increasing the variability does not affect the mean. What you stand to gain in good times is the same amount as you stand to lose in bad times, and if you are not risk-averse, there is no reason to worry about this. So far there is thus no reason to manage risk. Loosely put, some times are good and some times bad, and the bad times are not worse than the good times are better. Now think of the case where the relationship between the exchange rate and the value of the ﬁrm is like that in Figure 4.2. What we mean is that the value is concave in exchange rate ﬂuctuations. Here the value increases less when the exchange rate is favorable than it decreases when there is an equally large change in the opposite direction. To continue our small example, assume that if the exchange rate weakens by 10 percent you receive only 10,500 units of your own currency. If your domestic currency strengthens by 10 percent you receive 8,500 units of your own currency. So with the same probabilities as above, the expected value would now be

26 Figure 4.2

Exchange Rates and the Firm Value of the ﬁrm and the exchange rate, concave relationship

0.5 10,500 + 0.5 8,500 = 9,500 units of currency. This is clearly less than the 10,000 that would be received if the exchange rate were equal to its mean, 1. So in this case variability of cash ﬂows decreases the expected cash ﬂows and thus the value of the ﬁrm. Now we are in a position to understand why risk management can increase the value of the ﬁrm – or equivalently why variability lowers the value of the ﬁrm. What are the mechanisms that might make the relationship like that in Figure 4.2? Taxes are an obvious ﬁrst place to start. Think of the lower end of the value as representing losses. If you have to pay taxes when you make a proﬁt this will make the line ﬂatter for positive proﬁts. If there is no equivalent subsidy when the ﬁrm operates at a loss the relationship will become like Figure 4.2 (given that you had linear exposure before taxes). An ‘excess-proﬁts’ tax, or more generally a progressive tax system, would make this pattern even more pronounced. Another

Should a Firm Manage its Exposure?

27

way of stating the issue is that if expected taxes are increasing in the variability of proﬁts, this serves as an argument for limiting variability. If there are bankruptcy costs which are a decreasing function of the ﬁrm’s value, this would also lead to the relationship becoming more like that in Figure 4.2. Protecting oneself from bankruptcy thus is a motivation for risk management. Avoiding ﬁnancial distress in general is a good idea for a number of reasons. First, the simple perception by customers that the ﬁrm may go bankrupt entails costs. Customers may for instance believe that it could be harder to service the goods in the future, and demand compensation in the form of a lower price before they buy your products. Would you buy a car from a producer about to go bankrupt at the same price as you would from a ﬁrm that was ﬁnancially sound? Second, employees are likely to demand a risk premium for working for a company with a high probability of failure. In which position would you prefer to seek a new job – if your last employer was a classic success story hailed on the cover of business magazines or if it was a ﬁrm on the brink of bankruptcy? You would probably want some compensation for going to work for the struggling ﬁrm, for being associated with failure; and also want some compensation for the possibility of soon again having to incur the costs associated with having to search for a new job. Third, ﬁnancial markets or banks would also be more hesitant to lend money to a creditor with signiﬁcant risk of bankruptcy. Loans might be recalled, more securities demanded, or higher return demanded. Suppliers may also start wanting payment in advance or other arrangements that would tie up resources compared to having, for instance, three months of credit leeway. Fourth, ﬁnancial distress will increase the value of today’s cash ﬂows at the expense of the future. Investment spending, Research & Development or customer relations may be hurt. A speciﬁc example of this comes from Lewent and Kearney (1990), who study the hedging decision by pharmaceutical ﬁrm Merck. The hedging program was seen as important particularly for allowing stable R&D spending. In general it is well established that investment decisions of ﬁrms are sensitive to ﬁrm liquidity. Since this period’s cash ﬂows affect liquidity it is clear that typically greater variability of cash ﬂows is associated with greater variability in investment spending.2 In short, hardly surprising, it is generally a good idea to stay well clear of bankruptcy and ﬁnancial distress. Empirical evidence of this is presented in an interesting paper by Andrade and Kaplan (1997). They study 31 highly leveraged operations that became ﬁnancially distressed. All the ﬁrms had positive operating margins at the time of

28

Exchange Rates and the Firm

distress, and in a majority of cases margins were greater than the median in the respective industry. Apparently these were sound businesses that ran into ﬁnancial problems. We can get some measure of the cost of ﬁnancial distress. Andrade and Kaplan summarize their results (p. 1): ‘Our preferred estimates of the costs of ﬁnancial distress are 10 percent of ﬁrm value. Our most conservative estimates do not exceed 23 percent of ﬁrm value … Consistent with some costs of ﬁnancial distress, we ﬁnd evidence of unexpected cuts in capital expenditures, undesired asset sales, and costly managerial delay in restructuring. To the extent they occur, the costs of ﬁnancial distress that we identify are heavily concentrated in the period after the ﬁrms become distressed, but before they enter Chapter 11.’ On last thing with regard to Figure 4.2 should be pointed out. The shape of demand and cost functions, when there are price rigidities, for instance, can lead to proﬁts becoming a concave function of the exchange rate(s). If hedging makes it attractive to change pricing behavior so that proﬁts become linear this would also add value to the ﬁrm.3 The shape of the proﬁt function will be the focus of Chapter 9. One more circumstance that favors risk management for riskneutral ﬁrms is worth mentioning, although it is not directly related to the pattern (concavity) in 4.2. The issue is whether high uncertainty creates a lot of noise, making it hard to evaluate the performance of management. ‘OK, so we lost money last year. But it’s not because I’m a sucker at managing this ﬁrm, we were hit really hard by the exchange rate.’ If you as chairman of the board don’t want to hear this from your CEO, risk management can be a good idea.4 These were the reasons why a ﬁrm should manage risk if it is risk neutral. Again, focus on the case where the value of the ﬁrm is linear in the exchange rate. Could hedging still be a good idea? Regard the case of the ﬁrm owned by a single person who is risk-averse. So what does his utility of wealth look like? Well, simply put, if you are riskaverse, you are made less happy by good times than you are hurt in bad times. So your utility as a function of wealth looks like that in Figure 4.3. That is, utility is concave in wealth – you would prefer getting secure mean wealth in comparison playing a game with the same expected wealth. Obviously, risk management is a good idea in this case. But what about a public ﬁrm with widely dispersed ownership? Why not let it be risky: owners can put together their own preferred portfolio reﬂecting their attitude towards risk. One limitation here is that generally ﬁrms themselves have a much clearer view of their exposure and are thus

Should a Firm Manage its Exposure? Figure 4.3

29

Utility and wealth, concave relationship

likely to be able to manage risk at a lower price. An example of this is that the association of Swedish ﬁnancial analysts is very critical of the lack of information about exchange rate effects in annual reports. According to one of Sweden’s major news/business papers (Svenska Dagbladet) not a single one of the annual reports from 1995 fulﬁlled the requests from the association.5 Firms, at least in Sweden, are getting better at reporting, but there are obviously large asymmetries left. Let’s sum up. Should you manage exposure? The answer is generally yes, unless you have very deep pockets in relation to what’s at risk. At the very least you should keep track of exposure and see what happens in a worst-case scenario.6 Not hedging can be perfectly ﬁne. Not knowing the risks that you are exposed to is not ﬁne. All the reasons for hedging that we have surveyed thus far are connected to the value of the ﬁrm. Management may want to manage risk for their own reasons, and not necessarily with an eye to the value of

30

Exchange Rates and the Firm

the ﬁrm. If management has a signiﬁcant share of its wealth invested in the ﬁrm’s stock this will tend to make them more cautious with respect to the risks that the ﬁrm takes (if managers are risk-averse). On the other hand, options programs may make management riskseeking. De Marzo and Dufﬁe (1995) explore how asymmetric information on the labor market can lead managers to hedge in order to look good on that market.7 If future employers will not be able to observe your abilities perfectly, you as manager may wish to avoid sending a bad signal, even if this comes at a somewhat lower mean return. There is a risk that managers will let the exposure of the ﬁrm be ruled by what is good for them rather than by what is good for the ﬁrm. This underscores that the owners and the board should be active in designing the goals of risk management. So much for theory: how do ﬁrms behave in practice and why do they hedge? As academics we now remarkably little about the reasons for why ﬁrms hedge in practice. Practitioners naturally (hopefully!) know what the practice is in their own ﬁrm or industry, but have dim notions of what happens in other industries. The evidence that we have access suggests to that many ﬁrms hedge risks to some extent on the ﬁnancial markets. Perhaps the most comprehensive survey of hedging practices in recent years is Wharton/CIBC Wood Gundy (1996). The questionnaire was mailed to 2,000 randomly selected US ﬁrms plus a number of Fortune 500 ﬁrms in 1995. Only 350 ﬁrms actually responded, which may open up potential biases. That is, we do not know if the ﬁrms that answered are representative of the whole population. Of the ﬁrms that did answer, 41 percent answered yes to the question ‘do you use derivatives?’ (forwards, futures, swaps, options). Studies from other developed countries paint much the same picture. A signiﬁcant share of ﬁrms do hedge exposure with the use of ﬁnancial instruments. We will discuss the methods and amount of hedging in more detail late when we come to the individual parts of exchange rate exposure. What reasons for hedging seem to be the most important empirically? From speaking with practitioners, the question in my experience raises quite a few further question-marks. Many claim that ‘of course we hedge,’ feeling that further motivation is unnecessary. As discussed by Froot, Scharfstein, and Stein (1993, note 2), the same to some extent goes for the ﬁnancial literature. They make the observation that ‘This gap in knowledge is illustrated in the most recent edition of Brealey and Myers’s (1991) textbook. Brealey and Myers do devote an entire chapter to the topic of “Hedging Financial Risk,”

Should a Firm Manage its Exposure?

31

but the chapter focuses almost exclusively on questions relating to hedging implementation. Less than one page is devoted to discussing the potential goals of hedging strategies.’ How to hedge has been the emphasis of the literature, rather than why, when, and how much to hedge. Tufano (1996) studies management of gold price (and not exchange rate) risk. He studies essentially all the publicly traded North American gold mining companies in 1991–3. But we may here learn quite a bit about the reasons for hedging exchange rate risk as well. First we note that more than 85 percent of the ﬁrms managed gold price risk to some extent. In the 48 ﬁrms studied by Tufano, theories of managerial risk aversion seem to explain hedging patterns better than theories of shareholder value maximization. Thus in his sample of ﬁrms, risk seems to be managed in order for the management to look good or beneﬁt, not for reasons related to increasing the value of the ﬁrm. One indication of this is that he ﬁnds that ﬁrms in which managers hold more stock, manage more risk. The more stock that managers hold, the more of their wealth will be tied up in the ﬁrm, and if managers are risk-averse they will thus want to decrease risk. Further support for the managerial motive for hedging comes from the ﬂipside of the coin – ﬁrms where managers hold options tend to manage less risk (remember that the value of an option increases with variability). On the other hand, Tufano ﬁnds virtually no relationship between hedging practices and characteristics that would speak for hedging exposure on the grounds of maximization of shareholder value (likelihood of ﬁnancial distress, investment programs, and convexity of tax schedules). Géczy, Minton, and Schrand (1997) study a sample from 1990 of 372 Fortune 500 nonﬁnancial ﬁrms. All of these ﬁrms could be expected to be exposed to exchange rate surprises in the absence of hedging. About 41 percent of these ﬁrms used ﬁnancial instruments such as currency swaps, futures, forwards, or options to manage currency exposure. Géczy et al. do ﬁnd that ﬁrms with greater ﬁnancial constraints are more likely to use currency derivatives. This is consistent with the deep pockets hypothesis – if you face ﬁnancial constraints a bad outcome can prove very costly. Not surprisingly ﬁrms with greater foreign involvement (sales or debt) are more likely to use currency derivatives. These are the ﬁrms that we expect to be more exposed to exchange rates. A third interesting study is Nance, Smith, and Smithson (1993). They mailed a questionnaire to all the Fortune 500 and S&P 400 ﬁrms in 1986. Somewhat more than 30 percent of

32

Exchange Rates and the Firm

ﬁrms responded, and of these some 60 percent used hedging instruments to manage exposure. They do perform some tests that indicate that responding ﬁrms are not systematically different from nonrespondents. Their results are consistent with the notion that hedging is undertaken for shareholder value maximization purposes. The more rapidly taxes increase as proﬁts increase (convex tax schedule), the more likely is a responding ﬁrm to hedge. In addition, their results are supportive of the hypotheses that ﬁrms that are more likely to experience ﬁnancial distress hedge more. They also provide a detailed survey of previous related studies. A brief summary of Chapter 4 then reads like this: A number of reasons exist why a ﬁrm would want to manage exposure. Empirically we know that many ﬁrms do manage exposure, but we have as yet only scant knowledge about the reasons for hedging in practice and the evidence that we have is essentially from one country, the US. The evidence from the gold mining industry suggests that hedging takes place for reasons related to the managers themselves rather than the value of the ﬁrm. The evidence that we have from large ﬁrms (S&P 400 and the Fortune 500), however, points to hedging being undertaken to increase the value of the ﬁrm. Note that these large ﬁrms are companies in which we a priori would expect few of the reasons for hedging, such as nondiversiﬁed ownership or bankruptcy risk, to be relevant.

5 The Instruments Commonly Used for Hedging The hedge of course works by creating an offsetting exposure. If your cash ﬂows move in one direction because of an exchange rate surprise, hedging implies that you also have a contract, the value of which moves in the opposite direction. You create an offsetting exposure. In this chapter we will introduce the most commonly used ﬁnancial instruments available for hedging currency exposure. The instruments which we will explain are forwards, futures, options, and swaps. For a more comprehensive guide we refer the reader to any of the textbooks mentioned in the introduction, which typically have this as their main focus. Let us commence with the forward currency contract. A forward contract determines an amount of foreign currency to be sold (or bought) at a speciﬁed future date and at a price that is speciﬁed today. Forward contracts for 30 and 90 days are the most common, but there typically exist longer instruments such as 180 or 360 days, or several years, and forwards can be ‘tailor-made’ to ﬁt with the maturity, underlying currency, and date. We can illustrate how the forward works with the aid of a simple example. Let us assume that you are a British exporter having sold golf clubs to a US importer. When you sign the contract the spot exchange rate is equal to 0.60. That is, you needed 0.60 pounds to buy one US dollar. As payment for the shipment you are to receive US dollars 2,000,000 in 90 days. Say that you want to protect yourself fully from the impact of exchange rate surprises during the period of the trade credit. Further assume that the rate that you get when you talk to the bank on the 90-day forward contract is 0.6029. According to the forward contract you have both the right and the obligation to sell 2,000,000 dollars to the bank at the rate of 0.6029. The actual spot rate prevailing in 90 days is naturally unknown. What happens at maturity in 90 days? You receive payment of the 2,000,000 dollars which you convert at the spot rate that then prevails, say 0.62. You have an inﬂow of 2,000,000 0.62. You are also committed to selling 2,000,000 dollars to the bank at the rate of 0.6029, so you have an inﬂow of 2,000,000 0.6029. You have to buy 33

34

Exchange Rates and the Firm

these 2,000,000 dollars at the current spot rate of 0.62 however. So what is your total cash ﬂow at maturity? 2,000,000 (0.62 + 0.6029 – 0.62) = 2,000,000 0.6029. The cash ﬂow is only dependent on the forward rate. Given a known amount in foreign currency a forward contract can thus eliminate the uncertainty due to the future spot exchange rate. Instead of using the forward market you could have replicated the forward contract using the home and foreign money markets. This is called a money market hedge. Due to the possibility of arbitrage via forward markets a relationship known as covered interest parity will hold, which can be used to replicate the forward contract. 1 Use the same example as above, where you know that you will receive US dollars 2,000,000 in 90 days. Borrow the present value of US dollars 2,000,000 (at, say, 6 percent annual interest) today and convert this into pounds right away. You should thus borrow X = 2,000,000/(1 + 3/12 0.06) = 1,970,443 dollars today. Convert this into pounds at the spot exchange rate, and you thus receive 1,970,443 0.60 = 1,182,266 pounds, which you invest in Britain at the going interest rate of 8 percent per annum so that in 90 days you will receive 1,182,266 (1 + 3/12 0.08) = 1,205,911 pounds. So what are your cash ﬂows in 90 days? First of all you receive the payment of 2,000,000 dollars from your customer which you convert at the spot rate that then prevails. There is thus an inﬂow of 2,000,000 0.62. You also have to pay back the loan in US dollars so there is an outﬂow of 2,000,000 0.62. These ﬂows clearly cancel each other; what remains is a ﬂow from your pounds account of 1,205,911 pounds. If you had hedged using the forward rate you would have received 2,000,000 0.6029 = 1,205,800. Apart from some rounding off errors, the two are thus equivalent. Another instrument is the futures contract. These are standardized contracts that exist for some high-turnover currency markets and for relatively short horizons (up to one year). The standardized nature of futures contracts makes for lower transaction costs and greater ease in going into our out of positions. The practice on futures markets known as ‘marking to market’ means that proﬁts and losses on the futures are paid at the end of each day. This limits the risk associated with default of the counter-party. Currency swaps are yet another instrument. You exchange (swap!) obligations denominated in one currency for obligations denominated in another currency. Say that you are a British ﬁrm that has borrowed in US dollars and converted this into pounds. By making a swap arrangement you contract for a counter-party to service the dollar

Hedging Instruments

35

loan for you. In return you agree to pay the counter-party an agreed upon amount in pounds. A drawback of the above contracts is that you not only have the right, but also the obligation to sell foreign currency at a prespeciﬁed rate. In the small example that we used to illustrate the forward contract you would have preferred not to do so, since you would have received more pounds should you have used the spot rate at maturity to convert your dollar revenue. Foreign exchange options are the solution to this dilemma since they in this case confer the right, but not the obligation, to sell the foreign currency to the counter-party (this is what is called a put option). You can also buy an option which gives you the right to buy foreign currency (a call option) at a speciﬁed rate, the strike price. In the little example above you would thus use the option at maturity only if the strike price was higher than 0.62. In the forward example you would have preferred not to use the forward since the spot rate at maturity, 0.62, was more favorable to you than the forward rate was, 0.6029. Say that the option strike price was 0.61, you would then have chosen not to use the option and instead received the spot rate. On the other hand, if the exchange rate at maturity was 0.59 you would have exercised your right to buy pounds at the rate 0.61. There are no free lunches to be had, so the drawback to options is of course that you have to pay to get someone to accept the risk associated with writing the option. As we will see later, forwards are the most common instruments used by ﬁrms for hedging exposure, in particular contractual exposure. The ﬂexibility of options implies that they are more commonly used when there is larger uncertainty about the underlying currency ﬂows, such as is the case with operating exposure. A closer presentation of instruments, how they are priced, hedging by proxy (using contracts denominated in a currency highly correlated with the one you have exposure in), and so forth are beyond the scope of this book. As noted previously, there are a number of books that do focus on these issues. A ﬁnal point to notice is that exposure is really concerned with the real exchange rate, whereas the instruments surveyed here are derivatives of the nominal exchange rate. Since price levels tend to be stable, real exchange rates are driven mainly by the nominal exchange rate. This implies that instruments based on nominal exchange rates can be used to hedge for real exchange rate changes in the short to medium run. If you are using really long instruments, spanning several years, this does not hold true any more, and issues become more complicated.

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Part II Economic Exposure

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6 Economic Exposure Economic exposure is deﬁned as the sensitivity in the value of the ﬁrm to exchange rate surprises. For this purpose the ﬁrm’s value is measured as the present discounted value of expected future cash ﬂows. Since economic exposure is concerned with cash ﬂows and the value of the ﬁrm, the reasons for hedging that we mentioned in Chapter 4 are potentially important. The most common distinction is to say that economic exposure consists of, on the one hand, contractual (transaction) exposure and, on the other hand, operating exposure. As suggested by the name, contractual exposure refers to already known net ﬂows in foreign currency – past contractual undertakings that have future cash ﬂow consequences. The extent of the operating exposure (and hence economic exposure) hinges on how the ﬁrm, consumers, and competitors respond to exchange rate changes. How do the prices of your competitor change, how do you change your prices, how sensitive is demand to price changes, to what extent can you set prices on different national markets independently? These are all questions relating to economic exposure. It is thus clear that economic and operating exposure are ruled by issues relating to industrial organization and macroeconomics as well as to ﬁnancial issues. In the rest of Part II we will show how one can measure Economic exposure using econometric techniques, and learn about the mechanisms relating the value of a ﬁrm and its cash ﬂows to the value of currencies. Before we do that, however, let us spend some time further clarifying concepts. One important issue to understand is that a ﬁrm may be exposed to exchange rate changes even if it has no foreign subsidiaries (no accounting exposure) or has no cash ﬂows denominated in foreign currency (no contractual exposure). Let us examine an example – a Swedish ski-resort. The amount of foreign tourists to most of them is negligible – the Norwegians tend to stay on their side of the border and a few Finns or adventure-seeking Germans or British tend to be the only foreign birds to be seen. This pattern is particularly strong for the group of resorts going under the joint name of Sälen. They are the closest major ski resort to large parts of southern Sweden, including Stockholm. So can Sälen be 39

40

Exchange Rates and the Firm

exposed to exchange rates? There is little foreign denominated debt, no foreign subsidiaries, and essentially no cash ﬂows denominated in foreign currency. Remember the deﬁnition of economic exposure – the sensitivity of cash ﬂows to exchange rate surprises. The obvious alternative to spending a winter week in Sälen is to go to Norway or the Alps. As the Swedish krona ﬂuctuates, the price of competing goods thus ﬂuctuates as well, and this leads to changes in demand for vacations in Sälen. The competing goods are to a signiﬁcant extent priced in foreign currency – a trip to the Alps is typically paid in Swedish kronor but all expenses once on location are of course paid in foreign currency. Indeed, following the devaluation of the Swedish krona in November 1992 by some 20 percent, sales of lift tickets in Sweden were 50 percent higher in the winter of 1992–3 than in the previous winter.1 Large changes in the exchange rate are one of the dominant variables affecting the proﬁtability and cash ﬂows of Sälen ski resorts. This was one example of how ﬁrms without foreign trade can have signiﬁcant exposure to exchange rates. Sälen was an example of demand being affected because the price of substitutes (foreign ski vacations) changed. You may also be exposed if your customers in their turn have signiﬁcant exposure. The UK chemical products industry provides an example of this. Chemical Market Reporter writes ‘“Around 70 percent of domestic demand for chemicals comes from the manufacturing sector, so if it is not exporting so much, that has a double effect on the chemical sector” says Mr. Sturgeon.’2 Another channel through which a ﬁrm can be exposed to an exchange rate change is through competition with imported inputs. Again turning to the Chemical Market Reporter, they state that3 ‘An increase in cheaper chemical imports due to the stronger pound is also driving down chemical prices in the UK. Chemical imports were 5 percent higher in April than a year ago.’3 Yet another exposure channel is through revenue from export sales. The above article states that ‘The pound has risen by an average 20 percent against leading currencies since last summer … In the ﬁrst four months of this year, UK chemical export sales … dropped by 4 percent, although in the ﬁrst quarter they were 3.5 percent higher in volume terms.’ In short, there are numerous channels through which a ﬁrm might be exposed, whether it is an exporter or importer. Demand can be affected if the price of competing or complementary goods are affected by exchange rates, if the demand for your customer’s goods is affected by exchange rates, or through costs and the prices that you can charge.

Economic Exposure

41

Another important aspect of total economic exposure is that it in practice can only be partially hedged on the ﬁnancial markets. Financial instruments can only protect you against unexpected events, the logic being the same as the one that states that you cannot insure your house against ﬁre after it has burnt down. A classic illustration of this point is the case of Volkswagen in the early 1970’s.4 During this period the D-mark strengthened considerably against the US dollar. VW tried a number of different strategies for dealing with the issue: for one, they tried to hedge expected revenues on ﬁnancial markets. For VW there was no escaping the fact that the D-mark was strengthening; it had a sequence of forward contracts at successively stronger D-mark rates. In a situation like this, hedging just amounts to buying time. As illustrated by the VW case a ﬁrm will be interested in the sensitivity of proﬁts to the level of the exchange rate more than changes per se. We will return to this question in more depth in Section 9.1. The experience of a number of US ﬁrms during the episode of the strong dollar of the mid-1980s is another classic example of operating and economic exposure. A prominent case is competition in the market for photographic ﬁlm. In 1979 Kodak had a market share of approximately 80 percent and Fuji a share of 4 percent. Kodak produces in the US and Fuji produced in Japan. As the dollar successively strengthened, Fuji used the advantage of a favorable exchange rate to establish itself more ﬁrmly in the US market. By the time of the dollar cycle’s peak in 1985, Kodak’s market share had decreased to 64 percent and Fuji had expanded to having 11 percent of US sales. 5 Kodak has lately become known as one of the cutting edge companies in managing exchange rate exposure. The question that naturally arises is how should one measure economic exposure? Remember that it is deﬁned as the sensitivity in the value of a ﬁrm to exchange rate changes. So for publicly traded ﬁrms we can in a simple fashion see how the stock market valuation of a speciﬁc ﬁrm changes as a relevant exchange rate changes. The standard reference for deﬁning and measuring economic exposure in this way is Adler and Dumas (1984) – in their words, exposure is a regression coefﬁcient. Essentially one runs a regression on change in the stock market valuation of a ﬁrm, on the change in the exchange rate. In Chapter 7 we will discuss the empirical evidence from the studies that employ this technique. We should stress that this deﬁnition of economic exposure is only interested in how the expected value of future cash ﬂows change in

42

Exchange Rates and the Firm

response to exchange rate surprises. It is worth quoting the seminal article of Adler and Dumas (1984, p. 48) to remember their concerns: ‘Until now, corporate exposure to foreign exchange risk has largely been investigated in the literature from the viewpoint of the ﬁrm and its managers. Here we have looked at it in a way that conforms to the interests of stockholders and analysts.’ They stress (p. 42) that exposure measures what one has at risk, and that ‘A currency is not risky because devaluation is likely. If the devaluation were certain as to magnitude and timing, there would be no risk at all.’ This is often a narrower deﬁnition of the impact of exchange rates on ﬁrms than what ﬁrms are really interested in. From an investor’s perspective it makes sense: asset prices should be moved only by unexpected events. Everything that we know to affect the value of an asset should be incorporated in the price of that asset. A ﬁrm, however, will be interested in how it should deal with a very strong exchange rate even if the level of the exchange rate is not a surprise. In the second step, in a rational world, investors would incorporate knowledge of the ﬁrm’s strategies and this would then be reﬂected in the market price. A devaluation that is certain does not constitute risk of course – if the cost of producing in your home country decreases by, say, 25 percent against other countries, I would nevertheless want to know what strategy the CEO has in mind to beneﬁt from the situation.6 Everything that is known today has been a surprise at some point. For instance, take the year 1984: Kodak knew with reasonable certainty that the dollar would be strong. Their problem was not that the dollar price of one yen unexpectedly fell from 0.0044 on 1 May 1984 to 0.0043 on 1 June 1984; the main problem was that the dollar was strong, that the failure of prices to compensate for the accumulated nominal exchange rate changes led to changes in their competitive situation. The strong dollar had presumably already been incorporated in the stock price of Kodak; this did not relieve Kodak of having to have a strategy to deal with the issue. Unexpected or not this was a problem that had to be dealt with. Financial instruments are for obvious reasons worthless in dealing with this issue. When the spot dollar rate is strong, so will the forward rate be, if there is no change in sight. The mechanisms and strategies relating cash ﬂows to exchange rates that we discuss below will be relevant also for dealing with ‘known variability.’ I will make a simplistic illustration of the issues to further stress the point. I am convinced that a lot of the confusion about economic

Economic Exposure

43

exposure that one meets when talking to ﬁrms stems from this. Assume that the asset we study is the yield from one girl picking grapes during one day. The grapes here are the analogue of the cash ﬂow and thus of the value of the asset. The amount of grapes picked depends on the temperature: if it is hot the girl will pick fewer grapes, and if it is colder she will pick more. The temperature takes the role of the exchange rate in this little toy example. So the issue here is one of exposure to the temperature – how much fewer grapes do you expect the girl to pick if the day turns out to be hotter than you had thought? The same temperature will prevail the entire day, and the temperature is revealed at 9 a.m. The price of the asset should adjust immediately as the temperature is known. The story does not end there, however. The grape picker must have some strategy for how to pick given that it is a hot day. She competes with other grape pickers in the ﬁeld: how heat sensitive are those ladies? What grapes should she go for – high, low? How often should she stop to rest in the shade? How much should she drink? In some way she should deal with the fact that it is a hot day, just as a ﬁrm in some way has to deal with a strong or weak real exchange rate. Knowledge of how she will deal with the hot weather then determines how the price of the asset (the right to her grape yield) will change in the morning, when the day’s weather is announced.

6.1

WHO IS MORE EXPOSED?

The best start to the question of which ﬁrms have the largest economic exposure is to remember the obvious – cash ﬂows are the difference between revenue and cost. So when would revenue be affected much by exchange rate changes? The potential clearly increases if the ﬁrm exports much of its production; similarly if it faces strong competition whose prices in turn are much affected by exchange rates. As regards costs, the potential effects are clearly stronger the more of the inputs are imported and the more of a price taker the ﬁrm is (is it importing oil? Is it a major manufacturer importing from a small subcontractor?). Cost and revenue effects can partly cancel. Take the example of a Spanish ﬁrm producing tin from scrap metal. Both the input price and the output price will be determined on the metals exchange in London. So if the input prices increase because of a depreciation of the peseta this will be at least partly outweighed by the fact that output prices, when measured in

44

Exchange Rates and the Firm Table 6.1

Economic exposure – signs of the effect of a depreciation of the home currency

Activity

Sign of effect

Exporter Importer Import competitor User of internationally priced inputs

positive negative positive negative

pesetas, will also increase. We summarize this small discussion in Table 6.1. It states the direction which expected future cash ﬂows typically move when the home currency depreciates. The result that a depreciation raises expected cash ﬂows for an exporter is easy enough: if the ﬁrm can convert foreign currency earnings at a more favorable rate its cash ﬂows will increase. If my Korean ﬁrm sells for a million US dollars in a given month it is of course more favorable if I can convert this into Korean wons at an exchange rate of 1,500 won per dollar rather than at an exchange rate of 1,000 won per dollar. The opposite clearly goes for a ﬁrm having inputs priced in US dollars – do my imports or imported inputs cost 1.5 million won or 1 million? Similarly, do the goods that I compete with cost 15,000 won or 10,000 won? If a higher price of competing goods increases your cash ﬂows, the effect of a depreciation will be positive. It should also be noted that all ﬁrms are potentially affected by exchange rate changes – for instance, through channels of demand by customers. A shoeshine boy working on Wall Street could conceivably see demand ﬂuctuate with the strength of the dollar. If the dollar’s strength was reﬂected in the earnings of his customers and if the demand of shoeshine services was very sensitive to income, his earnings would be affected by the dollar strength. That point aside, we are of course interested in ﬁrms where we have the potential for strong effects. Even though I will have some revenues in British pounds from this book, I would not advise my barber to devote resources to developing a strategy for dealing with exchange rate variability. If my barber’s clientele on average spent a day per week in London the issue would be different – the point of course being that exchange rate exposure is a matter of degree. For many ﬁrms and businesses exposure is economically trivial. A different issue is the macroeconomic implications of large exchange rate changes (or the lack of them). A

Economic Exposure

45

Mexican- or Indonesian-style exchange rate collapse of course has profound macroeconomic implications affecting all and everybody. Since the exchange rate is the relative price of two national currencies, this relative price will be inﬂuenced by (and in turn inﬂuences) macroeconomic policy and shocks. The issue then is that of exposure to macroeconomic shocks more generally – a fascinating subject in itself but one that we will largely disregard in this book, as noted in the Introduction.

7 The Evidence Think of an asset with value V where V depends on a number of variables some of which are exchange rates. The value is the sum of future discounted cash ﬂows. Let E denote expectation and x denote partial derivative, the economic exposure of this asset to currency ei is then given by Ê xV ˆ Exposure of V to ei = EÁ ˜ Ë xei ¯

(7.1)

That is, the exposure is the expected change in the value of the ﬁrm as ei changes, holding the effect of all other variables constant. Writing this in the form of a regression and using index t for time period we can write the exposure as Vt + 1 – Vt Vt

= constant + ␤1

et + 1 – et et

+ error term

(7.2 )

Using some market price as a measure of the value of the asset, this kind of econometric analysis should thus give a convenient way of determining how exposed an asset has been historically to exchange rate e. Evidently, historic relationships are relevant for the future only to the extent that the rules of the game do not change too much. Measured exposure will also only measure the impact after any hedging has taken place. If you as an investor study the exposure of a given ﬁrm you will need knowledge of the hedging practices of the ﬁrm in order to be able to price it correctly. If the ﬁrm changes its hedging practices, the measured exposure will change. We must not forget that the resulting exposure coefﬁcient from a regression run along the lines of (7.2) does not necessarily represent a causal relationship, it may just reﬂect that both the value of the ﬁrm and the exchange rate are driven by some common shock. It must not be the case that exchange rate changes are what is causing the change in the asset price. A simple example would be that of monetary policy – a sudden expansion of the monetary stock should in theory lead to a depreciation of the domestic currency and an increase in nominal 46

The Evidence

47

market value of a ﬁrm.1 As we print more money all nominal prices should go up – both the prices of stocks and the price of foreign currency. In a regression such as the one above, this would show up as signiﬁcant exposure. With this word of caution we proceed – we return to the mechanisms relating market value of a ﬁrm to exchange rates further below. The widespread interest in exchange rate issues and the ease with which one can apply a regression of the type shown in Equation 7.2 has led to a surge of academic papers. The seminal empirical paper is Jorion (1990). Jorion studies the exposure of 287 US multinationals for the period 1971–87. As exchange rate Jorion uses a trade weighted index.2 His regression thus takes the form Rit = ␤0i + ␤i1Rst + ␧it

(7.3)

Where Rit is the return on stock i (percentage change in stock price), Rst is the change in the trade weighted exchange rate, and the last term is an error term. If one ﬁnds that ␤i1 is statistically signiﬁcantly different from zero one thus ﬁnds that stock i is exposed to currency (or index) s. With currency measured in the common way (higher value implying a depreciation), a positive coefﬁcient, a positive ␤i1, thus implies that a depreciation of the exchange rate is associated with an increase in the stock market valuation of the ﬁrm. The coefﬁcient of determination R2 describes how much of the variation in the return on the stock is ‘explained’ by the variability in the exchange rate.3 Jorion ﬁnds signiﬁcant exposure for a number of ﬁrms, but coefﬁcients are surprisingly small and in quite a few cases not stable over the period of study (that is, they change sign). He then proceeds to relate the estimated exposure coefﬁcients to the ratio of foreign sales. In the sample there is a statistically signiﬁcant pattern of ﬁrms with a larger share of foreign sales exhibiting stronger exposure. In this sense Jorion’s ﬁndings are consistent with what can be regarded as the common wisdom. However, the strength of estimated exposure effects in the literature that has followed Jorion has been much weaker than was commonly expected. Likewise the explanatory value of regressions has been low. Exchange rate changes have only been able to explain a small share of stock movements. Indeed, the typical exchange rate exposure article opens with a sentence outlining the common wisdom, only to note surprisingly small

48

Exchange Rates and the Firm

effects. For instance Donnelly and Sheehy (1996) open with ‘Conventional wisdom and economic analysis suggest that ﬁrm value is related to exchange rate movements.’ Bartov and Bodnar (1994) state that ‘It is a widely held view that exchange rate movement should affect the value of a ﬁrm.’ Booth and Rotenberg (1990) say that ‘All ﬁrms involved in international trade, and conceptually even purely domestic ﬁrms, are affected by changes in currency values.’ Finally Grifﬁn and Stulz (1997) note that ‘It is widely argued by economists, journalists and politicians around the world that some of the industries in their country compete vigorously with industries in other countries and that exchange rate shocks affect their competitiveness. For instance in the US, it is routinely stated that some US industries compete with Japanese industries and that an appreciation of the Yen is good for these US industries and bad for the competing Japanese industries.’ As we stated before, the effects found in the ﬁrst wave of research were surprisingly small. Amihud (1993) studied the simultaneous (that is, the change in stock market valuation associated with a change in the exchange rate in that same period) exposure for the 32 largest US exporters 1982–8 and failed to ﬁnd any signiﬁcant exposure. Bodnar and Gentry (1993) ﬁnd signiﬁcant exposure for only 11 out of the 39 US industries they study for the period 1979–88. Booth and Rotenberg (1990) study 156 Canadian ﬁrms for the period 1979–83. With this sample they ﬁnd strong evidence of signiﬁcant exchange rate exposure. However, the effects are typically negative, that is, in their sample a depreciation of the Canadian dollar is on average associated with a decrease in the market value of studied ﬁrms, also for ﬁrms who are large net exporters. Their results collide with common wisdom. In the words of Chow, Lee, and Solt (1997, p. 107), ‘The paucity of evidence in support of exchange rate exposure is bafﬂing since expressed concern with ﬂuctuations in exchange rates is widespread among ﬁrms.’ Should one then conclude that conventional wisdom is wrong? If this is the case you may wonder why you are reading this book at all. To some extent the conventional wisdom is wrong – effects are certainly smaller and less direct than what was commonly believed. Still, given the widespread concern about exchange rate exposure, and pictures such as that presented by Figure 7.1, it is hard to shake off the feeling that we are missing something. Real exchange rates impact the

The Evidence

49

Figure 7.1 Operating proﬁts as a share of turnover in Swedish manufacturing, and real exchange rate, 1975–93

cash ﬂows of ﬁrms. Then news about the real exchange rate should affect the stock market valuation of ﬁrms. Figure 7.1 maps the operating proﬁts as a share of turnover for Swedish manufacturing against the real exchange rate 1975–93. For instance, in the year that the trade-weighted real exchange rate was at 130 (weak), operating proﬁts in the Swedish manufacturing sector (dominated by exporters) were some 7 percent of turnover. The picture shows a pretty clear pattern: during these years, a weaker real exchange rate was associated with a higher proﬁtability. A ﬁgure such as 7.1 may merely illustrate a coincidence, but it does ﬁt in with conventional wisdom. Can it be that studies that follow the above methodology are missing something? Let us therefore turn to a number of extensions that can be made that typically tend to increase the measured exposure coefﬁcients and increase signiﬁcance.4 The ﬁrst is to recognize that the technique used above only measures the contemporaneous exposure, that is, the change in stock market valuation in a given period to the exchange rate change in that same period. This is the correct technique only if the full effect of an exchange rate change is reﬂected rapidly in stock prices. Bartov and Bodnar (1994) study 208 US ﬁrms on quarterly data for the period 1978–89. Consistent with the previously discussed evidence, they fail

50

Exchange Rates and the Firm

to ﬁnd any signiﬁcant evidence of contemporaneous exposure. They propose that the complex nature of exchange rate exposure means that it takes time to learn about the effects of an exchange rate change on the expected future cash ﬂows of a ﬁrm. It is very conceivable that only gradually will it be known how competitors and the ﬁrm itself will deal with an exchange rate change. This leads to inclusion of lagged exchange rate changes as explanatory variables – by doing so, they ﬁnd stronger evidence of exchange rate exposure. The lack of detailed knowledge on the exposure and exact hedging practices of ﬁrms makes it hard to observe, simply by looking at the data, when effects occur. An example of this comes from the Swedish pharmaceutical giant Astra. The annual report for 1994 stated that 50 percent of net ﬂows in foreign currency were hedged. In summer of 1995 Astra noted to some ﬁnancial analysts that they had seen no revisions in earnings expectations despite the strengthening krona of the time. When the stock market learned that the hedges would successively run out, the stock price plummeted four days in a row. 5 The information that Astra would be affected did not come as the krona strengthened – it came when the stock market learned something about the strategy of Astra. Reconnecting to the grape-picking example, you need to know the strategy of the grape picker, as you learn how hot it is going to be, in order to be able to make a correct valuation of the asset. Indeed, the Association of Swedish analysts (Sveriges Finansanalytikers Förening (1996)) criticize the information in Swedish annual reports and stress that the information provided is often incomplete. If you learn about the strategy only gradually, the response of the asset price will also be gradual. Chow, Lee, and Solt (1997) also ﬁnd that using long-horizon returns (up to 48 months) leads to signiﬁcant exchange rate exposure for the US portfolios they study over the period 1977–89. Bartov and Bodnar (1994) ﬁnd that the coefﬁcients on the lagged exchange rate tend to get weaker in the latter part of the sample – this would suggest that analysts have increasingly learned about how to evaluate exchange rate effects as we have grown more used to ﬂoating exchange rates. It may also reﬂect that the information provided by ﬁrms has become better and that strategies are more well deﬁned. The second observation to be made is that the above literature has used exchange rate indexes instead of individual currencies which may contribute to the weak signiﬁcance. A particular US ﬁrm may for instance be exposed only to the Mexican peso, which has no weight at

The Evidence

51

all in the standard exchange rate indexes. Even an extreme exchange rate change such as the collapse of the Mexican peso would thus not show up in the exchange rate exposure coefﬁcient. Lindé and Öhnell (1998) and Nydahl (1998) ﬁnd that using separate currencies is a promising avenue for ﬁnding more signiﬁcant exposure coefﬁcients. The drawback to this approach is that one needs to know more about the ﬁrm of study to determine the relevant exchange rates to include. It is also the case that exchange rates exhibit multi-collinearity: that is, to a large extent they tend to move together, leading to lower signiﬁcance of estimated coefﬁcients, since only the variability speciﬁc to that currency goes into determining the exchange rate exposure coefﬁcient. A third observation to be made is that most of the studies focus on US ﬁrms (not a unique case in economics!). To be sure there are a number of US ﬁrms that have a dominant share of their revenues resulting from foreign sales. Almost by deﬁnition, however, ﬁrms in more open economies will typically have a larger share of their revenues potentially exposed to exchange rates. One could also speculate that the returns to analyzing exchange rate exposure would be larger in a more open economy. Studies of exchange rate exposure in more open economies tend to ﬁnd signiﬁcant exposure coefﬁcients to a much larger extent. Examples are Nydahl (1998) for Sweden, Donnelly and Sheehy (1996) for the UK, and He and Ng (1998) for Japan. Friberg and Nydahl (1999), in a study of ten national stock markets also ﬁnd that stock markets, in more open economies tend to be more exposed to exchange rate changes. On the other hand, in an ambitious cross-country industry study, Grifﬁn and Stulz (1997) ﬁnd exchange rate exposure effects that are generally of little economic relevance. This holds true also in more open economies, even though they are stronger there than in the US. They examine weekly industry data from the US, Canada, the UK, France, Germany, and Japan for the period 1975–97. They ﬁnd that industry-wide shocks are more important than exchange rate shocks in explaining stock movements. Furthermore, the industry-wide shocks tend to affect ﬁrms in the same direction – as they put it: what’s good for GM is good for Toyota, on average. Common to all the studies above is that they study a large number of industries or ﬁrms, paying little attention to industry-speciﬁc details or ﬁrm-speciﬁc variables. Exposures of ﬁrms within the same industry may very well cancel. One can draw connections to how the ﬁeld of

52

Exchange Rates and the Firm

empirical industrial organization has developed. Much empirical work was previously done in the so called structure–conduct–performance tradition. This was very much in the same spirit as the exchange rate exposure literature. Newer work tends to be in the ‘new empirical industrial organization’ tradition – looking at one or a couple of markets or ﬁrms only, and paying careful attention to the details of the industry in question. An interesting type of study would be to take an industry where we know something about what kind of exposure to expect, what prices have been, and compare this to the stock market reaction. Take for instance the case of Kodak and Fuji: how did their stock prices develop over the last 20 years? A study somewhat in this spirit is Chamberlain, Howe, and Popper (1997), who examine the exchange rate exposure of 30 large US banks and around 100 Japanese banks on daily and monthly data for the period 1986–93. Controlling for stock market movements and industry effects they ﬁnd signiﬁcant exchange rate exposure for about a third of US banks. The indicators of foreign exposure that they use (for instance, foreign loans, foreign exchange contracts that mature within one year, accounting exposure) explain (the coefﬁcient of determination) 25 to 40 percent of estimated exchange rate exposure. They ﬁnd less evidence of signiﬁcant exposure for Japanese banks. Rather than just statistically measuring exposure, one should also be interested in how it interacts with, for instance, price adjustment by the ﬁrm. Bodnar, Dumas, and Marston (1998) take steps in that direction. They derive both price-setting behavior and exchange rate exposure from underlying characteristics of the competitive situation on a market. A safe bet is that we will see a lot more empirical work in the future incorporating aspects of industrial organization and ﬁnance. The ﬁrm itself can do similar regressions on cash ﬂows to determine their sensitivity to different currencies. Oxelheim and Wihlborg (1995) examine the sensitivity of cash ﬂows of the passenger car division of Volvo to exchange rates and other macro variables during 1981–9 (and use the period up to 1992 to evaluate how their estimates perform out of sample) to exchange rates and other macroeconomic variables. Their results indicate that the exchange rate vis-à-vis the D-mark is very important for the cash ﬂows of Volvo. Germany is not a very important market; neither is it a major source of production for Volvo. An intuitive channel for why the D-mark mattered, however, would be operating (or competitive) effects. A (real) appreciation of the D-mark would typically affect competitors of Volvo neg-

The Evidence

53

atively (BMW, Mercedes, VW, …). As Oxelheim and Wihlborg rightly notice, this kind of econometric analysis does not provide any information on the mechanisms through which exchange rates affect cash ﬂows and the value of a ﬁrm. We will return to that issue after using Chapter 8 to expand on the straightforward part of economic exposure, the contractual exposure.

8 Contractual Exposure Contractual exposure (or transaction exposure) is the sensitivity of future cash ﬂows to exchange rate changes due to past contractual undertakings. That is, it will be the net of accounts receivable and accounts payable (and loan payments) in foreign currencies. Take a simple example. You are the manager of a British ﬁrm. You have previously sold some Stilton cheese to a German ﬁrm, but since the German ﬁrm had three months’ trade credit you will receive the 100,000 D-marks on, say, 30 May. You have also imported some sauerkraut from Germany, the payment for which, 50,000 D-marks, is due on the same date. What is the contractual exposure of this ﬁrm to the D-mark? Simply, the net of receivables and payables, that is, 50,000 D-marks. An ongoing ﬁrm will typically have in- and outﬂows at many different dates; one can then calculate the contractual exposure for each date. Straightforward as it is, history provides quite a few examples of ﬁrms going bankrupt because of failure to hedge contractual exposure. This is most pronounced when countries have abandoned a ﬁxed exchange rate and ﬁrms have taken loans in foreign currency, to beneﬁt from lower interest rates abroad. Southeast Asia provides a number of examples, as does Sweden in the 1990s. A well-known Swedish example is the ferry ﬁrm Slite. Slite was a co-owner of Viking Line, which we will study later. It had ordered a new ship, a giant ferry named Europa from Germany. Slite had chosen not to hedge, given that Sweden had a ﬁxed exchange rate with the D-mark having a substantial share in the currency basket – from 1991 Sweden was tied to the ecu. When Sweden let the krona ﬂoat in 1992 it rapidly depreciated against the D-mark by some 25 percent. The ship became 200 million kronor more expensive, and Slite subsequently went bankrupt in April 1993 – the ship being a major contributing factor to this. The direct cause of the bankruptcy was that Nordbanken refused to postpone interest payments. Whether this decision was optimal or not has been the focus of quite some debate.1 It is an illustration that once you get into ﬁnancial distress you are very vulnerable. When hedging contractual exposure one should also take account of how operating proﬁts will be affected by exchange rate changes. We take a simple example of two ﬁrms. One, ‘Johan i Hallen,’ was a meat 54

Contractual Exposure

55

wholesale-dealer. They had signiﬁcant loans denominated in foreign currency. When the krona depreciated these loans became more expensive to service. The depreciation also implied that it became more expensive to import meat. Operating and contractual exposure pulled in the same direction, and eventually ‘Johan i Hallen’ went bankrupt.2 Secondly, one of the ski resorts that belong to the Sälen group, Lindvallen (that we discussed in the introduction to Part II), also had substantial loans in foreign currency. For Lindvallen, operating exposure outweighed contractual exposure, however, and on net the fact that servicing foreign currency loans became more expensive was no threat to the company’s existence. It deserves to be emphasized that hedging of contractual exposure does not eliminate the effects of exchange rate variability on the ﬁrm. Financial hedging implies a gain on one contract (the hedge) that partially or fully offsets the loss on the other contract that is due to trade credit. Hedging of contractual exposure does not affect operating proﬁts; it is primarily a way of facilitating budget projections, unless exposure is very large.

8.1

HOW DO FIRMS BEHAVE IN PRACTICE?

Since contractual exposure involves cash ﬂows, it is often worth hedging for one or more of the reasons discussed in Chapter 4. Indeed, there is evidence that ﬁrms to a quite large extent do hedge contractual exposure. From the Wharton/CIBC Wood Gundy (1996) study we know that of the responding ﬁrms that do use foreign exchange derivatives, 49 percent ‘frequently’ hedge contractual commitments and a further 42 percent do it ‘sometimes.’ Forwards/futures are the instrument of choice for most ﬁrms when hedging contractual exposure: 86 percent of the ﬁrms rank these as the most important. Seven percent responded that options were the most important instrument for hedging such exposure. Soenen and Aggarwal (1989) ﬁnd that for the responding companies, contractual exposure was the main focus of exposure management for 39 percent of UK ﬁrms, 47 percent of Dutch ﬁrms, and 57 percent of Belgian ﬁrms. A further 52 percent of UK ﬁrms claimed that both management of contractual and accounting exposure was the focus of exposure management. The corresponding ﬁgure for the

56

Exchange Rates and the Firm

Netherlands was 42 percent and that for Belgium 31 percent. The vast majority of ﬁrms in all three countries pursued a policy of selective hedges. The highest share of ﬁrms using a policy of full hedging was found among the Dutch respondents (26 percent). Full hedging means that one sets up contracts that fully offset the contractual exposure. In all three countries, the most popular instrument for hedging contractual exposure was forward foreign exchange contracts. Lindé and Öhnell (1998) examine 51 Swedish companies listed on the Stockholm exchange. Out of 38 companies with foreign sales representing more than 10 percent of total sales, 68 percent have the goal of reducing or even eliminating Contractual exposure. We return to a further discussion of hedging in section 9.1. Leaﬁng through annual reports gives one a picture that is largely consistent with the above. Many ﬁrms hedge contractual exposure, and forwards are the most commonly used instrument.

9 The Mechanisms and What can be Done about Them – a Close Look After the focus on contractual exposure in Chapter 8 we now return to the question of economic exposure. It would have to be a very brave, or foolish, businessman that built strategy on results from regressions such as those in Chapter 7 above, without understanding the underlying mechanisms. This point is of course not new: for instance Coppé et al. (1996) stress that ‘Companies need to understand – not just correlate – the relationship between foreign exchange movements and cashﬂows.’ This is not to say that statistical analysis is pointless – it can serve as a valuable complement to economic analysis. In Chapter 6 we noted the characteristics of ﬁrms that are more exposed. We now turn to a closer look at the mechanisms. How should a ﬁrm manage economic exposure – what strategies should be used? As with any risk, the possibility of a bad outcome should be weighed against the chance of a good outcome. Remember that we are now looking at total economic exposure. That is also operating exposure which includes competitive responses. How should the ﬁrm deal with a strong exchange rate? With a weak? How can we classify strategies? We will try to use Figure 9.1 to organize the discussion. Each of the issues raised in Figure 9.1 will be dealt with in more detail in the rest of Chapter 9. Again we go slightly outside the deﬁnition of economic exposure. The measure of economic exposure as deﬁned by Adler and Dumas (1984) measures only the expected slope of the curves in Figure 9.1. If exposure is not linear, the curvature also is important. If proﬁts are affected by exchange rate changes like A (concave) in Figure 9.1, the ﬁrm will loose more in bad times than it gains in good times. Exchange rate variability will then lower average proﬁts over time. If revenue decreased more when price was increased (appreciation of the exporter’s currency), than it increased when price was decreased, such a pattern would emerge. As we will note later, this is a property of a wide class of demand functions. Similarly, if marginal costs were sharply increasing in produced quantities, a pattern like A would 57

58 Figure 9.1

Exchange Rates and the Firm Proﬁts and the exchange rate, examples of relationships

emerge. When the exchange rate was favorable and the ﬁrm produced more, markups would be lower due to the increasing marginal costs, and you would gain less than you would loose for an appreciation of the same size. By stabilizing foreign currency revenues an exporter would achieve a pattern more like D, where the exposure was linear as we discussed in Chapter 2. If foreign currency revenues are ﬁxed, cash ﬂows are affected equally much by an appreciation or depreciation of equal size. The goal of hedging is to make the relationship more like B – to make proﬁts more independent of exchange rates. The goal of successful dealing with exchange rate variability (unless you’re riskaverse) is to get them more like C (convex). In C the ﬁrm gains more under a favorable exchange rate than it looses under a less favorable exchange rate. This builds on ﬂexibility – making the most of the good times and limiting damage in bad times. Essentially what we do in the

The Mechanisms – a Close Look

59

rest of this chapter is to discuss various strategies of stabilizing foreign currency earnings (and home earnings as well) to get exposure more like D; and various strategies to achieve greater ﬂexibility – to get the relationship more like C. It will help us to organize the discussion if we set up an expression for the value of cash ﬂows of the ﬁrm. Remember that economic exposure was concerned with how the value of the ﬁrm would change as the exchange rate changed. The value of the ﬁrm is measured as the expected discounted value of cash ﬂows. Equation 9.1 sets out a very stylized version of discounted cash ﬂows where we suppress the expectations operator. The value of these cash ﬂows is given by the revenues on sales on all the markets (indexed by i) where the ﬁrm is present, deducting the costs of production and including the sum of cash ﬂows from any ﬁnancial market hedges initiated at earlier time periods.1 The value of the hedge will be dependent on when and at what rate it was bought, and on what kind of hedge it is (option, forward, or what have you). To keep the Equation simple and general we introduce ﬁnancial market hedges in a simplistic fashion. pi is the price that the ﬁrm receives from each market. qi is the quantity demanded on the respective market. Demand will depend on the price that consumers face, piC, and on the prices of your competitors, Pi. The reason for separating the price that the ﬁrm receives from the price that customers meet will become clear when we discuss what currency to set price in. Say that you set price in your own currency, p. The price that customers face, piC, will then be equal to p/e. Demand also depends on other factors, summarized by i. Costs depend on the produced quantities. The future of course consists of a number of equal expressions for times t + 1, t + 2, and so forth, discounted at some discount rate, ␳. n

m

( p i q i ( p iC , P i , ␪

Vt = i =1

i

Hedget – k + ␳Vt + 1

) – C( q i )) +

(9.1)

k =1

Exchange rates affect the value of a ﬁrm through all the parts of the value-function V. The exchange rates are implicit in the equation above, and have the potential to affect the price that the ﬁrm receives (if priced in another currency than the ﬁrms ‘own’). They can also affect the price that your customers meet, as well as the price of competing goods or exogenous demand. To recapitulate: economic exposure measures the change in Vt as exchange rates change. The change

60

Exchange Rates and the Firm

will be dependent on all the including parts, and I will organize the following discussion of strategies based on the expression above. We commence with a discussion on whether ﬁnancial hedges can eliminate the effects of exchange rates on the value function.

9.1

THE LIMITATIONS OF A HEDGE

Suppose for a moment that you want to completely remove the effect of exchange rates from the cash ﬂow represented in Equation 9.1. Can you do this? To put things simply, you can only achieve a perfect hedge if the world is static; that is, if cash ﬂow in foreign (and domestic!) currency is given. This is an assumption hidden in many of the beautiful hedging results presented in textbooks and academic papers. If you are British and thus interested in pound income, and know that you will receive 1,000 US dollars per year for the next ﬁve years, there is little problem hedging this. In the same sense it is little trouble to hedge contractual exposure as discussed in Chapter 8. If the cash ﬂow depends on the exchange rate in a complicated way, the simple hedging result disappears. When should the hedge be undertaken? If you want to hedge a cash ﬂow at some future date, say ten years from now, you would want to update the hedge every time you learn something new. If I want the exchange rate to have no effect on my cash ﬂows in 2004, how much should I hedge? This creates the need for constant updating, and in addition creates risk associated with holding constantly changing numbers of forward contracts, or whichever instrument you use. Unfortunately, as practitioner you are largely on your own in trying to implement an optimal hedge strategy over time. The work that deals most seriously with the problem of when to initiate a hedge is Dumas (1994). It is worth working through his paper in some detail. Consider a random cash ﬂow Rt, to be received at time t that is related in some way to the recent change in a spot exchange rate, et – et – k. There are also a number of other factors inﬂuencing this random cash ﬂow, but for ease of notation we suppress them. Let Ft – k be the forward rate of the currency at time t – k. Say that the owner of this cash ﬂow made a hedge at time t – k of – b, a forward contract. We can then write the overall cash ﬂow at time t as R(et – Ft – k) – (et – Ft – k)b

(9.2)

The Mechanisms – a Close Look

61

b is the regression coefﬁcient on R from et – Ft – k. By construction the variance of this cash ﬂow has then been reduced as much as possible by the use of a forward contract. Dumas argues that a ﬁnancial cash ﬂow is typically correlated with the change in the exchange rate, whereas a commercial cash ﬂow depends on the level of the exchange rate. Remember the grape-picking example from Chapter 6 where we stressed this point. The cash ﬂows of ﬁrms exporting to the US in 1985 were strong. The fact that the dollar was worth almost 10 kronor was what mattered for the cash ﬂow of, for instance, Volvo. That the krona appreciated against the dollar from 9.01 to 8.98 during the month of April was not crucial. Their engagement on the US market is long term. Look at the issue of a ﬁnancial asset instead – a ﬁnancial cash ﬂow stems from assets that are typically liquid. It is easy to adjust the portfolio, and any news should affect the price at the same time as it appears. Except for dividends, the return to holding an asset is the change in the asset price over a period. It is reasonable to focus on the rate of return over a relatively short holding period. The asset generating the cash ﬂow is easily tradable and all of the effect on the price of the ﬁnancial asset should occur simultaneously with the exchange rate change. Now instead think of the case where the cash ﬂow depends on the level of the exchange rate. The cash ﬂow at time t then is R(et) – (et – Ft – k)b

(9.3)

The important point is that the risk due to et has been replaced by Ft – k risk. The ﬁrm has a risk due to the forward rate rather than to the spot market rate. Let us employ Figures 9.2 and 9.3 to provide an illustration of the problem. Figure 9.2 illustrates the spot price in Swiss francs of US dollars from 1993–8. It also shows a nine-month forward rate (calculated with the covered interest parity relationship from Chapter 5). We see that they follow each other closely. The exchange rate follows a random walk and the best prediction is today’s value; consequently the forward rate follows the spot rate to a large extent. Essentially, in a situation like this using forwards to hedge just means locking yourself into today’s exchange rate. Now take the longer term picture of 9.3, which shows the real exchange rate of Switzerland vis-à-vis the US for the period from 1973 (with the real exchange rate arbitrarily set equal to one in January 1990). We see that there are a number of swings in the real exchange rate, often lasting for a couple of years. To isolate a Swiss importing

62

Exchange Rates and the Firm

Figure 9.2 1993–8

Swiss franc price of one US dollar and 9-month forward rate,

Figure 9.3

Real exchange rate, Switzerland/USA, 1973–97

ﬁrm from the strong dollar of the mid-eighties, a hedge would have had to be implemented around 1980. If a ﬁrm had a policy of hedging exposure well into the future it would have locked itself into forward contracts with a very unfavorable rate on the contracts it took up around 1983–5. By hedging with forwards you can thus isolate yourself from the contractual exposure but you will still be affected by the swings of the exchange rate. A recent example comes from Coca-Cola,

The Mechanisms – a Close Look

63

‘which earns 80 percent of its proﬁts from outside the US, [and] has historically engaged in extensive currency hedging operations to protect its dollar proﬁts, but the long rise in the dollar has reduced the effectiveness of these measures.’2 By using options you circumvent this latter problem; but options come at considerable cost, as noted earlier. Dumas (1994) tries to implement an optimal hedging plan on an unspeciﬁed British importing industry. He ﬁnds (p. 29) that ‘none of the long-term [hedging] policies adds measurably to the short-term hedge. The case example has illustrated that the beneﬁts of long-time hedging are hard to reap.’ Copeland and Joshi (1996, p. 77), in a study of a US multinational ﬁrm, reach a similar conclusion: ‘We found that the actual hedged cash ﬂows were just as volatile as the unhedged cash ﬂows.’3 It should also be stressed that as one leaves the simple setup where cash ﬂows are ﬁxed in some currency one may have a natural hedge and hence ‘ﬁnancial’ hedging may increase exposure. Copeland and Joshi (1996) cite the example of a European Airline that in the mideighties contracted for Boeing airplanes to a total value of a couple of billion dollars. So if the dollar strengthened further, the payments for these planes would increase in terms of the airlines domestic currency. The airline made ﬁnancial hedges to protect themselves from this. However, they overlooked that for this airline a strengthening dollar also meant increased commercial cash ﬂows. More Americans will travel across the Atlantic – this and other effects dominated the cash ﬂow of this airline, leading to a stronger dollar being associated with a stronger cash ﬂow. The airline contract constituted a natural hedge – taking a ﬁnancial position thus increased exposure to the dollar. The heart of the matter is that the commercial cash ﬂow depends on the level of the exchange rate, it is not some ﬁxed amount in the currency of denomination. So how should a ﬁrm that wants to reduce risk behave in practice? The evidence that we have on the hedging practices of economic/ operating exposure paints a somewhat disparate picture. In the Wharton/CIBC Wood Gundy (1996) study 50 percent of responding ﬁrms that do use derivatives, hedge anticipated contractual exposure ‘frequently’ and a further 41 percent ‘sometimes,’ A look through Swedish annual reports also suggests that many ﬁrms enter forward contracts that correspond to percentages of expected exposure. The policy of Cardo (annual report 1996) is typical of many of the Swedish ﬁrms. Cardo states that they hedge large contracts fully (contractual

64

Exchange Rates and the Firm

exposure) and have forward contracts corresponding to roughly 50 percent of expected sales in the coming 12 months. They clearly state that the purpose is to allow for some time for prices and costs to adjust. The share of expected sales that is hedged is often allowed to vary quite a bit, depending on what the ﬁrm believes about exchange rate developments – in effect ﬁrms are thus speculating. Most ﬁrms hedge from a few months up to perhaps a year. The stated policy of truck producer Scania (annual report 1996) is not unrepresentative – Scania generally hedges contractual exposure when it occurs (implying a 3–4 month hedge) but allows hedging to vary between 0 and 12 months. Some ﬁrms hedge expected sales further off in the future: most notable among Swedish ﬁrms is perhaps Volvo. Volvo hedges 40–80 percent of expected ﬂows for the coming 12 months, 20–60 percent for periods 13–24 months ahead, and 0–40 percent for the period from 25–36 months ahead. This kind of rolling hedge seems to be prominent among some European car manufacturers – Brealey and Kaplanis (1995) cite evidence of UK and German luxury car manufacturers employing a similar strategy. The longest hedges that I found evidence of in Swedish annual reports from 1996 were employed by the mining ﬁrm LKAB, who had hedges covering ‘a signiﬁcant share’ of expected dollar inﬂows until 2001. A case study of Swedish chocolate ﬁrm Cloetta (Hegbart and Jutterström, 1995) can teach us something about how ﬁrms can estimate and hedge exposure. On markets where Cloetta feels that they have a stable market share and can make reasonably good predictions of future cash ﬂows in foreign currency, they hedge. Cloetta use forwards for this purpose. On markets where the uncertainty is greater they hedge to a lesser extent. The markets where uncertainty is great are typically smaller markets. As opposed to the case of contractual exposure, options are often chosen for hedging anticipated exposure according to the Wharton/CIBC Wood Gundy study. Over half of the ﬁrms that hedge anticipated exposures at longer maturities than one year cited options as their preferred instrument. The ﬂexibility of the option is of great value when the exposure to be hedged is uncertain. When asked if they hedge competitive economic [operating] exposure only 8 percent of responding ﬁrms in the Wharton/CIBC Wood Gundy study claimed that they hedged frequently. Sixty percent of responding ﬁrms never hedged competitive economic exposure. In Belk and Glaum’s (1990) UK study, 6 out of 16 respondents did not manage their economic exposure at all. The rest of the ﬁrms did manage exposure in some

The Mechanisms – a Close Look

65

way, but practices varied greatly. It is worth quoting Belk and Glaum at length (pp. 6–7): Because of the complex nature of the topic and the great diversity of the companies interviewed, it is not surprising that the questions about the management of economic exposure and the longer term, strategic aspects of foreign exchange risk management produced very heterogeneous results. Some of the questions met with only hesitant replies, and at times the use of the term ‘economic exposure’ seemed to evoke a feeling of uncertainty and unease with the interview partner. The following gives a good instance of this[:] Company A: We do think about our economic exposures a lot, but it is difﬁcult to say exactly what we do … One of the most signiﬁcant results of the questions on economic exposure was that none of the companies interviewed used any means of managing exchange risk other than ﬁnancial means. One aspect of risk management that we will not go deeper into concerns where in the company it should take place, how centralized it should be, and how the control of the risk management policy should work. There have been a number of well-publicized option brouhahas – such as Barings, Orange County, and Metallgesellschaft. The wellknown crashes depend on lack of control of the traders. Reading an account of Nick Leeson’s lofty affairs or Jorion’s (1995) description of the Orange county collapse is instructive. This is not really an argument against hedging or a limitation of the hedge; it is, however, an argument for closely monitoring the risk reduction techniques used by the ﬁnance department and the positions of individual traders. The economies of scale and competence needed often speak for concentrating ﬁnancial hedging activities. Shell states, for instance, that ‘Except in exceptional cases, the use of derivative instruments is generally conﬁned to specialist oil trading and central treasury organisations which have appropriate skills, experience, supervision and control and reporting systems.’4 All in all we see that hedging is at best only a partial protection against negative effects exchange rate variability. Levi (1990, p. 440) states, ‘The techniques of forwards, futures, options, and swaps used for hedging purposes are not designed to help eliminate operating exposure.’ What hedging may accomplish is to buy time during which real operations can be adjusted, as discussed by Cardo. Brealey and Kaplanis (1995) mention this motivation for hedging in their analysis

66

Exchange Rates and the Firm

of different hedging strategies in a stylized framework. They summarize their ﬁndings (p. 765) as: ‘We show that commonly used strategies, such as one-period cash ﬂow hedges and long-term ﬁxed hedges, may leave the ﬁrm very exposed to foreign exchange risk. One possible explanation for the popularity of one-period cash ﬂow hedges is that the ﬁrm may shift its operations in response to an exchange rate change. We argue that the opportunity for such shifts may help to explain the use of short term hedges.’ One may also buy some time during which one can adjust prices – for instance, Sverker Martin-Löf, president of Swedish forestry ﬁrm SCA, observes: ‘It usually takes around nine months to change our prices vis-à-vis customers. Therefore it seems logic to hedge ﬂows during a nine-month period.’5 How should operations and prices be changed? This is what we turn to next – how the operating proﬁts will vary with exchange rates. The ﬁnancial hedge can create an offsetting exposure to the operating exposure but it does not affect the operating cash ﬂows per se (unless there is some sophisticated argument whereby the fact that you have a hedge affects the nature of competition) – which is what we now turn to.

9.2

CHOICE OF CURRENCY OF DENOMINATION

In which currency should the ﬁrm (try to) denominate its foreign trade? Given that prices are ﬁxed for some period of time, in which currency should they be ﬁxed? In terms of Equation 9.1 this will affect both the price that you receive and the price that importers pay. The ﬁrst important point to recognize is that the reason why the currency choice matters at all, is that the combination of ﬁxed prices and variable exchange rates shifts relative prices. If we negotiate price and quantity at the same time and I get paid right then, it does not matter if we count in apples or pears. As soon as there are lags the currency choice will matter. We here take the viewpoint of an exporter. A stylized international transaction has the following timing of events, which are also illustrated in Figure 9.4. First, the price is set in some currency, some time elapses, an importer decides what quantities he will wish to purchase at the prices that he then faces, contracts are signed, and there is some trade credit before the invoice is ﬁnally paid. Begin by noting, as did nineteenth-century economist Stanley Jevons, that money (internationally as well as domestically) fulﬁlls three major roles; it acts as a medium of exchange, as a store of value,

The Mechanisms – a Close Look Figure 9.4

67

A stylized international trade transaction

and as unit of account.6 The different stages of the stylized international trade transaction above broadly relate to these different roles. The ﬁrst relates most closely to the unit of account. The currency in which the trade credit is given will be mostly inﬂuenced by store of value considerations. Finally, the currency of payment will fulﬁll the medium-of-exchange role. We discuss them in reverse order. What do we look for in a medium of exchange? Above all it should be acceptable to others as payment for a good or service. In Swedish newspapers one on and off sees curious ads where someone wants to exchange 2,000 Christmas cards for a cellular phone, or something else to that effect. One alternative is that it is some form of covert message from one drug dealer to another. If it is not, the guy with the cards probably has to search for quite a while. Selling the cards for Swedish currency and then using this to buy the cellular would evidently make the trade much simpler. Money fulﬁlls the medium-ofexchange function. That is, money solves what economists call the double coincidence of wants problem. How then does this relate to the currency choice? Similarly, a currency that functions best as medium of exchange is the one that is acceptable to the most people. High turnover in this currency will also lead to lower transaction costs (a lower bid–ask spread). Medium-of-exchange considerations thus typically point at using an international currency or at least the currency of an industrialized country with reasonable turnover. Figuratively, you might have to search for quite a while before ﬁnding someone who is ready to trade Sao Tome dobras or Kirgistani som against your home currency, say Canadian dollars. The bid–ask spread will be large and the market illiquid. It will pay to use a third currency as a vehicle currency. The Sao Tome importer exchanges his dobras for US dollars, which you accept and then exchange to Canadian dollars.

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Exchange Rates and the Firm

The store of value function is closely related to contractual exposure – the time between the signing of the contract and the payment taking place. A currency that serves well as a store of value above all is one with low inﬂation. The most obvious example of this is when people in high inﬂationary countries switch to holding their wealth in, for instance, dollars. In trade between developed nations this is less of an issue nowadays than it once was. Magee and Rao (1979) and Viaene and De Vries (1992) are two theoretical analyses of the choice of invoicing currency. They assume away the existence of ﬁnancial hedging instruments and look at how the risk-aversion of the trading partners determines the outcome. One way of avoiding the contractual exposure is of course to have the trade payment denominated in your domestic currency. On the other hand, note that if your trading partner is risk-averse she will want some compensation for assuming the risk. Magee and Rao (1979) propose that the choice of invoicing currency will be irrelevant for precisely this reason. The counterparty will accept the risk associated with the contractual exposure only of he is compensated for this. A further consideration in the same vein of thought is which of you, importer or exporter, can hedge contractual exposure at the lowest cost – if you are negotiating price and quantity at roughly the same time it may be proﬁtable (in the sense of achieving a better price) to assume the risk involved in contractual exposure. Say that you are large-scale ﬁrm such as ABB and you are delivering some power equipment to a local power company in Chiang Mai – for whom do you think it would be cheaper to accept the contractual exposure?7 One way of handling contractual exposure is through netting: gearing currency ﬂows so that you have matching ﬂows in a currency (or a currency highly correlated with that currency). Say that you have an outﬂow of US dollars in three months and are now negotiating about what currency to denominate an inﬂow in – by steering this to dollars as well, the effect on cash ﬂows from movements in the dollar spot rate will offset. This is thus one further consideration in the choice of the denomination of trade ﬂows. Turn then to the ﬁrst determinant – the price-setting currency. In the short to medium run, prices are often ﬁxed in some currency. Take Swedish chocolate ﬁrm Cloetta for instance: they update their pricelists once a year (and each party has the option of one renegotiation). If the price-list is printed in their own currency, kronor, they will know what price they will receive, but since the price that foreign importers’ face will ﬂuctuate, foreign demand will be uncertain. If price is set in

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the importers currency demand will be relatively stable but the price that Cloetta receives will be uncertain. Say that Cloetta faces competition from a third country that prices in its own currency – by setting price in that same currency the exporter stabilizes its relative price. In other words, in the case of a Korean ﬁrm exporting to Canada and facing competition from a US ﬁrm pricing in dollars, in which currency should it set prices on its exports to Canada? In Korean won, in Canadian dollars, or in US dollars? Theoretically the answer will depend on properties of demand and cost functions – the mathematical relationship between demand and prices and costs and quantities. Giovannini (1988) and Friberg (1998) are two studies of the choice of price-setting currency when the ﬁrm acts as a monopolist. The issue boils down to if it is better to stabilize price (setting the price in the exporters’ currency) or to stabilize quantity (setting the price in the importers’ currency, when there is little competition from ﬁrms pricing in another currency, or keeping relative price stable in the case of strong competition).8 Figure 9.5 illustrates the case of setting price in the importers’ currency. Expected proﬁts are given by the expected price that the exporter receives (E(e)pf) times the quantity sold, Q. As before E(e) denotes the expected value of the exchange rate and pf denotes the price that is set in foreign currency. A depreciation of the exporter’s currency increases proﬁts by the area A, whereas an appreciation of equal size decreases proﬁts by area B. A and B are of the same size, implying that proﬁts are linear in exchange rate surprises – you gain as much by a depreciation as you lose from an appreciation, and average proﬁts are not affected. For it to be proﬁtable to deliver also in bad times, the markup has to be large enough so that the exchange rate variations can be absorbed in markups. Figure 9.6 illustrates the case of setting price in the exporter’s currency. The exporter will be certain of the price that he will receive, p; demand, however, will be uncertain, as the price that importer’s face (p/e) will ﬂuctuate with the exchange rate. Here a depreciation of the exporter’s currency will lead to an increase in proﬁts of size C and an appreciation will lead to a decrease in proﬁts of area D. In the case depicted (linear demand) it will be best to set quantity even in the case of constant marginal costs. As seen in the ﬁgure, demand is such that you gain less from a favorable exchange rate than you lose from an unfavorable one. Accordingly you get the concave pattern that we had in curve A in Figure 9.1, whereas expected proﬁts were unaffected by variability when price is set in the importer’s currency as in Figure 9.5. This result is sensitive to the shape of the

70 Figure 9.5

Exchange Rates and the Firm Setting price in the importer’s currency

demand function but holds relatively generally. If marginal costs are downward sloping, if it becomes cheaper and cheaper to produce an extra unit as you produce more, this can lead to C becoming larger than D, and a depreciation leading to a larger increase in proﬁts than that lost by appreciation. Proﬁts then become convex in the exchange rate as in curve C in Figure 9.1. If demand is very insensitive to these exchange rate induced price changes (such as when the contract is already written!), setting price in your own currency of course lowers risk. The situation that we have analyzed so far is one where an exporter has a price list and can choose the trade currency. If the transaction is intraﬁrm, other considerations will come into play – most notably tax issues. Tax authorities will have demands on how transfer prices can be set. The US tax code, as described in Bitler (1993), for instance, demands that transfer prices be at arm’s length. ‘Acceptable methods for determining arm’s-length prices are detailed in Sec. 482 regulations and have been updated under the proposed Sec. 482 regulations. … Letter ruling (TAM) 9237008 stated generally that under Sec. 482, the IRS had the right to make appropriate adjustments for foreign exchange exposure.’ Talk to your accountant.

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So much for the theoretical background – how then do ﬁrms behave in practice? Generally the same currency is used for the whole chain of transactions. There are some exceptions though; for instance, SSAB,9 a Swedish steel exporter, invoice in local currency on most markets, the exception being the Nordic countries, where the invoice is made in Swedish kronor but the price is set in local currency. Surprisingly enough, there have been essentially no thorough surveys of price setting currencies used at ﬁrm level. However, we know the trade currency in aggregate trade ﬂows to quite a large extent. Traditionally trade between developed countries was mainly invoiced in the exporter’s currency (see e.g. Page, 1981). The main exceptions were Japanese exports which were denominated in dollars to a large extent, and exports to the US which tended to be denominated in US dollars. Patterns are evolving over time. The result, that exports are denominated in the exporter’s currency, is often referred to as Grassman’s law after Sven Grassman’s (1973) investigation of Swedish exports. At the time 66 percent of exports were denominated in Swedish kronor. In the last few years the share has been around 40 percent. The prevalence of denominating trade in the exporters’ currency is an indication that exporters often feel that it is easier to deal in their own currency (in Grassman’s study it was typically the exporter who decided the currency denomination). The fact that some 50 percent of world trade is denominated in US dollars whereas the US share of world trade in manufactured goods is only some 15 percent shows that vehicle currency/medium of exchange considerations are often important. The US dollar is the main vehicle currency. A look in annual reports and discussion with Swedish ﬁrms points to the fact that arm’s length trade is often priced in the importer’s currency. First note that Cloetta, which we studied previously, behaves as one would predict based on this discussion. On major markets where it is well established it sets price in the importers’ currency; when there is more uncertainty, it quotes in Swedish kronor or in international currency, US dollars. Other examples of price-setting in the importers’, or consumers’, currency come from newspapers. Just today I received an offer from The Financial Times to subscribe. The offer, which was directed at Scandinavian countries, had prices quoted in Danish, Norwegian, and Swedish kronor – price-setting in the importers’ currency. The magazine The Economist does likewise, as do many other international magazines and newspapers.10

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Figure 9.6

Setting price in the exporter’s currency

We noted earlier that when you face strong competition from a third currency it will stabilize relative prices if you set price in the same currency. Friberg (1997) provides a theoretical analysis. Swedish pulp exporters behave as one would believe based on that kind of analysis – when they export to European markets, products where the main competitors are North American are priced in US dollars (softwood pulp), whereas hardwood pulp, where competition is mainly from Portugal and Spain, is priced in ecu. 9.3

WHEN AND HOW TO CHANGE THE PRICE

The last section studied only the case of rigid prices. The more important question is, once you do change prices, how should they be changed? This will affect the price that you as an exporter receive as well as the price that customers have to pay. There is a large economics literature studying this issue, the question of exchange rate passthrough. How much should import prices change when the exchange rate changes? The great push of that literature came during the period

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of the strong dollar. Despite the huge movements in the dollar one saw very little effect on the prices of many goods. The question initially was mostly studied by macro- and international economists whose predictions about terms-of-trade and current account effects of exchange rate changes were way off the mark. Many economists expected prices to reﬂect the exchange rate changes much more rapidly and fully. The stylized facts that have emerged from attest literature is that import prices change much less than exchange rates for many goods. Two questions are relevant – when should the price be changed; and when it eventually changes, how much should it change? 9.3.1

When Should You Change Price?

Obviously there are some costs associated with continually changing prices. Depending on the nature of the industry these costs will take on different form and shape. First there may be what economists call menu costs – costs of printing new price lists or communicating the price change decision, or ﬁxed costs of the time that is taken up by a price change decision.11 If the underlying variable (cost or demand) that is important for the desired price, changes continually (for instance a ﬂoating exchange rate!), it will not be optimal to change the price all the time if there are ﬁxed costs of adjusting the price. Instead it will be optimal to let the random variable drift until some threshold is reached before acting. This is the fundamental insight from a theoretical literature known as the (s,S) price setting literature.12 As soon as one leaves the simplest case (which is tricky enough!) these problems become very complex theoretically. However, the basic intuition is usually straightforward. I will discuss two examples of (s,S)-type behavior in price-setting. The ﬁrst comes from an international setting, the duty-free shop of Viking Line, a ferry line operating between Finland and Sweden. 13 Viking Line quotes prices in both Swedish kronor and Finnish markka to cater to both nationalities. This is in line with the choice of pricesetting currency discussed in Section 9.2, setting price in the consumer’s currency. The exchange rate ﬂoats, which implies that as long as price is not adjusted every day, the law of one price will not hold. It is expensive to print new catalogs and re-optimize the price continuously, and Viking Line follows the strategy of adjusting price when the relationship between prices has drifted too far. In Viking Line’s case

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they make the adjustment before the deviation from the law of one price has reached 20 percent. Right outside the duty-free shop is a foreign exchange booth where you can exchange currency at no ﬁxed cost. Figure 9.7 shows the deviation from the law of one price for a box (10 packets) of Marlboro cigarettes over the period 1990–6. For the calculation I proceeded as follows; if the law of one price holds, the price in kronor (psek) = the exchange rate expressed as the price in kronor of one markka (e) times the price in Finnish markka (pﬁm). If the law of one price holds, e pﬁm/psek should thus be equal to 1; the deviation from the law of one price (as percent of the kronor price) is given by (1 – (e pﬁm/psek)) 100. This is what I plot in Figure 9.7. A speciﬁc example may make it clearer. On 12 November 1997 a one-liter bottle of Remy Martin V.S.O.P. Cognac cost 230 Finnish markka and 345 Swedish kronor on Viking Line. In the exchange booth that day you had to pay 135 kronor to get 100 markka. Remember that there is no ﬁxed fee associated with exchanging. In which currency was it cheaper? The Finnish price was 1.35 230 = 310.5 kronor. By exchanging 310.5 kronor for markka and using this to buy the bottle instead of buying it with kronor you would thus on this speciﬁc day save 345 – 310.5 = 34.5 kronor (somewhere in the neighborhood of 4 US dollars). In other words, it was (34.5/345) 100 = 10 percent cheaper to buy in Finnish markka; there was a 10 percent deviation from the law of one price. Figure 9.7 Deviation from the law of one price for Marlboro cigarettes (one carton of 200 cigarettes) in a duty-free shop, 1990–6

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According to Viking Line, the share of customers that shop in Swedish kronor is stable and little affected by the price differential. Customers use the possibility of arbitrage offered by the exchange booth to only a small degree. As an economist one is slightly amazed that deviations can be so large without prompting adjustment. 14 Of course the situation is not perfectly transferable to other markets and ﬁrms, but I believe that there are at least two lessons from the Viking Line case that are applicable to many situations. Customers prefer to deal in their own currency and can be quite reluctant to ‘optimize’ – this is an example of what economists call bounded rationality. There are some costs associated with constantly optimizing so that you follow various rules of thumb, in this case shop in your own currency. Second, Viking Line claim that what prompts them to change price is not customers switching to paying in the other currency, but rather that customers complain about the price differential. This is not the way that we as economists traditionally would expect pressure to adjust prices would come about. We typically assume that if customers are dissatisﬁed with something they substitute away from that good (or currency in this case), rather than voicing concerns and trying to inﬂuence. We have focused on what Albert Hirschman (1970) has called the ‘exit’ option. Hirschman noted that there is another way for customers to inﬂuence ﬁrms (organizations, etc.): that of voice – trying to change the practices or goods. Voice is typically analyzed in the political realm. The importance of voice in the decision to change the price indicates that long-term relationships with customers are important and that we are quite a way from the frictionless, perfectly competitive economy. Of course there are also speciﬁcities to the Viking Line that can not automatically be generalized, most notably that customers are small consumers and not large ﬁrms. One last thing to note about Viking Line prices is that the ‘implicit’ exchange rate between kronor and markka used in pricing the Remy Martin was 345/230 = 1.5. The same implicit exchange rate is used for all goods in a catalog, and it is some nice even number (such as 1.1., 0.9) for all the catalogs that we have, the oldest ones going back to the early eighties. This is clearly not the exact exchange rate when prices were set, nor is it some expected future or forward rate. Rather it is an indication that rules of thumb are important not only for customers, but also for Viking Line. A not uncommon form of (s,S) rule is to have an exchange rate clause. Simply put, it is a form of institutionalized (s,S) rules – in a contract or price-list it is a clause stating that prices will change if an

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Exchange Rates and the Firm

exchange rate changes beyond a speciﬁed value. For instance, the computer shop where I buy my computers issues a price-list that they say is good through a certain date given that the US dollar is not stronger than, for instance, 8 kronor. Another importing ﬁrm, Bergström Instruments, imports microscopes and measurement equipment that it sells to Swedish research institutes and companies. Its offer prices are set on the proviso that the exchange rate vis-à-vis the yen does not move more than 2 percent, in which case the offer price will be renegotiated.15 Swedish chocolate exporter Cloetta has a similar kind of clause: their price-lists are good for one year, but each party has the right to one renegotiation. Another example of price-setting when there are menu costs, ﬁxed costs of adjusting price, comes from the Swedish gasoline market.16 Price-setting on the Swedish gasoline market is dependent on the exchange rate against the dollar since the price of imported gasoline is set in US dollars. The competition on the gasoline market is quite intense – it is close to being an homogenous good. Prices are also adjusted frequently: during the period 1980–97 the price to consumers was adjusted, on average, every third week. The ﬁrms continuously monitor the market for inputs and their competitors for signiﬁcant developments. Figure 9.8 is a typical illustration of how the output price follows the costs (Rotterdam spot market price of gasoline translated into kronor and the quantity tax). The last few years the range of Figure 9.8 Development of VAT-adjusted retail price of gasoline (RP) and costs (MC + TAV), Sweden, fall 1995

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inaction has been somewhere in the neighborhood of 7 öre (about 1 US cent) – when input costs have moved 7 öre in either direction since the last price adjustment, this tends to trigger a price response. Analyzing in detail the price-setting decision, as we do in Asplund, Eriksson, and Friberg (1997), one ﬁnds that price adjusts only gradually to a new equilibrium following a change in input costs. Prices change often enough that the full adjustment is completed after 2 months. In other words, it is a gradual but not very drawn out process. Reasons for a gradual approach on this market can come from the responses both of competitors and customers. Of course many ﬁrms are highly dependent on the prices of competitors. Discussions with ﬁrms often indicate a certain caution, uncertainty whether competitors will follow if the ﬁrm raises price. If price is lowered too much you may risk triggering a price war. This would lead to a strategy of making a large desired price change, only in small steps, stopping and listening between each step if anyone is following. It is also often assumed that customers dislike large price changes. Given that customers dislike large price changes, the ﬁrm’s price should optimally move only gradually towards new equilibrium following large exchange rate changes. Both these effects have been modeled as quadratic adjustment costs that rise more than proportionally in the size of the price adjustment.17 In the next section we will discuss the relationship with customers and competitors and how this affects price-setting in more detail. It seems reasonable that many ﬁrms are faced with both ﬁxed costs and some cost of adjusting price that is related to customers or competitors. Modeling and estimating this kind of situation formally and stringently is complicated; Slade (1998) is proof of this. The third type of costs typically studied by economists when it comes to price adjustment are cases where it is costly to learn about the state of demand. You need to gather information, which is costly, to determine the optimal price. Since it is costly you economize on information gathering by doing so at certain predetermined intervals. The most prominent example of course wage negotiations. It is costly to make forecasts about the economy, so in this situation it makes sense to renegotiate the price only at ﬁxed intervals. Viking Line is another example: they typically readjust all their prices in Finnish markka once a year only, though they monitor for signiﬁcant developments in the meantime, when only the Swedish price readjusts if it has deviated too far from the law of one price.

78 9.3.2

Exchange Rates and the Firm How Should Price be Changed?

Once you change price, how much should you change it? There is a rapidly expanding literature that studies this issue, both from theoretical and empirical perspectives.18 Traditionally international economists assumed that prices were set in the exporters’ currency, or given as a world market price, and that the law of one price held – this implies that import prices on foreign markets have to change by the full amount of the exchange rate change, or that we have full exchange rate pass-through. We know now that on many markets and for many goods this does not hold. So how much should price change in response to an exchange rate change? In microeconomics one of the classic exercises is to study how a quantity tax change is transmitted to consumer and producer prices. One learns that if demand is relatively inelastic, relatively insensitive to price changes (and supply elastic), then consumer price will change almost by the full amount of the tax. If we disregard the uncertainty aspect, a real exchange change can be analyzed using the same methodology as for a quantity tax or tariff change. So on a market under perfect competition the pass-through will be dependent on the relative elasticity of demand and supply. This must be at the root of one of the most common misperceptions in economics: that the more market power a ﬁrm has the more it should pass-through the exchange rate change to consumer (import) prices. This is not true. Remember from your old micro book that the footnote on the tax-incidence diagram said that it was a correct analysis only for perfect competition. When the ﬁrm has market power the pass-through will depend on how the demand elasticity changes as the price changes. This is of course a lot less sexy than the perfect competition result – most people have an idea about how much market power Ferrari has in comparison with Hyundai for instance. What are your thoughts about the shape of the demand function, and thus how the elasticity will change as the price changes? If you’re not an economist by trade (and probably not then either!) you are not likely to have a clue if Ferrari’s demand curve in the US is linear, constant elastic or even trans-log. This is unfortunate, as the shape of the demand function is what determines optimal pass-through. If demand is linear and marginal costs ﬂat (as in Figures 9.5 and 9.6), passthrough equals one-half (half the exchange rate change is passed through to import prices), whereas if demand is constant elastic, passthrough will be more than complete, that is, the exchange rate change will be more than reﬂected in the import price (or perfectly reﬂected

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in percentage terms). A ﬁrm with market power will set price so that it maximizes proﬁts. If it could change price without having an at least proportionate change in demand, why wouldn’t it already have set price so high in the ﬁrst place? How much of the exchange rate change you let the importers bear thus depends on how the elasticity changes as the price changes. What are the implications for a ﬁrm then? Well the ﬁrst point is that even though you may have a strong position on the market it is not necessarily optimal to let importers take the full price change. You will have to experiment a bit. Having said this, it should be stressed that a ﬁrm with more market power has more leeway in pricesetting. A ﬁrm operating on a commodity market will have demand that is very price sensitive, amd have little or no opportunity to have a different price from competitors. So if you have more market power you can set your own price to a larger extent – this, however, does not imply that it is optimal to let the full effect of an appreciation be reﬂected in consumer price. Competitors Let us discuss the interaction with competitors some more. The case of pass-through is easiest to analyze in one of the polar cases of perfect competition or monopoly, but this should not make one blind to the fact that in the real world, the behavior of competitors is often central. One insight that carries through in most models and is intuitively reasonable is that the pass-through to import prices is larger the larger the market share of competitors from the same currency area.19 The larger the share of domestic companies on a market, the less affected by an exchange rate change will be the average price and the less adjustment will normally be optimal for an individual exporter. This is pretty intuitive: if you are a Japanese ﬁrm selling to the US market, you would change your price more following an appreciation if 95 percent of your competitors were Japanese, than you would if 95 percent of your competition were American. In industries with fairly homogenous (similar) products, a single ﬁrm has little possibility of having a different price from competitors for any long time period. A reason for not lowering prices too much when your currency has depreciated would be the wish to avoid a price war. There is some form of implicit understanding (explicit understanding is of course illegal in most countries) about the price level or level of output – there is implicit collusion. Economists have

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been interested in the issue for a long time – at least since the eighteenth century. A classic remark by Adam Smith: ‘People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.’ Accordingly there are a wealth of theoretical results on when (if) collusion breaks down and how this depends on the structure of the game – for instance, how many stages there are, do the ﬁrms set prices or quantities, how differentiated are their products, and what do shocks look like.20 The basic intuition is the same in all models – ﬁrms will follow the implicit agreement as long as they gain more from cooperating than they do from defecting. Unfortunately few lessons beyond this generalize and there is no accepted general model (quantity-setting, price-setting). The lesson that has come out of the discipline of industrial organization the last few years is that every industry is different in the sense that various characteristics differ across industries: the extent of ﬁxed costs, R&D intensity, or observability of competitors’ strategies. The economics literature also focuses on collusion as a means of raising proﬁts. For our present purposes we are mostly interested in it as a way of reducing the variability of proﬁts. A good example of the difﬁculties of maintaining implicit cooperative agreements comes from the pulp and paper industry. During the late 1980s and early 1990s pulp and paper manufacturers added a lot of new capacity, which accordingly led to stronger competition and price wars. Limiting capacity is of course a classic way of keeping prices high – OPEC is exhibit number one in this regard. We return to the capacity choice in the pulp and paper industry later – on the issue of prices The Financial Times reports that ‘UPM-Kymmene has announced that it hopes to seek price rises of between 5 and 12 percent … Niemala, Chief Executive of UPM-Kymmene believes such price rises should be achievable if the industry keeps its head and does not, as in the last cycle, run blindly after orders … European manufacturers hope to prevent that scenario [price pressure from Asian manufacturers] by teaming up with Asian suppliers, persuading them to concentrate on higher value-added production and serving local markets rather than ﬂooding the fragile European industry. That is easier said than done.’21 Scherer and Ross (1990, ch. 7) examine ﬁve institutions that facilitate oligopolistic coordination. The two most relevant in the international setting are perhaps 1) overt and covert agreements (Adam

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Smith again); and 2) price leadership, or when other ﬁrms follow the prices of one ﬁrm. Scherer and Ross quote examples from a number of different industries and conclude ‘we ﬁnd that price leadership tends both to increase prices on the average and reduce the magnitude of price ﬂuctuations’ (p. 261). The pulp and paper industry saw strong competition and great volatility of prices a few years ago and seems to be trying to head in this direction – a stated goal of one ﬁrm is ‘expansion [which] aims to reduce volatility by increasing the inﬂuence of the largest producers over the market price.’22 The other mechanisms facilitating implicit collusion that Scherer and Ross discuss are: rules of thumb (making rivals’ price adjustment more predictable); the use of focal points; and the keeping of inventories to avoid having to make price adjustments in order to meet changes in demand. It should be stressed that collusion based on these kinds of mechanisms need not lead to the industry achieving monopoly proﬁts jointly. It will however lead to higher prices than under a totally noncooperative regime. Customer Markets Firms often think of their stock of customers or the market share as an asset. In most markets, customers do not change suppliers all the time, continuously searching for the best deal. Rather, they tend to stick to brands they have purchased before, only now and then checking to see that their choice still is a good one. This affects how a ﬁrm should set prices – if long-term relationships are important between exporters and customers this gives the exporter some market power. The ﬂipside of the coin is that if it is harder to lose customers it is also likely to cost you more to get a customer back once you have lost her. The implication is that for changes in costs or real exchange rates that you believe will be reversed at some not too distant future, it will be optimal to stabilize prices to consumers. In the words of Bengt Johansson, CFO at Kinnarps, a Swedish furniture supplier: ‘We follow developments. It is not good to disturb customer relations by jumping up and down in price development.’23 The pricing decision takes on an element of investment; having low prices in this period will give you a larger pool of customers in the next period. If you believe that a strong currency for the exporter is a temporary phenomenon, caution is advised when raising prices.24 Naturally, given the difﬁculties in predicting exchange rates, it is hard to know which changes are temporary and which are permanent.

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When the exchange rate is favorable it may be a good time to enter a market and gain market shares. This is, for instance, the way Fuji behaved during the 1980s: in period of a strong dollar Fuji expanded on the American market, investing in market share when the price of investing was relatively low. When the dollar fell in the second half of the eighties Fuji did not raise prices proportionately, not wanting to lose the investment they had built up. In Section 9.6 we will discuss further when to enter and exit markets and how to create switching costs. Should Price Adjustment Be Asymmetric? Yet another issue regarding price adjustment is if it should be symmetric; that is, should you raise prices as much when your currency is strong as you decrease prices when the currency is weak? A reason for letting a weak currency have a smaller impact on prices than a strong one is if there are important bottlenecks in production or distribution. The higher quantities associated with a lower price would then only materialize to a lesser extent. If there are some quotas, such as the ‘voluntary export restrictions’ on Japanese auto sales to the US in the 1980s, this would also limit the attractiveness of lowering prices. Loosely put, there is no point in lowering prices if you can’t meet the resulting increase in demand. Fear of ruining some nice implicit collusion would also make price adjustment asymmetric in this direction – you do not want to decrease prices too much when your own currency is weak for fear of breaking down collusion. Fear of allegations of dumping and of the triggering of protectionist measures would also hamper the downward ﬂexibility of prices. A recent example comes from Japanese auto exports to the US – The Financial Times reported: ‘“Honda has surged in the US”, says Edward Brogan, automotive analyst at Salomon Brothers in Tokyo, “but that is because it feels politically secure, given its heavy investments in the Nafta region … Toyota, on the other hand is showing remarkable restraint,” says Mr Brogan, … “They are about to start up signiﬁcant capacity in North America over the next few years. The last thing they want is to run into political problems.”’25 You can also have asymmetric adjustment working in the other direction – if you are trying to build market share you are likely to let a strong currency have a smaller impact on prices than a weak currency. When your currency is weak you attract new customers by lowering your price. As your currency strengthens you do not want to loose these customers and therefore you are careful about raising prices.

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The empirical evidence is inconclusive. In some sense this is also what we expect it to be – the importance of bottlenecks and market share considerations will differ from industry to industry. There are some studies that seem to support the ‘market share hypotheses’ – Marston (1990) studies Japanese export price adjustment for a number of industries and ﬁnds some support for price adjustment being asymmetric in this direction. Knetter (1994) studies German and Japanese auto exports to the US and ﬁnds some weak evidence in support of the ‘market share hypotheses’ as well, although he in most instances can not reject that pass-through is symmetric. A very careful study is Goldberg (1995). She estimates a model of the US car market for the period 1983–7. She uses her model to simulate how car prices respond to changes in the exchange rate, holding product characteristics ﬁxed. She does indeed ﬁnd that price adjustment is asymmetric but that the effects work in the opposite direction than that described by Marston: a depreciation of the dollar has a larger effect on the price of imported cars in the US than does an appreciation. The price effect on Japanese cars was small (15–30 percent), whereas German imports respond much more to exchange rate changes (65 percent for appreciations of the dollar and around 100 percent for depreciations). When the dollar is weak prices are increased; whereas they are not decreased proportionately when the dollar is strong. This would thus support price adjustment behavior based on bottlenecks or fear of breaking down collusion. She also ﬁnds that in the presence of a quota, the prices of Japanese cars were independent of the exchange rate. Finally, Goldberg stresses that one cannot study price adjustment on goods such as cars without paying attention to whether there are changes in quality: a Mazda in 1983 was not the same good as a Mazda in 1987. Kadiyali (1997), in her study of competition in the US market for photographic ﬁlm, ﬁnds that prices do not decrease as much during the dollar’s appreciation as they increase during the dollar’s depreciation. She thus ﬁnds qualitatively the same pattern as Goldberg does. Nevertheless, pass-through is very incomplete in both directions in the US market for ﬁlm. Kadiyali ﬁnds that in the period 1980–4 less than 8 percent of an exchange rate change was reﬂected in the price, and in 1985–90 some 18 percent was reﬂected in the price. How Does It Look? We have now, then, examined a number of connections between exchange rates and prices, and also examined the evidence on

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asymmetric price adjustment. So what do we know empirically about the pass-through of prices more generally? Quite a lot.26 There are a large number of studies on exchange rate pass-through and the closely related phenomenon of pricing-to-market. Pricing-to-market studies examine how the markups to different export markets change as exchange rates change, whereas pass-through just looks at the change in import prices to one market. The main difference is perhaps that by looking at two markets one corrects for the inﬂuence of cost changes. Say for instance that one looks at Swedish imports from the Netherlands of tulip bulbs and ﬁnds incomplete pass-through. This could be due to some variable not included in the regressions – if input prices had decreased for the tulip bulb producers, for instance. If we make the, often reasonable, assumption that costs for producing to different export markets are essentially the same, we will learn more about price-setting behavior by studying price adjustment on two markets. If we ﬁnd larger adjustment on one market than on the other we know that this will be because of the competitive situation on that national market and not because of costs. The dominant ﬁnding in the large number of studies that examine price responses to exchange rate changes is that of less than perfect pass-through. A pass-through elasticity (percentage change in import prices when there is a percentage change in the exchange rate) of about one-half (incidentally the prediction from a linear demand curve) is the mean of pass-through to the US. This reading of previous studies comes from a survey by Goldberg and Knetter (1997). So about one-half of an exchange rate change is reﬂected in import prices, a depreciation of the dollar by 10 percent against the pound would thus imply that the US price of imports from Britain went up by 5 percent. We know the extent of pass-through across many markets and many goods. Another thorough survey is provided by Menon (1995). Forty out of the 46 empirical studies surveyed by Menon report that import prices respond less than proportionately to exchange rate changes. We know a lot less about how the extent of pass-through depends on the structure of the market. There is some evidence supporting the idea that a larger market share from one country leads to a larger pass-through.27 Most of the studies are on customs data aggregated to the industry level (e.g.: Sweden imported a total of 2,500 tons of cars with an engine size above 1.5 liters to a total declared value in customs of 250 million kronor – the ‘price’ is thus the value divided by the quantity), which means that the whole literature has few anecdotes and that the details of price adjustment are somewhat obscure.

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One issue that has attracted some interest arises when we ask if US exporters behave differently from those of other countries. There has been some evidence suggesting that US exporters are different, passing-through more of exchange rate changes into import prices than exporters of other nationalities. Knetter (1993) studies this amongst some other questions. He ﬁnds that there is little evidence that US exporters are different if one compares price-setting behavior within the same industry. With respect to other issues there is to date too little evidence to say anything even remotely deﬁnite. 9.3.3 Price Adjustment as a Means of Handling Exchange Rate Changes – Summing Up Before summing up what we have learned above price adjustment we should note that price is not the only variable that can be adjusted. For instance ﬁrms can adjust quality, terms of delivery, warranties, or service level. Economists focus on price adjustment, however, because that is where we have access to a large theoretical and empirical literature.28 Price is also the variable that is easiest to adjust in many instances. Kadiyali (1997), in her study of the competition between Fuji and Kodak, ﬁnds that there was also incomplete pass-through of advertising by Fuji. That means that when the dollar depreciated and Fuji’s proﬁts were squeezed they did not decrease the amount of money put on advertising. We now try to sum up the connection between prices and economic exposure. Above all we should note the implications of limited passthrough for operating exposure. The connection has been noted by others, such as Dumas (1994), before. Marston (1996) and Friberg (1997) are two papers dealing with the issue. Marston studies quantity adjustment – that is, ﬁrms determine the optimal quantity to produce and then the price that they receive is determined by the demand function. Marston says (1996, p. 1) that ‘Several of the studies emphasize the importance of demand and supply conditions in determining economic exposure, but none of these studies have focused on a remarkably simple fact about economic exposure: that in many forms of competition, including the most commonly studied case of monopoly, the economic exposure of an exporting ﬁrm is simply proportional to the ﬁrm’s net revenues based in foreign currency. In such cases, the ﬁrm does not need to know about the price elasticity of its product demand or its marginal costs in order to assess its exposure to exchange rates.’ The result stems from the fact that, under quantity

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competition, quantities are set optimally – when a small exchange rate change happens it will not pay to change quantity (because of a mathematical property called the envelope theorem), no quantity change implies that the price to consumers will not change – voilà, zero passthrough and stability of foreign revenues. Friberg (1997) ﬁnds similar results in a simple model of price competition. A recent interesting paper is Bodnar, Dumas, and Marston (1998), who develop a model in which the share of imported inputs and the market share are the two variables of interest for determining both pass-through and exposure. Rather than exploring the implications of pass-through for exposure, their model stresses that both pass-through and exposure depend on the underlying characteristics of the ﬁrm and the market on which it is active. The problem with long-term hedging rests to a large extent in difﬁculties in predicting the development of competitors’ prices and demand. So limited exchange rate pass-through implies that foreign sales tend to be more stable in foreign currency than one would otherwise expect. Price-setting in the importer’s currency and limited pass-through work towards making exposure linear (D in Figure 9.1), thus making hedging and planning easier. The more certain revenues in foreign currency are, the easier your life becomes – the uncertainty to a large extent then only arises from the exchange rate, rather than from wondering how customers and competitors will react. A necessary condition for being able to pursue this policy is that it is possible to segment different national markets – that it is possible to limit arbitrage across markets. Indeed the evidence shows that arbitrage places very little restriction on price-setting on different national markets. How can this be? This is the issue that we turn to next.

9.4

MARKET SEGMENTATION

Segmenting markets where one faces different sensitivity of demand is a way of increasing proﬁts for a ﬁrm. When you can price discriminate, or segment markets, you will be able to sell at a lower price to weaker customers and still be able to charge a higher price to the customers who can bear it. Traditionally one distinguished between three categorise of price discrimination. First-degree price discrimination: every customer pays according to his maximum willingness to pay for the good. We do not see this very often, the classic example being that

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of a country doctor who knows the wealth of each of his customers and can charge accordingly. Second-degree price discrimination is where you charge different prices for different quantities sold, giving discounts when higher volumes are bought. Third-degree price discrimination is the name given to the case where you separate various groups with different willingness to pay. There is some characteristic that allows you to separate the various groups, for instance student IDs. International price discrimination is a form of third-degree price discrimination – the location where the good is bought is used to segment markets. When the optimal prices are different in different countries, because of different incomes, different preferences, or different (price of) competing products, it will pay to segment markets. In countries where demand is sensitive you will have low prices and in countries where it is less so you will have higher prices. Now of course the strategy of charging different prices to different groups (national markets) demands that it should not be possible for the weak groups to resell the good to the less sensitive groups. It is no coincidence that prices where we see third-degree price discrimination often are personal services such as airplane tickets, gym cards, or hair cuts. Things that are hard to re-sell. There are few student discounts on the stock market. The mechanism that is supposed to limit price discrimination is arbitrage, re-selling. The deﬁnition of arbitrage is riskless proﬁt – if prices are lower in one market it pays to buy them there and resell them in the market where prices are higher. Financial markets are of course the prime example of arbitrage in practice. We note that there are essentially three ways that arbitrage in goods markets can take place. We are now concerned with the arbitrage across borders. First, consumers themselves can go to another country where the good is cheaper to buy. The larger the cost of the product, the more likely they are to do this, cars being perhaps the prime example. You might go to the Netherlands to buy a Mercedes if you in the process save 7,000 US dollars. You would hardly go to the Netherlands to save a dollar on a pencil, however. Simple. Trade over the internet may change this in the future somewhat, although one should probably not exaggerate the effects for most markets. Say that you want to buy a stapler or a salad bowl via mail-order; it would appear that the internet is easier than ordering a catalog and then leaﬁng through it, but I have a hard time seeing any fundamental difference. Some industries are likely to be more exposed than others. My prediction would be that industries where it is actually easier to present the product on the

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internet than in the store are those where we will see a major impact. Music on CDs could be an example of this: you can have material about the band, concert reports, try listening on the net, and also have access to a very large assortment – things that demand far too much space in attractive business locations.29 It is very hard to say what role the internet will have in promoting market integration in the future. What we do know is that, for the agricultural goods that Froot, Kim, and Rogoff (1995) study, the technological innovations of the last 700 years have mattered little for the degree of deviations from the law of one price. The second way that arbitrage can take place is for a third party to do the trade. Lack of distribution channels hinders the possibility for this kind of arbitrage. Another strong restriction is placed by asymmetric information. The classic example of asymmetric information is the car market. Your new car loses several thousand dollars in value just as you roll it out from the retailer. Why is this? The potential buyer will think that you know something about the car he does not and will want compensation in the form of a lower price. This obviously places a restriction on the degree of arbitrage. Would you buy a VCR from a man on the street or from newspaper classiﬁeds just to save 10 percent on the price? I would not, and that goes for many others as well. Voilà, market segmentation. Of course, if price differences become too large this will lead to arbitrage; an example is smuggling of cigarettes into Sweden. Cigarette prices have been higher than in other countries for quite a few years without sparking any major smuggling. During a short period prices were increased from 33 to 45 kronor for a pack of Marlboros. Given that they cost the equivalent 6 or 7 Swedish kronor in Estonia, the reward to arbitrage is big enough for quite a few individuals to take the risk. Arbitrage in the strict sense reﬂects a risk-free proﬁt, but of course smuggling of cigarettes is illegal and it is not risk-free. It is nevertheless noteworthy that the price differential had to rise to several hundred percent before sparking big time smuggling. The third possibility for arbitrage is when retailers on the local market buy their goods from abroad directly. In a well-publicized decision by the European commission, independent car dealers are now allowed to do this in Europe. An independent car dealer can go to the Netherlands (where car prices now are the lowest within the EU), buy cars, and then resell them on their national market, not having to buy from the national agent. We return to this issue in our discussion of EMU.

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To date, ﬁrms have often been quite successful in segmenting markets. Flam and Nordström (1995), for instance, in their study of European car prices 1989 – 92, conclude that ‘the results of our study are consistent with a simple oligopoly model with no interaction across national markets.’ Admittedly the car markets in Europe are a somewhat special case with quite a few restrictions to trade. On the other hand, cars are big ticket items so the gains from arbitrage are large. I mention cars here because they are one of the markets where we do have good information on the actual price levels in different local markets. The literature on the breakdown of the law of one price and pricing-to-market (which have typically used information on changes in prices) also show that national markets are segmented. Engel and Rogers (1996) study prices in a number of Canadian and US cities. They ﬁnd that the prices of similar goods vary much more across the border than the prices of dissimilar goods within countries. Their paper is entitled ‘How Wide is the Border’ – they ﬁnd that, at a minimum, crossing the border increases the dispersion between prices in different cities as much as if the cities had been 1,780 miles apart but within the same country. Their ﬁrst shot at an answer is actually that the border is 75,000 miles wide. The border clearly matters, even between Canada and the US, who largely share the same language, and have similar cultures and few trade impediments. Then how should a ﬁrm achieve market segmentation? It should be stressed that one often is on a collision course with the competition authorities, even though there is no evidence that price discrimination is always welfare decreasing. The simplest strategy to deter arbitrage by customers is to deny retailers the right to sell goods to foreigners, though it will not buy you much goodwill, and competition authorities do not particularly like it. An excellent example is Volkswagen’s refusal to allow Italian dealers to sell to Austrian and German customers. As we will discuss in Chapter 13, the policy did not attract many friends in the EU competitive authority. In general, having exclusive national dealerships will tend to deter arbitrage. Bundling with nontraded products is another way to deter arbitrage: for instance, selling with a warranty that is only good in the country of sale, having some form of post-sales service, or attaching some other beneﬁcial nontraded good.30 Pharmaceutical companies have been known to have different brand names in different countries, obviously deterring arbitrage. Such a strategy works especially well when it is hard to determine the quality and other attributes of the product. This is evidenced by the continued sales of expensive brands even though

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in many cases there exist identical generic brands. When local brands are bought by international giants they often continue to be sold under the old name. White goods giant Electrolux, for instance, sell under the names of Husqvarna, Zanussi, White-Westinghouse, AEG, Electro-Helios, and Frigidaire. If you use one brand mainly on one national market this will deter arbitrage. After all, customers typically want brands that they are familiar with. As simple a strategy as to have different packaging in different countries will deter arbitrage. These last two strategies have the disadvantage of lowering ﬂexibility in where one can sell goods; we return to that issue below. Another factor limiting arbitrage is how the product ages. Knetter (1997) the studies price-setting of The Economist on different national markets. Since the magazine is already out of date after a week, there is effectively only a day or two during which arbitrage would be possible. Nevertheless, I would not recommend any ﬁrm to increase the depreciation of their good (or make it more difﬁcult to transport) just to facilitate market segmentation. But it is worth noting that if your product deteriorates rapidly you might have more potential to segment markets than you thought. As with so many other cases in economics, the arbitrage mechanism works through the market, people buying and selling to beneﬁt from price differentials. As with Viking Line, ‘Voice’ may also be important. What do you say when a German customer calls and wants to purchase for the Spanish price? The phrase, ‘forget it – I’m price discriminating’ doesn’t sound too good, does it? Having different packaging, different names, and so forth helps here. 9.4.1

Flexibility Across Markets

Being able to segment markets and keeping local currency prices stable tends to make operating exposure linear and easier to hedge in the long run. The more certainty there is about foreign currency earnings, the easier it is to hedge and make plans. Of importance if we not only want to limit the negative effects of variability, but also make the most of the situation (remember Figure 9.1, curve C), is the ability to beneﬁt from the variability by changing sales to different markets. This would be one way of achieving more convex operating exposure. This is easier the less of a customer market the ﬁrm operates on. One of the basic tenets of microeconomics is that the proﬁts of a price taker are convex in price ﬂuctuations. The results stems from a classic article by Walter Oi (1961). The basis for this result is that if the ﬁrm

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ﬁrst observes price and then decides on output it will make the most of the good times, expanding output when the price is high and limiting the detrimental effects when price is low. In perfect competition you do not affect the price by producing more, the market will buy any amount that you produce at the given market price. The assumptions underlying perfect competition do not hold on most markets, but some of the intuition carries through. If the ﬁrm is ﬂexible enough to expand and contract sales on different markets to beneﬁt from variability, it can in a similar way make the best of good times. An example of this kind of behavior is the tendency of Canadian producers of newspaper and some wood products to sell to the European markets when the US dollar is weak. The more homogenous packaging and branding between markets, the easier it is to move goods between markets – not only for arbitrageurs but also for the ﬁrm itself! Another key to ﬂexibility is ﬂexibility in production and costs, which is what we turn to next.

9.5

COSTS AND PRODUCTION DECISIONS

Thus far we have focused on the revenue side of Equation 9.1. The cost side is no less important. There are two major issues pertaining to the cost side. First there is the direct effect on the price of inputs and how that is correlated with exchange rates. Second is how marginal costs are affected by changes in produced quantities (which in turn will be dependent on exchange rates). Let us deal with the ﬁrst issue. Clearly the choice of supplier will affect the covariation of input price and exchange rates – the price of foreign goods is more likely to be affected by exchange rate changes than the price of domestic goods. One caveat is in order: if the input is a commodity that is traded on a world market your choice of supplier will be of little consequence for this aspect; it will not matter for your input price if you choose to buy the gold that you use for production from a domestic or foreign producer, since the law of one price typically holds for commodities. As soon as inputs are more differentiated it will matter. Choosing local suppliers of inputs will tend to decrease the correlation between exchange rates and input prices. Having longer contract periods is of course another way to decrease the correlation, as are long-term relationships in general, which may give you more bargaining power in negotiations over input prices.

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Note that forcing a smaller supplier to invoice and set price in your own currency is not necessarily optimal; let us take a moment to explain why. Take an extreme example of inputs: employees. Would it not be a good idea for a Scottish ﬁrm that has their revenues in dollars to pay their wages in dollars as well? Probably not. A reasonable assumption is that the employees are at least as risk-averse as the ﬁrm is. It becomes obvious that the employee would demand a signiﬁcant risk premium for accepting the exchange rate risk. Would it not have been cheaper for the ﬁrm to accept the risk in the ﬁrst place, given that it, if it is a larger ﬁrm, probably has access to a specialized ﬁnance department and is less likely to be liquidity constrained than smaller ﬁrms or individuals? Yes, it would have, is the general answer. For the same reason it often makes sense for a smaller ﬁrm buying inputs from a larger supplier to try to shift some of the risk to the larger ﬁrm. The discussion thus far has dealt with how to deal with the correlation between exchange rates and input prices from a given supplier. It is often the case that relationships between suppliers and users are long-term. Just as in the case of consumer switching costs, there may be signiﬁcant costs associated with switching supplier. Macmillan, for instance, state that ‘The growth of our business depends on our ability to build long-term author and customer relations.’31 If this is not the case it is deﬁnitely worth shopping around for low input prices. The international power company ABB state a strategy of this type in their 1996 annual report. Through global synchronization of purchases ABB strives to buy as much of inputs as possible from countries with weak currencies or low costs in general. This of course demands ﬂexibility, for currencies will not be weak forever. Given that the price of local inputs such as wages are typically stable in the currency of the country where production is located, it matters where you produce. It also matters how rapidly and smoothly you can expand and contract production in different locations. In the next section we return to the issue of where to locate production, but for the moment note that being able to switch production between different locations will be important for the ﬂexibility of cost of production.32 Firms are also faced with a choice of producing themselves or buying inputs. Buying on the market may increase ﬂexibility, but the choice is part of the wider question, what should the boundaries of the ﬁrm be? Should the ﬁrm do most things itself or should it subcontract? We take an example – you are the manager of a brand of clothes. Should you own the factory that produces the clothes? The alternative would be to subcontract production. As always in econom-

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ics and life, one then faces a trade-off between using some form of market mechanism and using a hierarchy. Can I command you and tell you that you have to do a thing, or do we have to negotiate? Both mechanisms have costs associated with them. Using the market adds ﬂexibility, but it is not without cost. Agency problems (how can I make sure that my counter-party does what she says she will do?), negotiations, and other forms of transaction cost will affect that choice. How sensitive are marginal costs to quantity changes? This will be important for whether the ﬁrm can make the most of the ﬂuctuations or not. If the ﬁrm faces a market price that it cannot control and has great ﬂexibility in the choice of quantities produced, it will achieve proﬁts like C in Figure 9.1. It will thus gain more in good times than it looses in bad times – it will thrive on volatility. If marginal costs are rapidly increasing due to capacity constraints, your ability to beneﬁt from a favorable exchange rate is of course very limited. Let us brieﬂy illustrate this last point. Say that you are an exporter; your currency depreciates and you want to beneﬁt from this by expanding production. It is of course only proﬁtable to produce if you earn more by producing an extra unit than it costs to produce that extra unit. If the cost of producing an extra unit is rapidly increasing, it will pay less to expand production and consequently you are able to beneﬁt less from the good times. You may want to take a larger ﬁxed cost to achieve ﬂatter marginal costs if you are faced with much variability (but not a large enough ﬁxed cost that payments for it will threaten the ﬁrm in bad times).

9.6

THE LONG-RUN PERSPECTIVE

Let us reiterate where we stand so far. We have looked at how to set prices, which is a fairly short run issue and easily reversible. How to segment markets and the decision of how production costs should be affected by exchange rates are longer-term questions. The perhaps longest-term questions for many ﬁrms, however, regard on which markets and segments to be active, and where to locate production. In terms of Equation 9.1 we are now concerned with the i’s: what are the markets and locations we are summing over. The words ‘diversiﬁcation’ and ‘ﬂexibility’ will be lurking in the background frequently in this section. Diversiﬁcation works through lowering exposure to single currencies or markets. Having production and sales on many markets is of course a way of diversifying; being able to rapidly

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shift production or sales between markets will be a way of giving the ﬁrm ﬂexibility. In this section, even more than in the previous, it must be emphasized that exchange rate variability is only one parameter among many that should ﬁgure in decisions. 9.6.1

Which Markets? And When?

Start with the ﬁrst question: on which markets should you be active? The simple answer is on markets where you expect to make a proﬁt in the long run (or more speciﬁcally, where resources will get a higher return than somewhere else). Considerations about exchange rate variability should not be allowed to take away the focus from this point. The potential addendum is that being present on several markets is a way of spreading risk – diversiﬁcation. Lessard and Lightstone (1986) mention the example of Laker Airways. Laker operated transatlantic ﬂights, and had a signiﬁcant contractual exposure because they bought their airplanes from the US. The marketing had been geared very much towards British clients. When the dollar strengthened the planes got more expensive and operating proﬁts decreased when fewer Britons went to the US. Laker was eventually forced into bankruptcy, something that might have been avoided had it geared its sales more to the American market. So if this is the case, when should you enter and exit a market? First we note that only under rare circumstances will it be possible to enter a market without costs. This implies that once you have entered, it will be worth staying on that market even if you make a loss, given that you believe that it will become proﬁtable again in the future and that costs are not recoupable if you exit the market. That is, there is an option value associated with being present on a market. Dixit (1989) is an example of a theoretical paper analyzing this in an international setting. Examples of costs include building up of distribution networks, costs of marketing, and the like. The time to enter will likely be when the exchange rate is favorable; that is, when the cost of investing in market share, distribution networks, and so forth are relatively low. A parallel can be drawn with how one should work across the business cycle: work hard when the beneﬁts of working are high, when your productivity is high. Similarly it makes the most sense to enter a market when the costs of entering are low. Fuji’s expansion of market shares during the period of the strong dollar in the early 1980s is a good example of this. Market shares can be acquired in essentially one of two ways, either through building up your own market share (or letting an importer do

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it) or by buying that of someone else. Volvo provides a good example of the second type of behavior. Following the Korean exchange rate crisis in 1998, Volvo took the opportunity to buy part of Samsung, thus strengthening its position in Asia. The price was bargain basement compared to what it would have been six months previously. Paul Krugman (1998) discusses a number of similar stories. At the time of his writing, General Motors, Ford, Procter&Gamble, and Shell were all looking or negotiating to buy Korean companies. As he puts it: ‘no mystery about that change in conditions. In 1997 South Korea’s currency lost half its value against the dollar, and its stock market lost 40 percent of its value in domestic currency. Thus the price of South Korean corporations to foreign buyers in effect fell by 70 percent, in some cases producing what appeared to be spectacular bargains.’ The aftermath of the Mexican currency collapse in 1994 saw strong inﬂows of foreign direct investment in the same manner as appears to be the case in Korea. Just the same, there might be some mystery attached to how such behavior shows up in aggregate ﬂows. Why should a depreciation of a country’s currency be associated with ownership shifting to foreigners? Froot and Stein (1991, p. 1191) put it this way: ‘An economist might ask, “if a German has an advantage purchasing a particular US asset with marks, why can’t an American with access to global capital markets borrow marks (at the same opportunity cost as the German) and avail himself of the same advantage?”’ Froot and Stein examine inﬂows of foreign direct investment to the US and indeed ﬁnd that there seems to be strong correlation with the real exchange rates. Foreigners invest when it is cheap. They build a model where informational asymmetries on credit markets lead to a role for wealth – the richer you are the easier it is to borrow. The story goes along these lines: If I lend you the money for this project, how do I know you don’t take the money and run? I will only trust you to stay and work hard if you chip in enough money of your own in the project. The answer to why the American can’t do the same thing as the German, then, is that the American is poorer and thus cannot borrow to the same extent. Informational problems like this are likely to be less important for assets that are easily valued, such as a portfolio of stocks and bonds, whereas they might be severe for many forms of foreign direct investment. Froot and Stein test the implications of their model on annual data for inﬂows to the US for the period 1973–87. They ﬁnd no correlation between portfolio inﬂows to stocks and bonds but a very signiﬁcant pattern for foreign direct investment where informational asymmetries are likely to be important.

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Now of course ‘mergers & acquisitions’ is not just acquisitions but also mergers. So, what about it? Is exchange rate variability important in determining which mergers to make? As with the above, it is conceivable but rather unlikely. Mergers are a major shake-up for an organization: I am hard pressed to think of any mergers that have occurred because of exchange rate movements. Scherer and Ross (1990, ch. 5) is one overview of why mergers occur. 9.6.2

Switching Costs

So much for which national markets to be active on. We now turn to the issue of how to position your goods on each national market. Should you aim for upmarket or more generic brands? Another concern about which markets and segments to be active on regards the stability of the customer stock. What are the switching costs that customers incur by changing supplier? The higher the switching costs, the more of a lock-in effect will there be – the more leeway do you have in setting prices that differ from those of your competitors. The ﬂipside of the coin is of course that if your competitors have similar switching costs it may be very expensive and time consuming to win new customers. As we noted earlier this has implications for how you should set prices: keeping prices stable in the face of variability is a way to achieve higher proﬁts over time when there are switching costs. Klemperer (1995) lists the following switching costs: 1) Those associated with a need for compatibility with existing equipment: take for instance blades which must ﬁt razors, or a computer program which must be Windows compatible. 2) The transaction costs of switching suppliers. These can be costs of closing down and opening up services. For example, in Sweden you need to install a new electricity meter for some hundred dollars to be able to switch supplier. 3) Costs of learning to use new brands – just try switching computer programs. 4) Uncertainty about the quality of untested brands – how often do you change dentist or barber? 5) The lock-in achieved by discount coupons and similar devices: frequent-ﬂyer programs and BMW dealers accepting your old BMW as a signiﬁcant share of the price are examples of this. 6) Psychological costs of switching, or non-economic ‘brand loyalty’: You see few Hell’s Angels riding Yamahas. Similarly, when I many years ago spent a year with a US family, we would only drink Pepsi, the reason not being that anyone in the family preferred it to Coke, but rather that the local Pepsi brewers were good friends of

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the family and mom didn’t want to be caught with a shopping cart full of Cokes. All these mechanisms may thus be used to try to achieve lock-in effects. 9.6.3

Differentiation

In choosing how to position your goods you also have to make the choice of how to differentiate your goods. How should you differentiate your products vertically – that is, should you go upmarket or downmarket? How should you differentiate them horizontally – how ‘close’ should you be to the competitors? Many parameters go into the choice of how to position goods: Martin (1993, ch. 10), Scherer and Ross (1990, ch. 16), and Eaton and Lipsey (1989) give thorough accounts of what economists have to say on these issues. Broadly speaking, having more differentiated goods tends to make demand less sensitive to the price of competitors. Again returning to the case of the European pulp and paper industry, we have an example of ﬁrms trying do just that. The story reads like a textbook example of strategies to limit exposure and raise proﬁts.33 As we saw earlier, one response to the high capacity in the industry was to try to lower capacity, thus raising prices. Without implicating the pulp and paper industry, it must be said that it smells like implicit collusion. By appealing ‘to the industry to keep its head’, one hopes to limit quantities; and by teaming up with Asian manufacturers one tries to avoid them exerting price pressure. The other side of the response is trying to differentiate your products more (and divide the market between manufacturers) – Christian Georges of Credit Lyonnais is cited as stating ‘I am conﬁdent we will see a trend towards asset swaps. Companies will focus on particular grades rather than try to cover the whole spectrum.’34 The objective is to increase price-setting power. By going for upmarket goods, a ﬁrm will typically have a higher markup and thus be able to absorb more ﬂuctuations in markup. A classic example of this is the case of Volkswagen. I quote Shapiro (1988, p. 58): ‘Volkswagen, for example, achieved its export prominence on the basis of low-priced, stripped-down, low-maintenance cars … The appreciation of the deutsche mark relative to the dollar in the early 1970s, however, effectively ended Volkswagen’s ability to compete primarily on the basis of price. The company lost over $310 million in 1974 alone attempting to maintain its market share by

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lowering deutsche mark prices. To compete in the long run, Volkswagen was forced to revise its product line and sell relatively high-priced cars from an extended product line to middle income consumers on the basis of quality and styling rather than cost.’ I think the lesson that one should draw from VW is not necessarily that one should stay clear of low markup/high volume segments; rather, it is that if you go for the lower end of the market it pays to be ﬂexible as long as there is variability. Crudely put: if you go for the low end you should not have to try to maintain market share. To be able to maintain stable prices to customers in the face of ﬂuctuations you need a solid markup to absorb the ﬂuctuations. Campa and Goldberg (1995a) is an example of how higher markups can allow a ﬁrm to accommodate exchange rate variations in markups without having it affect investment. In their words, ‘In low price-over-cost markup sectors, markups are relatively unresponsive to exchange rate changes, whereas sectoral investment patterns are strongly affected. By contrast, high markup industries absorb much of the exchange rate ﬂuctuations in markups and pass relatively little through to real investment.’ Their study is performed on US manufacturing sectors for the period 1972–86. Going for the lower end of the market generally makes it easier to expand sales rapidly by lowering price, but typically also creates exposure to competitors’ prices, the extreme case of course being a homogenous good (commodity) where you act only as a price taker. We keep coming back to the choice between stability (more differentiation) and ﬂexibility (more homogenous goods and ﬂexible production). The increased sensitivity is potentially beneﬁcial given that one is ﬂexible enough. 9.6.4

Entry Deterrence

One more issue from the realm of industrial organization regards how one should deter entry onto markets. There exists an armada of strategies designed to deter entry of other ﬁrms onto one’s market. Investing in excess capacity (‘top dog’ strategy, in the widely accepted language of Fudenberg and Tirole (1984)), creating switching costs, and building a reputation for being a tough, even reckless, defender of other markets, are some of the ways that entry can be deterred under various conditions. The common element to these investments in strategy is that they are just that, investments – they cost something. In relating this literature to the issue of exchange rate variability one

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should note that incursion into a domestic market is likely to be the largest threat when the exchange rate is strong – when the cost for a foreign ﬁrm of investing in market participation is low and proﬁt margins will be squeezed. Overviews of this vast literature can be found in Gilbert (1989) (only theory) or Martin (1993). 9.6.5

Where to Locate Production

So far our long-term discussion has focused on the revenue side of the cash ﬂow equation. What about costs? The long-term question regards where to locate production. In discussions with ﬁrms an often-cited way of handling exchange rate exposure is to diversify production, to produce in several national locations – putting your eggs in different baskets. The investments by Japanese and German automobile producers are a particular case in point. When BMW was investigating production in the US, for instance, it was claimed that ‘BMW has studied production in the US in particular as a way of countering its exposure to exchange rate ﬂuctuations between the US dollar and the D-Mark.’35 Goldberg and Kolstad (1994) study bilateral foreign direct investment patterns between the United States and the UK, Canada and Japan on quarterly data for 1978–91. They ﬁnd (p. 4) that ‘Our main empirical ﬁnding is consistent with the theory: exchange rate volatility does tend to increase the share of productive capacity located abroad.’ The strategy of investing in production capacity abroad has two elements: ﬁrst, by spreading production one diversiﬁes and limits the exposure to one’s home currency. The second element is that if one is ﬂexible production can be switched to locations where costs are lower at a speciﬁc time. There are of course many other reasons for locating production abroad than a strategy to counter exchange rate volatility.36 Do not forget that there may be economies of scale associated with producing in just a few locations, leading to lower average costs and higher proﬁts even though these may be associated with greater variability. Also note that large exchange rate changes may be associated with calls for protectionism, such as the ‘voluntary export restrictions’ on Japanese autos to the US put in place at the time of the strong dollar. Producing on the market is naturally a way to avoid this.37 As discussed earlier, this has impacted the response of Japanese auto manufacturers to the appreciating dollar. This aspect also seems to ﬁgure in decisions of overseas ﬁrms to channel foreign direct investment to potential EMU countries.

100 9.7

Exchange Rates and the Firm PUTTING IT ALL TOGETHER

The purpose of this whole chapter, perhaps the central chapter of the book, has been to discuss how ﬁrms should manage their economic exposure. Very broadly what are the lessons? There are essentially two, partly complementary, strategies: 1) Oil on the waves or trying to achieve greater stability by stabilizing market shares and using hedging. Segmenting markets and stabilizing the relative price of your goods met by consumers are central in this strategy. Producing differentiated goods and creating switching costs for consumers are other strategies to achieve this goal. Stabilizing foreign (and domestic) currency earnings makes it easier to hedge. (In terms of Figure 9.1 this strategy aims for creating an operating exposure like D (linear) that through ﬁnancial hedging becomes like B.) This strategy possibly also involves spreading production. 2) Thrive on volatility, by using ﬂexibility in production and sales. Through ﬂexibility in volumes and sourcing you make the most of opportunities and actively limit the damage done by bad times. This strategy then aims to get the relationship more like C in Figure 9.1. It may be combined with short-term hedging to buy some time during which operations are adjusted. Related to the second strategy is the speed of adjustment. Almost by deﬁnition the more rapid you are, the more ﬂexible are you. One way of being ﬂexible is to have extensive contingency planning – what do we do if the currency strengthens by 10 percent? Shell is supposed to be a master of this art. For most noncommodity ﬁrms my recommendation for strategy would be to stabilize market shares and sales while trying to make production as ﬂexible as possible, not forgetting that ﬂexibility costs. We will now turn to a discussion of accounting exposure before moving on to an application of what we know to the issue of how EMU will impact exchange rate exposure.

Part III Accounting Exposure

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10 Accounting Exposure As deﬁned earlier, accounting exposure is the exposure of ﬁnancial statements to exchange rates. Exactly how accounting statements will be exposed to exchange rate changes depends on laws in different countries. Accounting exposure arises when a ﬁrm has foreign subsidiaries, and the ﬁnancial statements of the subsidiaries are maintained in some other currency than the parent’s home currency. Typically the ﬁnancial statements of subsidiaries are maintained in the local currency, that is, the local currency is the functional currency. For instance, a foreign owned South African company would have their revenues and costs in South African rand. Say that the South African company was wholly owned by a US ﬁrm. When the US parent draws up its ﬁnancial statement, it does so in US dollars, which is the reporting currency. For accounting purposes the ﬁnancial statements of the subsidiary, expressed in rand, have to be translated into US dollars as the parent prepares its ﬁnancial statement. Accounting exposure is concerned with the effect of changes in the dollar exchange rate vis-à-vis the rand on the ﬁnancial statement of the parent. This deﬁnition implies that there are no cash ﬂow consequences of accounting exposure, it is just a matter of accounting. Investors should be able to see through the veil of accounting – the true economic value of the ﬁrm and its subsidiaries should not be affected by whether it is counted in apples or pears; or in the price of pears when they were bought. The one cash ﬂow effect that might be present is an indirect one through taxes. This has led most economists to play down the role of accounting exposure. For instance, Sercu and Uppal (1995, p. 527) say that ‘Thus in many cases there are no tax repercussions, which implies that management should not attach undue importance to its accounting exposure. This does not mean that exposure is not important; however, what matters is economic exposure, not translation [accounting] exposure.’ Nevertheless, as we will see below, ﬁrms devote a surprising amount of resources to the management of accounting exposure. In the rest of this chapter we will brieﬂy review the methods available for translating and hedging before we move on to the evidence on how ﬁrms actually behave.

103

104 10.1

Exchange Rates and the Firm WHAT METHODS ARE USED FOR TRANSLATING?

Say that you are a UK ﬁrm with a US subsidiary. When drawing up the balance sheet you cannot simply add dollars and pounds. So you need to translate, but it is just a translation, you do not actually exchange dollars for pounds, there are no ﬂows of money involved. There are four principal methods for translating foreign currency denominated statements into home currency. Their relative merits will partly depend on institutional detail. See Flower (1995) for a discussion of the merits of different methods and the international evidence and rules. They methods follow. i) The current/noncurrent method. Each current asset or liability (inventories, current receivables, and so forth) is translated at the current exchange rate; noncurrent assets or liabilities (tangible and nontangible assets, for instance) are translated at the historical exchange rates – the exchange rates at which they were bought. ii) The monetary/nonmonetary method. This translates monetary balance sheet items (such as cash, short- and long-term debt) at the current exchange rate, and nonmonetary items (such as plants and equipment) at the historical exchange rate. iii) The temporal method. A reﬁnement of the monetary/nonmonetary method. The difference is that if inventories are shown in balance sheets at current market values they may be translated using the current exchange rate. This was the base for the accounting standard that the US used until 1982, known as FASB 8. iv) The current rate method. What it sounds like: all balance sheet items are translated using the current exchange rate (the balance sheet date). This is the base of current US accounting rules, known as FASB 52. So what should you choose? First note that it is not always your call, different countries have different accounting rules or different recommendations from regulating bodies. Given that economists generally view the translation of assets and liabilities as a non-issue, the current rate method has quite a bit to recommend it, as it is undeniably the simplest, and it is also the rule used in the US (and is the most common in Sweden). Eiteman, Stonehill, and Moffet (1995) claim it to be the most prevalent in the world today. Before moving on we should note that one must not necessarily use a single translation method for subsidiaries from all countries. One example, among several, is the Swedish corporation Atlas Copco.1 It uses the current rate method except when translating from high-inﬂation countries,

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when they use the monetary/nonmonetary method. The US rules under FASB 52 also allow for not using the current rate when translating from high inﬂation countries.

10.2

HOW CAN YOU MANAGE ACCOUNTING EXPOSURE?

First the ﬁrm should ask itself whether the accounting exposure should be managed at all. The exposure is not real in the sense that it affects any cash ﬂows. As we shall see below, many ﬁrms manage their accounting exposure notwithstanding. Among consultants (for instance Dolfe 1996) and ﬁrms one often hears the argument that hedging of accounting exposure is beneﬁcial since equity (and implicitly proﬁts expressed as return on capital) will develop smoothly. Why this would be beneﬁcial is usually not spelled out, and most economists would be hard pressed to ﬁnd any signiﬁcant beneﬁts. However, as a caveat, in the spirit of Keynes one might say that ‘there is nothing worse than being rational in an irrational world’. If your experience very strongly indicates that investors value hedging of accounting exposure then it might be worth going along. Matters will differ from country to country. A survey of institutional investors from Touche Ross showed that 63 percent of respondents preferred companies not to hedge accounting exposure.2 As it seems not to be uncommon to hedge accounting exposure, we should mention the ways in which it can be hedged. The available instruments are essentially the ones we mentioned in Chapter 5. Say that you are a British ﬁrm that has an accounting exposure of 100,000 US dollars, since dollar denominated assets exceed liabilities by 100,000 USD in your US subsidiary. By having the subsidiary sell 100,000 dollars on the forward market the ﬁrm will be hedged in the sense that you create an offsetting exposure. When hedging accounting exposure it is important to remember that you are thus creating an exposed cash ﬂow (the forward contract) to hedge an exposure without cash ﬂow consequences. By hedging you will actually increase volatility of cash ﬂows. The potential exception is parents that are in the business of buying and selling companies, and the price they receive when selling a foreign subsidiary is linked to the exchange rate exposure – hedging of accounting exposure may here serve as a proxy for hedging of economic exposure. If you are looking to sell a subsidiary, a change in exchange rates will have effects on expected future cash ﬂows. Taking loans in the exposed currency is another way of

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hedging, as are use of options or swaps or some other derivative instrument. Note that by changing the functional currency of the subsidiary, the parent can affect the accounting exposure. If the same currency is used, the accounting exposure clearly disappears. Typically the local currency is used as functional currency for the subsidiary as long as most of their business is tied to that country. An example is Kodak in their annual report (1997, note 1): ‘For most subsidiaries and branches outside the US, the local currency is the functional currency and translation adjustments are accumulated in a separate component of shareholders’ equity. For subsidiaries and branches that operate in US dollars or whose economic environment is highly inﬂationary, the US dollar is the functional currency’. The policy of the Shell group as stated in their annual report (1997, p. 36) is another example: ‘Each Group company measures its foreign currency exposures against the underlying currency of its business (its “functional currency”), reports foreign exchange gains and losses against its functional currency and has hedging and treasury policies in place which are designed to minimise foreign exchange exposure so deﬁned. The functional currency for most upstream companies and for other companies with signiﬁcant international business is the US dollar, but other companies normally have their local currency as their functional currency.’ The parent’s reporting currency is typically its home currency. Some ﬁrms where there is no ‘natural’ domestic currency, such as Swedish-Swiss ABB or Dutch-British Shell (from 1998), use the US dollar as reporting currency. We return to a discussion of reporting and functional currencies when discussing EMU.

10.3 HOW DO FIRMS MANAGE ACCOUNTING EXPOSURE IN PRACTICE? How do ﬁrms actually behave? We know surprisingly little about this, as there have been few surveys of ﬁrm behavior. The surveys that exist typically either use very small samples or have a very high share of nonrespondents. Given the very weak case for hedging translation exposure, ﬁrms still hedge it to a surprising extent. One of the most cited of studies is Belk and Glaum (1990). They study 17 major UK industrial companies in 1988. Typical of the research studying Accounting exposure, they state (p. 4) that ‘For some 15 years the literature on international ﬁnancial management has been demonstrat-

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ing that accounting exposure is not a useful concept as a basis for corporate foreign exchange risk management … Against this background it was surprising to ﬁnd that UK MNCs were still very much concerned about their accounting exposures. Of 16 respondent companies, only three considered it to be without relevance.’ Of the ﬁrms that considered it to be of relevance about half only managed their accounting exposure under certain circumstances. It should be noted, however, that when interest rates are higher in the home country than in the countries where some of the equity is placed, taking loans in foreign currency has then been a way of beneﬁting from interest rate differentials between home and abroad.3 The ‘hedging’ of accounting exposure has here been a way of making money rather than a hedge. The Wharton/CIBC Wood Gundy (1996) study of derivatives usage by US nonﬁnancial ﬁrms ﬁnds that a fairly low share of respondents hedge accounting exposure with derivatives. Fourteen percent of respondents hedged accounting exposure with derivatives ‘frequently’ and another 14 percent ‘sometimes’. We note that accounting exposure is often hedged with foreign currency loans. The share of US multinationals that in some fashion manage their exposure is thus likely to be larger than the survey might indicate. This is also the impression from an interview study by Collier et al. (1990) – of the 23 US ﬁrms in their sample, 16 managed accounting exposure. Of the British ﬁrms in their study, 9 out of 11 managed it. Another cross-country study is Soenen and Aggarwal (1989), where a total of 259 ﬁrms from Belgium, Holland, and the UK answered the questionnaire. Around 10 percent of ﬁrms in each country named accounting exposure alone as the focus of their exchange rate management. The share of ﬁrms that gave both accounting and contractual exposure as focuses ranged from 31 percent in Belgium to 52 percent in the UK. For Sweden we have a good source in Sveriges Riksbank (1997b). The Swedish central bank collects information from all Swedish ﬁrms that have foreign direct investments. (FDI here deﬁned as an investment abroad that corresponds to at least 10 percent of shares or votes of a foreign operation). The 6,000 Swedish ﬁrms that had foreign direct investments by this deﬁnition had equity of 427 billion kronor in foreign subsidiaries. Of this, 42.6 percent (182 billion) was hedged. The most popular way of neutralizing the effect of exchange rate changes on accounting statements was foreign currency loans: 48.9 percent of the hedged equity was hedged with foreign currency loans. Forwards accounted for another 43.4 percent of the hedges.

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Currency swaps accounted for 6 percent and other instruments for the remaining 1.6 percent. The share of foreign equity that is hedged has decreased the last few years (50.5 percent in 1995). This decrease has coincided with narrowing interest margins between Sweden, and for instance, Germany and the US. A leaf through Swedish annual reports from 1996 indicates that many ﬁrms that do hedge accounting exposure do so to 100 percent.

Part IV EMU

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11 A Brief Background So much for strategies to manage exchange rate exposure. The largest institutional change to take place on the monetary scene for a very long time is the Economic and Monetary Union in Europe (EMU). At the time of writing, the shape of EMU is still surrounded by great clouds of uncertainty – we still do not know if it will actually come into being with a common currency from 2002 or not. Neither do we know the exact modus operandi of the European Central Bank (ECB). How will discussions go? How much will national governments try to inﬂuence monetary policy? There are many questions, the answers to which will only gradually be learned. Needless to say, EMU will change the exchange rate exposure of essentially any European ﬁrm; of ﬁrms exporting to Europe and of those exposed to the EMU-area through competitors, imported inputs, or some other channel. In Part IV we will try to apply the lessons of our previous chapters to an analysis of how to formulate strategies under EMU. The discussion in Part IV will essentially follow the same structure as we have done so far. The only exception will be that we will analyze how accounting exposure will be affected before proceeding to how economic exposure will change. We discuss the cases for three main types of ﬁrms – those within the EMU (for instance a German ﬁrm), those in the periphery (say British or Polish), and thirdly ‘overseas’ ﬁrms such as Asian and American ﬁrms. In this chapter we start with a brief description of the EMU project before turning to what preparations EU ﬁrms have taken so far (May 1998). Chapter 12 analyzes the implications of EMU for accounting exposure and Chapter 13 analyzes the implications for economic exposure. Chapter 14 focuses on the monetary policy of the European Central Bank and its bearing on the issue of exchange rate exposure. From 1 January 1999 EMU is in effect: monetary policy in Euroland (the EMU countries) will be ruled by the European Central Bank in Frankfurt. The countries that will be part of Euroland are all the EU countries except Denmark, Greece, Sweden, and the UK. During the period from its start until 1 January 2002 the countries within EMU will retain their own national currencies – we can in effect think of them as having a completely ﬁxed exchange rate against the euro. For transactions that do not involve cash it is possible to make payments in euros during this period. These three years are a 111

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Exchange Rates and the Firm

Figure 11.1 Nominal exchange rate of French franc vis-à-vis the D-mark and US dollar, 1990–8

somewhat peculiar hybrid between ﬁxed exchange rates and common currency. During the six months from 1 January to July 2002 the national currencies will be replaced by euro coins and notes. We return to a few issues regarding how EMU will work in Chapter 14. Before we go any further we should take a little time to put things in perspective. Euroland countries are not entering into the EMU from a free-ﬂoat but instead from the monetary arrangements and ﬁxed exchange rates of the European Monetary System (EMS). An illustration of this point is given in Figure 11.1, which graphs the French franc price of D-marks and US dollars from the end of 1990 to the spring of 1998. The picture should be sufﬁcient to make the point that much of Euroland trade has not been subjected to the wild swings of exchange rates that would have been likely under freely ﬂoating rates. There have of course been devaluations and upsets within the EMS such as the currency turmoil of 1992, but all in all it has been a system of stable exchange rates. EMU will clearly be different from EMS but it is useful to remember where Euroland comes from, and it is not from a free ﬂoat. 11.1

EMU AND THE COMMON MARKET

It should be stressed that EMU stands for Economic and Monetary Union. The roots of the idea of a common currency can be traced

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back a long time, but EMU in its present shape is to a large extent the brainchild of Jacques Delors, the President of the EU commission 1985–95. EMU is seen by many as an important step on the road to a ‘United States of Europe’. It is viewed as part of an ongoing integration of the EU countries. The European community achieved tarifffree internal trade already in 1968. But many obstacles remained that were of a more informal character. The initiatives taken during the 1970s that tried to increase integration were largely unsuccessful even though, for instance, the intellectual roots of EMU can be traced to the Werner plan of the early 1970s. EMU is seen as complementary to the EU 1992 program with its four freedoms – free movement of goods, services, labor, and capital within EU. The EU 1992 program, as is well known, was set out in the Commission’s White Paper of 1985. Four general types of trade barriers were targeted: 1) Fiscal barriers such as taxes and subsidies. Various taxes that favor national ﬁrms and subsidies to local ﬁrms serve to segment national markets and limit mobility. 2) Quantitative barriers such as quotas on intracommunity trade (for instance on agricultural goods), and harmonization of quotas vis-à-vis countries outside the EU (when there are separate quotas against nonmembers this creates a need for border controls within the community). 3) Market access restrictions regarding ﬁrms from other EU countries (market access has been restricted within, for instance, the provision of energy, banking, insurance, and several professions). 4) Real costs of trade, such as customs paper work, which create administrative and waiting-time costs, both for government and ﬁrms. Also, different regulations on technical standards and packaging were targeted. The EU 1992 program is associated with stricter enforcement of competition law on the Community level. An accessible overview of the EU 1992 program is given by Flam (1992). The fact that the common currency coincides with the ‘single market program’ is not without importance when we are discussing strategies. When your competitors discuss strategies to meet the introduction of EMU it will most likely be in the context of the general lowering of trade barriers between EU countries. It may be hard to separate the effect of the common currency from other effects. EMU may put decisions on the desks of the board of directors that otherwise would not ﬁgure there. Take for instance the question of national versus Euroland-wide distribution networks. The Swedish ball-bearing producer SKF has decided to switch from having national to Eurolandwide distribution networks. This is likely to have implications for how

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the strategy of SKF on different Euroland markets evolves. EMU may have prompted the decision to change distribution networks, but it will be hard to discuss the impact of the EMU on Exchange rate exposure without tying the discussion to other structural changes occurring simultaneously in the EU. For accounting and contractual exposure it will be of limited importance, whereas it will be important for the operating exposure and how that should be managed. The goal of the 1992 program is to increase welfare in the EU by increasing trade. Increased welfare is assumed to come about through a number of different channels. Those that mostly concern ﬁrms are: greater specialization of production through better use of comparative advantage; more competitive markets; and more efﬁcient production by exploitation of economies of scale and positive effects due to concentration of production. It is worth keeping in mind that these beneﬁts, if they materialize, hinge on and crucially impact the behavior of ﬁrms. After all, these beneﬁts will come about through the actions of ﬁrms. We will go somewhat deeper into these issues when we discuss economic exposure.

11.2

WHICH PREPARATIONS HAVE FIRMS MADE?

The introduction of the euro will affect all business within the euro area, and quite a few businesses outside the euro area as well. Computer systems will have to be redesigned, ATM’s and other machines adjusted to handle new notes and coins, staff trained, legal issues as to contract continuity and currency denomination of contracts investigated, and so forth. Needless to say it is vital that ﬁrms deal with these issues in time. The focus of this book, however, is not these issues, but that of the changing operating exposure and strategies to manage it. There are a number of pretty good resources on the internet detailing action plans for dealing with EMU.1 Check them out because these are issues that need to be dealt with. The typical action plan will call for: 1) creating a task group which goes through the required needs and changes that have to be made at all different departments. This task group should also keep up to date about what others in the industry are doing; 2) creating an action plan; 3) informing your staff, customers, and owners; and then 4) the Nike thing – Just Do It. These kinds of checklists usually end with something along the lines of ‘adapt strategy to the changing environment and capitalize on opportunity’, which of course is ﬁne, because that is where this book comes in.

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One example of how a group working on strategy can be organized comes from British clothes retailer Marks & Spencer.2 Marks & Spencer are active inside and outside (for instance the UK) the Euroland countries. It has created a steering group, sponsored from the board level, comprised of the people most involved at the level of heads of division. Under this steering group a full-time project manager is employed with a special team to support him. Areas such as supply chain management, customer service policy, pricing and display policy, and ﬁnancial reporting are examined. One crucial element targeted by Marks & Spencer is communication with customers: ‘The most important assumptions we make are those we make about the behaviour of our customers, many of whom will be confused by and distrustful of the change. We must retain their trust and conﬁdence, demonstrating that the change itself is not the excuse for a price increase.’ If you haven’t gotten very far in the process of ‘adapting strategy to the changing environment in order to capitalize on opportunity’, you are not alone. Judging by the surveys done during 1997, many European ﬁrms have made surprisingly few preparations. The surveys of KPMG Management Consultants have been widely cited. The latest one available at the time of writing was conducted in September–October 1997. A total of 302 large companies (with at least 5,000 employees) responded to the questions. The 1997 survey was more uplifting than the one conducted during 1996, which ‘demonstrated that companies’ state of planning for Emu was woefully inadequate and that those with plans completed or in development were concerned with defensive measures, to minimise costs and risks rather than exploiting potential opportunities’ (KPMG, 1997). The most recent survey shows that there has been a growing awareness of EMU issues. In October 1997 almost two-thirds of ﬁrms responded that they had a strategy in place, compared with one-third in 1996. The focuses of such strategies were typically implementation issues related to accounting, treasury, and ﬁnance. Extremely few ﬁrms had developed strategies in the true sense of the word – that is, examined impact on production, plant location, and management structure. In only 3 percent of the ﬁrms was the board leading the review. The rest of this book should be helpful in designing such a strategy.

12 Accounting Exposure and EMU In many senses this was the easy part of exchange rate exposure, and the same goes for the impact of EMU. A German ﬁrm which has subsidiaries in, say, Spain and Portugal, today has an accounting exposure. This exposure will obviously disappear if all three countries take part in a monetary union. Similarly the basic issue is simple for ﬁrms outside EMU – a Swedish or US ﬁrm having a German subsidiary will have accounting exposure to the euro instead of to the D-mark. The issue has been slightly more complicated for subsidiaries of Euroland ﬁrms located outside the euro area. Today the local currency has typically been the functional currency of the subsidiary – a British ﬁrm owned by a German parent will typically have kept its books in pounds. A number of ﬁrms have indicated that they want to change this. To the extent foreign subsidiaries do switch to using the euro as their functional currency there would be no accounting exposure for the euro parent. Of course this does not mean that there is no exchange rate exposure. If I have a ﬁrm that imports cars from Germany and sells them to Swedish customers, nothing would fundamentally change just because I expressed my balance sheet in euros. I have some costs in Swedish kronor, some costs in euros (D-marks) and my revenues in Swedish kronor. This will not change just because I tell my CFO do the book-keeping in euro – the economic exposure does not change. One may try to change the economic exposure: we will turn to that in due course. For a ﬁrm that has a very large share of its business in the euro zone it might make sense to have subsidiaries use euros as their functional currency. An example of a ﬁrm intending to change its accounting and economic exposures is Siemens. ‘Siemens said that while it does not want to pressurise customers or suppliers into adopting the euro, it wants seamless processing payments and receipts in the new currency. The company also intends to offer its UK workforce the option of being paid in euros, as well examining the possibility of paying its UK taxes in euros.’1 In Sweden there has also been a discussion about Swedish ﬁrms that trade much with Euroland wanting to switch to having the euro as reporting currency – presenting their ﬁnancial statements in euros, 116

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having their equity denominated in euros, and paying their taxes in euros. The arguments for why this would be good are typically somewhat vague. One argument comes from rules regarding risks for investors. Many fund managers, for instance of pension funds, have rules saying that 80 percent, or some other speciﬁc share, of their holdings must be denominated in the domestic currency. If a ﬁrm wants to attract these investors it could thus be relevant to change reporting currency. There is an important caveat, however. The rules for the fund manager were presumably instated to limit the degree of foreign exchange exposure – as we have seen, book-keeping in euros does not in itself change the economic exposure, which does not go away just because we call it by another name. A further question of course is why fund managers should not be allowed to diversify internationally – not putting all the eggs in the same basket is one of the basic tenets of a risk-averse investor. Frankel (1996) provides a good discussion.

RELATED ISSUES We will end this short chapter with some observations relating to accounting exposure. One such is that EMU is expected by many observers, to lead to increased European ﬁnancial market integration. For instance, Paul de Grauwe (member of the Belgian parliament and well-known academic) writes, ‘EMU will dramatically increase the degree of capital mobility within the euro area. Today European capital markets are still relatively closed. Financial institutions and insurance companies in Germany, France and Italy hold an overwhelming share of their total portfolio (often more than 90 percent) in domestic assets. The complete elimination of foreign exchange risk following the introduction of the euro and the disappearance of regulatory constraints on “foreign” euro assets will change all that.’2 The resulting enhanced depth and liquidity of European ﬁnancial markets is expected to lead to ﬁrms using equity to an increasing extent instead of debt. Many also believe that the euro will lead to the introduction of new instruments. The Economist writes, ‘Another effect of the euro will be to create new ﬁnancial markets. Outside Britain, Europe’s corporate-bond markets are anaemic. The euro will change this, as bond investors try to outperform each other on their understanding of credit risk, rather than currency risk. The development of a European

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corporate-bond market may well be accompanied by other American imports, such as junk bonds and leveraged buy-outs.’3 The decision of which stock exchange(s) to list your company on will also be inﬂuenced. A likely outcome in the foreseeable future is that we will see a pan-European equity market with a couple of hundred major European corporations, while smaller and medium-sized ﬁrms will mainly remain national concerns. Most observers also believe that the structure of European equity trading will see signiﬁcant change, with a few stock exchanges emerging as the dominant ones. As with trade patterns, it may be hard to separate the effect stemming from the common currency from that of other EU moves working for market integration. The future of London as a ﬁnancial center has of course been one of the most discussed issues, precisely for this reason. Many believe that it will be hurt little by Britain not being a member of EMU: they point to liberal regulators, a sound mix of available, skills and lower income taxes than competitors on the continent. Others stress the importance of being where the European Central Bank is, and point to the emergence of Frankfurt as a ﬁnancial center. Time will tell, but it is clear that currency is only one among many parameters.

13 Economic Exposure As in Part II, we begin with taking a look at contractual exposure. We then proceed to take a broad view of how economic exposure will change, before going into the details of eeconomic and operating exposure such as market segmentation and choice of price-setting currency. First, a couple of words about who will be affected by the EMU. Here again it pays to remember the obvious – ﬁrms located in Euroland, and those competing with ﬁrms from or using imports from Euroland. A Chilean barber will be affected little. The conversion into euros will affect all ﬁrms within Euroland – this may also include strategic issues. One such question regards price points – many prices end on .99, .95, or similar numbers for psychological reasons. It is not likely that you will want your product to cost 14.73 euros. How should the price move: should markups be raised, lowered? should packaging or quality be adjusted so that .99-pricing works well? Clearly many ﬁrms having no exchange rate exposure whatsoever will have to deal with such issues. Since these concerns are not really related to exchange rate exposure I will not deal with them in this book. The strategic aspects of exchange rate exposure change will mainly pertain to ﬁrms that have some form of foreign exchange exposure today or which can expect entry (or exit) on the part of competitors or potential suppliers. Firms that compete strongly with ﬁrms from outside Euroland will ﬁnd that their currency exposure has changed – since the correlation of currencies has changed. This regards both frequent (smaller) movements as well as exposure to larger infrequent changes such as devaluations. Finland of course provides a prime example: it joined EMS at a late date, and faces major competition from Sweden and North America both in the forestry sector (which constitutes a very substantial share of exports) and in sectors occupied by ﬁrms like the cellular telephone maker Nokia. If the forestry sector runs into problems, under a ﬂoating exchange rate a depreciation of the markka could have been expected, but not so under EMU. Many Irish ﬁrms are also likely to be worried that the UK is not part of Euroland.

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120 13.1

Exchange Rates and the Firm CONTRACTUAL EXPOSURE

Contractual exposure will typically disappear for transactions within EMU. A Belgian ﬁrm selling to a Finnish importer who previously had accounts receivable in Finnish markka, and thus a contractual exposure, will now face none. Resources previously devoted to management and hedging of contractual exposure will be freed. This of course is one of the main motivating factors for a monetary union – making cross-border payment cheaper and smoother. The development of TARGET (Trans-European Automated Real-Time Gross Settlement Express Transfer), a system for speeding up and facilitating cross-border payments within EMU, will also make cross-border payments smoother. There is not really a whole lot more to say about how contractual exposure will change within EMU. There might be some industry where, for some reason, one would want to have a contract denominated (or linked to) another currency: that constitutes an exception. This might be the case for an Italian ﬁrm which buys some raw material denominated in dollars, processes it a bit before shipping, and then sells it to another Italian ﬁrm, which in turn sells it to the US market. For a transaction such as this it might make sense to have the contracts denominated in dollars, whatever the domestic currency. For ﬁrms from outside EMU the issue will be slightly more complicated. The replacement of several currencies by one currency only will make the handling of contractual exposure simpler. Until 2002 one will still have the choice of denominating the contract in the national currency (francs, D-marks, etc.), but it would certainly be easier to do all the trade in euros. The only time it would make any other difference is if EMU breaks down and one or more currencies devalue. As we saw in Chapter 8, ﬁrms hedge contractual exposure to a signiﬁcant extent. One should note that the pattern of correlation between the world’s currencies will change due the great institutional change that the euro introduction implies. This will have implications for how to hedge, the share of contracts to be hedged, and the price of hedging instruments. We cannot trust historical correlation between currencies to be a faithful guide to the future. Demand for different currencies will be upset through changing patterns of invoicing and through reserve currency holdings of central banks. We return to a discussion of the volatility patterns of the euro and other world currencies later on. Though it is hard to say how much things will

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change, the point is that greater caution than usual is warranted when (for instance) using cross-currency hedging in a time of institutional change. Firms from outside EMU will also have to make choices about which currency to use for invoicing and price-setting – we will deal with this issue below, but it clearly has implications for the contractual exposure. A reasonable guess is that more exports to EMU will be invoiced in the importer’s currency (euro) than is the case today (Dmarks, guilders, etc.). Note, for example, that almost all US imports are invoiced in dollars, for the US is another big area with a common currency. US exports are also to a very large degree invoiced in US dollars, and it is quite conceivable that EMU exports will likewise to a considerable extent be invoiced in euros. Contractual exposure will then tend to shift from EMU ﬁrms to ﬁrms outside EMU when there is trade between EMU ﬁrms and non-EMU ﬁrms. So much for the contractual exposure that arises because of trade credit. We noticed before that contractual exposure also arises when one has loan payments denominated in foreign currency. A word of caution is in order here for EMU ﬁrms. In the period 1999–2002 EMU will ofﬁcially be in place, but each one of the individual countries will still carry its own currency. The exchange rates will be irrevocably ﬁxed. What happens if there is a large, country-speciﬁc shock, or a monetary policy in one country that is out of tune, implying the need for exchange rate adjustment? There will still be notes, coins, national central banks and thus it is not inconceivable to let a currency ﬂoat. If ﬁrms have borrowed abroad, believing that EMU is in place and that there is no exchange rate exposure, the effects could be disastrous. History is replete with ﬁrms that have believed that exchange rates were credibly ﬁxed, taken loans abroad to beneﬁt from lower interest rates, and then went bankrupt as the exchange rate depreciated. Ask Indonesia. A classic example of an asymmetric shock is when Finland lost 20 or so percent of its foreign trade due to the collapse of the Soviet Union. The markka eventually ﬂoated. With EMU in place and common notes it would obviously be a very large step to devalue or ﬂoat a currency. With the EMU, but a national currency still in place, as during the transition period 1999–2002, would the markka have ﬂoated in similar circumstances? We do not know. Some observers deem it extremely unlikely. For instance, The Economist writes that ‘Short of a political earthquake, such as the one that blew apart the Soviet Union’s single

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currency, it seems unlikely that an euro member would ever want to go through all this [leaving EMU].’1 Other observers are more fearful of speculation. Peter Garber, a well-known authority2 on the speculation and breakdown of ﬁxed exchange rates, writes, ‘However, Stage III could be subject to an attack from speculators that could force a realignment of the “irrevocably ﬁxed” exchange rates and ultimately a break-up of the system. A scenario is presented that describes how the existence of the ECB and the Target payment system, rather than creating additional security, actually creates a perfect mechanism for an explosive attack on the system.’3 The point here is that the possibility of a currency being cut loose from EMU, should ﬁgure in the worstcase scenario. One cannot but agree with Euromoney: ‘Prudent ﬁnancial management demands that the risk of failure, exit by one country or dissolution should be considered. Research suggests it isn’t negligible and that its consequences for ﬁnancial contracts and exposures are devastating.’4

13.2

OPERATING EXPOSURE – PRELIMINARIES

The big issue is naturally how will operating exposure change? EMU is an institutional change of a magnitude seldom seen in times of peace. It is a monetary union among sovereign nations on a scale not seen before. It is the ﬁrst time that a large number of sovereign nations team up to create a new currency under the leadership of a common monetary authority – while still remaining sovereign nations. A concise and readable history of monetary unions is provided by Bordo and Jonung (1997). Previous monetary unions that the world has seen have been created when new nations evolved (Germany and the US, for instance), or monetary unions of nations which retained their own central banks during the period of the gold standard (such as the Scandinavian and Latin monetary unions of the late nineteenth and early twentieth centuries), or countries which tied themselves to an existing currency, often that of a former colonial power, such as is the case with the CFA franc of West Africa which is tied to the French franc. The development of a common monetary policy within Euroland coincides with far-reaching deregulation seeking to integrate national markets, but Euroland is still quite far from becoming one country. All of this means that operating exposure will change, that it may be hard to see in what ways – and that there is precious little previous experience for comparison.

Economic Exposure 13.3 13.3.1

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OPERATING EXPOSURE – A CLOSER LOOK The Choice of Currency of Denomination

The choice of price-setting currency for trade within Euroland will be euros (except in very unusual cases). It is also likely that a large share of exports to the EMU area will be denominated in euros. We know that traditionally trade between developed nations to a fairly large extent has been invoiced in the exporter’s currency. The most notable exception to this pattern has been exports to the US, which have almost exclusively been denominated in US dollars. Most observers believe, analogously, that the majority of exports to EMU will be invoiced in euros. Many of the arguments for choice of trade currency point in this direction. From the price-setting perspective it is often preferable to stabilize relative prices to customers (price setting in the importer’s currency – the euro), as we saw earlier. Also the medium-ofexchange/transaction cost argument will speak for using the euro where perhaps today the Spanish peseta, the Italian lire, or what have you was not used. It will also be easier to hedge revenues in euros than revenues in (for instance) Portuguese escudos; there will be a larger set of ﬁnancial instruments available. If one is to believe the declarations of the European Central Bank (ECB), the euro will be a currency characterized by price stability, so that the invoicing/storeof-value roles of currency also would speak for its use. The prediction that comes out of all this is that if you do not have any strong reasons against invoicing exports to Euroland in euros, it would be wise to go with euros – your competitors probably will. So much for trade within, and imports to, Euroland. There are of course two more cases to consider: exports from the EMU area, and ﬁrms competing with EMU ﬁrms outside the EMU area. Which currency should EMU exporters use for trade denomination? The same arguments as those above rule currency choice, and it is likely that the share of exports from the euro area will be larger than the share of national currencies today. The pattern might well be less dominating than for imports since many arguments speak for price-setting in the importer’s currency. The medium-ofexchange/transaction cost argument is likely to speak for an increased use of the euro. Portes and Rey (1997) is an analysis of the transaction cost/medium-of-exchange argument for use of euros. The focus of discussion has been on whether the euro will replace the US dollar as the

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world’s premier vehicle currency. At ﬁrst the medium-of-exchange argument may seem a bit far-fetched – my chance of bumping into someone who wants Sao Tome dobras is pretty limited, or in the words of economists, there is a problem solving the ‘double-coincidence-of-wants’ problem. But ﬁnding people willing to accept dollars is not likely to prove hard in the future. Portes and Rey quote evidence stating that transaction costs are likely to be a decreasing function of volume – more trade in euros means a lower bid–ask spread. It is hard to conceive that bid–ask spreads on euros will be much lower than those for dollars; Portes and Rey point out that since volumes are large, small differences will have considerable incentive effects. They stress the role of more efﬁcient European ﬁnancial markets in a rise of the euro as an international currency. If many of one’s competitors start price-setting in Euros this would also make it more attractive. This is related to the price-setting role in arm’s-length trade. This effect, as well as the transaction cost effect, are obviously dependent on the behavior of others. Beliefs about the behavior of others may thus be an important factor in shaping the role of the euro. It is conceivable that the euro will indeed take a large role in export denomination. Portes and Rey (1997, p. 11), for instance, say that ‘EMU is likely to bring almost exclusive invoicing in euros by EU ﬁrms.’ This statement is not founded on any deeper analysis of the choice of invoicing currency, but is a just that – a belief. A belief that may become self-fulﬁlling. Many observers believe that the US dollar will continue to be the dominant international currency and that if the euro overtakes the dollar, it will do so only gradually.5 At least the Americans themselves are arguing this – for instance, US Deputy Treasury Secretary Lawrence Summers is quoted by Portes and Rey (1997, p. 3) as stating, ‘The dollar will remain the primary reserve currency for the foreseeable future. … We expect the impact of the euro on the monetary system to be quite limited initially and to occur only gradually.’ Both relative price stability and transaction costs depend on what others do, and this kind of situation tends to lead to quite a bit of inertia in the system. One often hears that when the dollar replaced the pound as the world’s premier vehicle currency it was a slow process taking place over decades and not years. The euro is different of course, since it creates a large currency area overnight, and there are really no previous empirical results for comparison to. Since the behavior depends on what others do this promotes inertia; on the other hand, if something happens that shifts beliefs of agents a general

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shift may happen very rapidly. Firms should keep in mind what we discussed in Section 9.2, while keeping an eye on what others are doing. Qui vivra, vera. 13.3.2

When and How to Change the Price

As before, the important issue for the ﬁrm is typically not the choice of trade currency but rather the choice of when and how to change the price. We start with looking at the issue of price adjustment of intraEMU trade and exports to EMU. Broadly speaking, less exchange rate induced swings in costs and relative prices will mean less need for price adjustment. Increased use of the euro as trade currency will imply less need for frequent price adjustment. Say that you are a Spanish ﬁrm competing with a US ﬁrm on the Spanish market. If the US ﬁrm previously has stabilized price in US dollars but now switches to price-setting and price stabilization in euros, this will clearly imply fewer shocks and less need for price adjustments, other things equal. A larger proportion of producers in your market will have costs in the same currency, which will also typically lessen the need for price adjustment, even though we probably should not exaggerate this effect too much – remember that Euroland is coming from having had ﬁxed exchange rates and not a free ﬂoat. There have been few signiﬁcant exchange rate induced swings in competitiveness between the Netherlands and Germany in latter years for instance. If before there was competition on the Dutch market from Finland, Italy, and Israel, now there will be competition from two currency areas, Euroland and Israel. The stronger the Israeli ﬁrm’s position, the more it is likely to signiﬁcantly inﬂuence the pricing decision of the industry. To the extent that a Euroland ﬁrm faces strong competition from ﬁrms based outside Euroland, exchange rate changes of the euro vis-à-vis the rest of the world will create the need for price changes. How price adjustment depends on the composition of nations on a market is an area where we know surprisingly little. The standard theoretical models predict that the larger the share of producers from one country the more will exchange rate changes affect the price in the importing country. This would point to a lesser need for price adjustment on EMU markets. The implication of this discussion for trade going in the other direction should not be overlooked. A German ﬁrm competing with Finnish and Italian ﬁrms on the Israeli market will probably ﬁnd that its competitors to a larger extent than before will want to change

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prices at the same time. This can increase exposure (if exchange rate movements have been such that they have been partly offsetting – you appreciate against one competitor but depreciate against another), or decrease it. It will, however, reduce the number of factors affecting the exposure, so in this sense it should become easier to understand. One last setup should be mentioned – that of a non-Euroland ﬁrm competing on a foreign market where Euroland ﬁrms have a signiﬁcant market share. Take the example of a Japanese ﬁrm competing with a number of Euroland ﬁrms on the US market. The price of competitors can be expected to move more in unison – there is a possibility that the variability of the euro vis-à-vis other currencies will be higher than in the case of, for instance, the D-mark today. Higher variability of the euro and higher exposure would translate into higher variability of cash ﬂows. We return to a discussion of the variability of the euro when discussing some of the macroeconomic implications of EMU. If, and this is a large if, the euro turned out to be a weak currency, with a major real depreciation, the effects on such a Japanese ﬁrm could be disastrous. It is not a very likely scenario, but it stresses that we are handing over the monetary policy of a sizeable share of the world economy to an untested institution. 13.3.3

Market Segmentation

One of the most common myths in the business community and in public debate is that the introduction of a common currency will lead to export markets becoming ‘domestic markets’. In the same breath, it is claimed that when prices are expressed in a common currency the ease of price comparisons will lead to the same price pervading the EMU area. Market segmentation on a national basis will thus be precluded. Let us look at this argument in detail. As we discussed earlier, there are essentially three ways through which arbitrage could work and thus put an equalizing pressure on prices in different markets: arbitrage by the customer, arbitrage by a third party, and arbitrage by the retailers. How would a common currency make arbitrage easier? The ﬁrst point is that the cost of exchanging currency disappears. If I live in Germany and go to the Netherlands to buy a car I will need to pay in Dutch guilders and there will be some cost associated with the exchange of currency. This cost is small enough, though, that it is very unlikely that it will be important for the decision to conduct arbitrage for most goods.

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The second claim is that price comparisons are made easier by being expressed in the same currency. This is likely to be true to some (very) limited extent. As we saw previously, customers have some costs associated with dealing in different currencies, as indicated by the price adjustment behavior in the duty-free shops on the ferries going to Finland. This cost seems associated with rules of thumb: there is some implicit cost associated with taking the time to do the calculation. As individuals we are not constantly going around optimizing all the time on minor issues. It appears from the Viking Line example as if price-setting in different currencies to some extent can contribute to why the law of one price doesn’t hold. A setting where one would have guessed that the difﬁculty in comparing prices has been used is on the in-ﬂight sales of Scandinavian air line SAS. As with Viking Line, SAS post prices in several different currencies. In their catalogs the prices are given in Swedish kronor, Danish kronor, and Norwegian kronor, as well as in US dollars. Customers can choose to pay in any of these currencies and may also use their credit cards with any of these currencies. There is no exchange rate booth inﬂight, but it is always possible to enquire about the exchange rate or check in newspapers. Figure 13.1 shows the price of a carton of Marlboro cigarettes. The mostly straight line is the price in Swedish kronor, while the jagged line is the cost in Swedish kronor if you made your purchase using the Danish price.

Figure 13.1 Price of Marlboro cigarettes (one carton of 200 cigarettes) in the SAS in-ﬂight shop, 1994–8

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Exchange Rates and the Firm

For instance, on Christmas eve 1997, this carton of cigarettes cost 165 Swedish kronor and the Danish price was 125 Danish kronor. That day you had to pay 1.15 Swedish kronor to buy one Danish krona. By charging your credit card in Danish kronor you thus pay only 125 1.15 = 144 Swedish kronor instead of 165. Prices of cigarettes at the time were higher in Sweden (45 Swedish kronor) than in Denmark (around 33 Swedish kronor), both in regular stores and in the duty-free shops at the airports. If one could segment the Swedes from the Danes one would thus in all likelihood want to charge a higher price for the Swedes, since their alternative is more expensive and thus demand less sensitive. New catalogs are issued monthly, so there have been many instances when prices could have been brought into line. At the very end of the time period there is a drastic increase in the Danish price. I do not know whether this is because Swedes started to shop in Danish kronor. The fact that prices were quoted in different currencies appears to have allowed some degree of market segmentation at SAS. The Viking Line example above showed that prices could be different when expressed in common currency without leading to drastic changes in the currency use by customers. Remember that normally the law of one price can break down for lots of reasons (nontraded components, costs of arbitrage, and so forth), but, none of these objections are present in the duty-free shops. We are looking at one good with two different price tags. Two instances where Viking Line said that they did feel some pressure to adjust prices also teach us something about the mechanisms forcing the law of one price to hold. The ﬁrst was that Viking Line felt that commuters, people using the ferry say once a week, were more inclined to shop in the cheaper currency. This is classic rule-of-thumb behavior: you will not optimize if you are in a situation only seldom and the potential gains from optimizing are likely to be small. However, in a repeat situation you are more likely to optimize, since the potential gains from optimizing are larger. Second, in the past, Viking Line has had some problems with employees making the exchange themselves, the potential savings thus accruing to the personnel. The gains for someone handling large sums of money each day are of course larger than for someone who is looking for a bottle of Jack Daniels and nothing else. The rules of thumb are likely to be important only when small sums are involved. The price-setting currency can not be expected to be important for larger price differences or more big-ticket items. Say that you have to pay 0.88 D-marks to buy one Dutch guilder. If a car costs 30,000 in Dutch guilders this

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translates into 30,000 0.88 = 26,400 D-marks. This is less than the German price of 34,000 D-marks. Most people bright enough to drive a car could manage making that calculation. So the mechanisms above are not likely to be relevant for the degree of market segmentation to any larger extent. One thing that might matter is that there are likely to be ﬁxed costs associated with arbitrage and that arbitrage takes time. If the difference in prices is small, I have to take some of the costs of arbitrage today (booking the boat to wherever the good is cheap, paying for the hotel room and the cost of searching), but will only make the arbitrage later, when a ﬂoating exchange rate may have made it unproﬁtable at the time of the transaction. If I am risk-averse, ﬂoating exchange rates (and different currencies) would thus make arbitrage harder. It is hard to say how important this mechanism is, but it is likely to play some role. It will be more important the longer the time span involved from starting to look into arbitrage to the actual deal taking place. Perhaps the most likely mechanism through which a common currency will put an equalizing pressure on prices is negotiations with importers. Why are the prices that the Dutch retailers pay 15 percent lower than the prices we pay? As exporter it will be impossible to blame price differences on exchange rate risk or anything like that. Given that various long-term relationships are important, ‘Voice’ will be a signiﬁcant mechanism. This would tend to equalize prices. It is thus likely that there will be more pressure in the direction of the law of one price for ﬁrms. We must remember, though, that factors that segment markets in Europe are many different languages, different tastes, different laws, different taxes. Given that a loaf of bread costs 20 kronor at the convenience store right outside my ofﬁce and only 15 kronor at the larger store two blocks away, and I still shop at the former, it is clear that the simple fact that the two countries have the same currency will not by itself lead to prices being the same throughout. What is true is that typically the law of one price holds much better within countries than between. Parsley and Wei (1996) study the prices in some 50 US cities of a number of goods. They conclude that ‘tradable goods (perishable and nonperishable categories) converge very fast to price parity. The half-life of a price gap for tradable goods is roughly four to ﬁve quarters (fried chicken and corn ﬂakes), and ﬁfteen quarters for services (beauty salon visit).’ They ﬁnd much smaller and more short-lived deviations from the law of one price than one does across borders. But there are many other things than currencies that segment national markets.

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One thing to remember at this time is why a ﬁrm would want to segment markets. If exchange rate ﬂuctuations disappear, so will many of the ﬂuctuations in purchasing power, measured in common currency. The beneﬁts of market segmentation will be lower. Remember that it is proﬁtable to segment markets only when the sensitivity of demand is different across markets. Taking away exchange rate variability will take away the systematic ﬂuctuations in purchasing power due to exchange rates, and if the countries have similar purchasing power and willingness to pay for your goods you will want to charge the same price in both countries. You will still want to charge a higher price to the customers willing to pay more, but that will be intracountry price discrimination. The price of the same roundtrip airline ticket from London to Paris today depends on where you buy it. With a common currency there may be less reason to separate national markets so that the price for the same plane ticket would be equalized. You would still want to charge customers the maximum willingness to pay, so we would still see student discounts, business class, a lower price if you stay away over weekends, and other mechanisms used to separate the people who are prepared to dish out substantial amounts for a ticket from the weaker groups. To sum up, the introduction of a common currency is likely to lead to some equalizing pressure in prices on different national markets. This effect should not be exaggerated. We should stress that this discussion has revolved around the impact of a common currency on the breakdown of the law of one price. As discussed numerous times above, the introduction of the euro takes place at the same point in history as the move towards the single market is made. This is likely to have an equalizing pressure on prices. As various exceptions to EU competition rules are not renewed (?), this will also tighten the pressure towards price equalization. One such exception is exclusive dealerships within the auto business. Local dealers which are tied to the larger producers cannot buy their cars from just any foreign dealer. Loosely put, it is OK for a car maker to say that a local dealer in, e.g., Toulouse has to buy from the French importer and is not allowed to buy directly from the Dutch general agent. The exception will be good until fall 2002. But the dealer is not allowed to refuse private persons the right to buy in another EU country. The steep ﬁnes of 102 million ecus (about a third of proﬁts) levied against Volkswagen in 1998 by the Commission for refusing to allow Italian dealers to sell to Austrian and German customers is an

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example of how grave the anticompetitive behavior was seen to be.6 In their press release, the European Commission state that ‘The size of the ﬁne is an indication that the Commission will not tolerate practices of this kind and will act with similar determination against other manufacturers who set out to partition the market.’7 Indeed, in the new guidelines as outlined by ‘Competition Commissioner’ Karel van Miert, on a scale from ‘minor infringements’ to ‘very serious infringements’ he classiﬁes compartmentalization of national markets as a very serious infringement. It is commonly accepted that the competitive authorities in the EU have taken a tougher and more active stance lately. At the same time it should not be forgotten that decisions have to be taken unanimously by the Commission – the existence of ‘national champions’ and various national and regional concerns implies that the decision process still leaves a lot to be decided by politics. Especially when it comes to public procurement one would expect that there have to be a lot of changes before a French government agency is as likely to buy goods or services from a Finnish ﬁrm as it is from a French. According to the press release from the European Commission there was a lot of incriminating evidence found during raids at Volkswagen-Audi and their Italian subsidiary. For instance, about 50 authorized dealers were threatened with dealership contract termination if they sold to foreign customers, and some 12 dealerships were actually recalled. Internal documents from Volkswagen-Audi purportedly show that they were well aware that the measure ‘is very likely to attract a ﬁne’. Audi obtained details of vehicle registration in Germany, and passed details on to the Italian subsidiary so that the dealers who sold the cars could be identiﬁed. Proving uncompetitive behavior is likely to be a lot harder in many other cases. In the Commission’s biannual reports on car prices in Europe there seems to be no tendency towards price equalization; rather, the difference between the lowest and highest price has actually increased.8 Prices were generally highest in the UK – a ﬁrst guess at an explanation would be that left-hand driving makes arbitrage more complicated. Also relevant to the political realm is the fact that price discrimination beneﬁts weaker consumers. Let us illustrate this with the case of Losec – the ulcer medicine from Astra.9 Today prices on the different national markets are set in negotiations between producers and health authorities on each EU market. This has led to large price discrepancies and the development of ﬁrms who conduct arbitrage – buying Losec cheaply in Greece, Italy, and Spain and reselling them in, for

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instance, the UK and Sweden. In the Swedish pharmacy monopoly, personnel are instructed always to choose the cheapest alternative if there are several suppliers of the same medicine. The eight ﬁrms that currently provide parallel imports of Losec to Sweden thus buy cheap abroad and are able to sell them through the same channel as the ‘Swedish’ Losec. The ﬁrst ﬁrm providing parallel imports started 1 January 1997; during the ﬁrst four months of 1998 the parallel importers had 60 percent of the market. Astra’s response has been to threaten to stop selling Losec in Greece and to introduce a special variety called Losec Mups that is not sold in the cheaper countries. What about the promised political dimension? Greece and the other cheap countries are not particularly keen on raising their prices, because a common price across Europe would be geared to stronger markets. A ﬁrm wanting to segment markets is thus likely to ﬁnd allies in the cheaper European countries. To sum up, EMU is likely to make it somewhat harder to segment markets, particularly through channels of negotiation (‘Voice’) rather than by making consumer arbitrage easier. The ‘single-market’ program and a potentially more aggressive stance by European competition authorities can be expected to make it signiﬁcantly harder to segment different national markets. 13.3.4

Costs and Production Decisions

We start with the issues facing an EMU ﬁrm. One factor inﬂuencing costs is where imports come from. The lack of exchange rate ﬂuctuations implies that there is no exchange rate risk associated with importing goods from other EMU countries.10 If the ﬁrm previously tended to import from domestic suppliers because it wanted to avoid the risk associated with exchange rate variability, the reason for shopping domestically would now disappear. Many other obstacles to importing goods will remain, even though, thanks to the general process of EU integration, they will tend to diminish over time as laws and rules become more harmonized. Greater stability of produced quantities implies that there will be less need for ﬂexibility as regards costs. It will matter less how marginal costs increase or decrease as quantities change. (In terms of Figure 9.1, the schedule becomes more like B.) In the next section we will return to the issue of where to produce and the choice of the cost mix of ﬁxed and variable costs.

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For ﬁrms exporting to the EMU area the issue is somewhat different. There would be a very large bloc of customers whose exchange rate moved in unison and would do so in the future as well. Whereas previously the exchange rates to different markets may have moved in opposite directions and thus made the net effect limited they, would now move together. Flexibility may thus become more important for ﬁrms selling to the EMU. Many observers also believe that EMU would imply greater volatility of Euroland currency against, for instance, the US dollar than is the case today. We will examine this argument in Section 14.3. 13.3.5 The Long-run Perspective: Where to Locate Production, What Markets to be Active On? For EMU ﬁrms the question of where to locate production may change somewhat – if costs (wages) are lower in one member country the ﬁrm knows that this advantage will tend to be more stable and lasting if there is no possibility of exchange rate adjustment. All else being equal (which it typically is not), you want to produce somewhere where wages are low. EMU in itself may also lead to more policy coordination and thus less risk of wide discrepancies in policies between member countries than is presently the case with EMS countries today. Taken together, these arguments would make production in low wage countries within the EMU (such as Portugal) more attractive. More stability also leads to less need for ﬂexibility in sourcing, at least within EMU. It would thus pay to go for economies of scale (if there are any), and to concentrate production rather than aiming for ﬂexibility and producing in many locations (remember that economies of scale mean that unit cost will be lower if you produce large quantities). The process of deregulation associated with the common market will push in this direction. Again we run into the problem that it is hard to separate the effect of EMU from that of the EU 1992 program. Reading the popular press one often gets the impression that somehow Europe will turn into a ﬁercely competitive integrated market as the common currency is introduced. This is hard to believe. It is also hard to believe that the aim of eliminating trade restrictions within EU would have no effect whatsoever. On the speciﬁc issue of industry location the standard comparison is between the US and Europe. Check a textbook on the economics of European Union and

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you are bound to ﬁnd a comparison of the number of ﬁrms producing some good in the US versus the number of ﬁrms producing that good in Europe. More careful studies also indicate that production is much more concentrated in the US. In the long run the likely effect of European integration (where EMU is playing its part) is a concentration of both number of producers and location of production within Europe. The prime example of concentration in the number of producers is of course the car industry. To beneﬁt from economies of scale many producers are trying to seek greater volumes. Economies of scale need not be limited to the production process itself but also apply to distribution, sales, and marketing. For these reasons we are likely to observe fewer but bigger manufacturers in many industries. If there is little potential for economies of scale, the pattern of concentration will of course be less pronounced. How large should plants be and how many should there be? The basic trade-off is between economies of scale and transport costs (including costs of crossing borders such as tolls). For instance, the high import tolls on cars in Thailand make it proﬁtable to produce cars in Thailand in comparison with importing them. The costs of producing on that small scale are very high, however – by centralizing production much lower unit costs would be achieved. In the same sense, but on a less extreme scale, the lowering of trade barriers within the EU will in all probability lead to more concentration, to there being fewer producers, in many industries. This is at least the case if the US experience is any guide to future patterns in Europe. As Europe becomes more integrated we are also likely to see a concentration of production to different locations. The US has the information technology industry concentrated in Silicon Valley and Route 128 in Massachusetts, show business in Hollywood, car manufacturing in Michigan, ﬁnancial business in New York City, carpet producers in Dalton, Georgia, and horseradish in Tulelake, California.11 Why do we see clustering like this? The factors promoting concentration of similar manufacturers in one location are the positive externalities often associated with clustering. First, by locating close to other ﬁrms in the same industry you will have access to a large pool of skilled workers. It is easier to ﬁnd a computer programmer in Silicon Valley than in Riksgränsen. On the other hand, it will be easier to ﬁnd a mountain guide in Riksgränsen. Secondly, there will exist a larger pool of skilled subcontractors. It is easier to ﬁnd a ﬁrm that will make computer animations for your next

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movie in Hollywood than in Nikkaloukta. The third reason for clustering is that there often exist knowledge effects – if you are close to others in the same industry rumors and new technology will reach you faster than if you insist on staying in the boondocks. In the words of Robert Lucas: ‘What can people be paying Manhattan or downtown Chicago rents for, if not for being near other people?’12 A fourth effect, and I do not know whether it has been analyzed formally, although personal observation indicates that it holds true, is that there are more and more relationships where both spouses are professionals. To be able to lure a person to take a job it is certainly a lot easier if the business is located somewhere where the spouse is likely to ﬁnd a job as well. My wife is an economist working in politics. I could convince her to move with me to New York, but Dartmouth would be tough. To the extent that we are not unique, this would lead to clustering of jobs for professionals in large cities, or wherever there are many suitable jobs. Maybe it is better to locate your research department outside London? Before putting the US map over Europe we should, however, note that information technology, the creating of ‘virtual networks’, and so forth tend to make location less important. To what extent this will matter is hard to determine. We have now strayed a bit from exchange rate exposure même. Nonetheless the fact that the lowering of trade barriers, of which exchange rate variability may be one, will have implications for where you locate production deserved to be pointed out.13 So much for ﬁrms within EMU – what about ﬁrms based outside the EMU area? One argument often proposed in favor of countries (at least Ireland, Sweden, and the UK) joining EMU is that foreign direct investment will go to EMU countries since foreign ﬁrms want to limit variability vis-à-vis the large EMU market. It has been a hot topic in the debate on EMU, especially in Britain, which receives some 40 percent of the EU’s inward investments, and in interviews one easily ﬁnds a large spectrum of views. Many investors assign little importance to whether the UK is in or out – this appears to be the case for US construction equipment giant Caterpillar.14 On the other hand, there have been plenty of comments such as that of Mr. Okuda, president of Toyota, who has said that Toyota might shift investment strategy away from Britain if it did not join the EMU.15 A reasonable prediction in the longer run is that other considerations will remain important, but that on the margin, investments geared to Euroland will be located in Euroland. It very much hinges on how monetary and other policies work in Euroland. In the out countries (UK, Sweden)

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there is also fairly strong belief that they will in time join EMU, should it be deemed a success. Investment in an out country is therefore likely to join EMU if it is successful. On What Markets? On what markets should your ﬁrm be present? What one can say is that long-term economic plans can be made with less uncertainty (at least about exchange rates!) under ﬁxed exchange rates. This would make it more attractive to enter other EMU markets for a risk-averse ﬁrm. It will also make it more attractive for other ﬁrms to enter your markets. As an economist one is often surprised by the enthusiasm with which businessmen hail EMU and welcome its (ostensible) stronger competition. How strong will this latter effect be? We can to some extent draw on studies that examine how lower trade barriers (tariff reductions, taking away ‘voluntary export restrictions’ and the like) affect the strength of competition within industries. The more competition is strengthened, the more will proﬁtability decrease. If the competitors come from other EMU countries your exchange rate exposure will decrease but on the other hand you will be forced to lower markups. As so often in economics, it has been hard to empirically determine the strength of effects. Surprisingly few have tried. Levinsohn (1993, p. 2) notes that ‘When faced with intensiﬁed international competition, domestic industries, which may have reaped oligopoly proﬁts in a protected domestic market, are forced to behave more competitively … As important, intuitive, and old-fashioned as the hypothesis may be, it appears that it has not been rigorously tested with ﬁrm level data.’ Nevertheless, on balance, the evidence that exists is supportive of this intuitive and old-fashioned (?) idea. In summarizing the literature on the question of changes in markups of ﬁrms when trade liberalization occurs’, Feenstra’s (1995, p. 1564) reading of the evidence is that there is ‘Weak evidence that markups have fallen for some developing countries.’ Economists do not have access to any crystal balls so one cannot be certain of the effects of EMU in this regard, but it would be surprising if effects tended to be as strong as is commonly believed, at least in the short run. There is little support for the notion, common in the popular press, that a tidal wave of increased competition will sweep over Europe as an effect of EMU. The caveat is that some industries will clearly be affected to a greater extent than others.

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One mechanism through which competition is supposed to increase is through mergers and takeovers establishing foreign players on markets previously dominated by domestic producers. Martin (1993, p. 235) quotes the European Commission: ‘mergers and takeovers will permit strategies aimed at better exploitation of returns to scale, wider geographic diversiﬁcation, and greater international division of labour within the European market.’ He goes on to summarize what we as economists know about mergers: ‘Empirical studies of mergers also produce negative results. Firms which engage in mergers lose market share and suffer reductions in proﬁtability more rapidly than similar ﬁrms that do not engage in mergers. The shareholders of ﬁrms acquired in takeovers enjoy a one-time beneﬁt – the increase in stock price that typically results from the takeover – but mergers do not result in a signiﬁcant increase in the value of shares of stockholders of acquiring ﬁrms.’ If merging does not increase value, proﬁtability, or market shares it is hard to see how they will be a major driving inﬂuence in the restructuring of the European business landscape. A merger wave by deﬁnition implies a change in the makeup of the market, but if the evidence above is a faithful guide to reality it is hard to see increased competition coming about through the mergers (rather the contrary). This is not to say that the structure of markets will be unchanged by the common currency or the abolishing of formal barriers to trade; rather that, based on what we as economists know from previous empirical evidence, it will not happen overnight. A caveat is that one of the important lessons that comes out of the study of industrial organization is that every industry has its own characteristics which will be important for how the industry reacts to various changes in the rules of the game. We can exemplify the point with a comparison of retail banking and commercial banking. Retail banking is an area where much of the liberalization that has taken place has had surprisingly small effects to date. Dixon (1993, p. 119) notes that ‘even in those countries like the UK, where the market has been completely open to foreign banks for over a decade, many aspects of banking have remained predominantly national concerns. This is because there are many unofﬁcial barriers, and these have perhaps even more of an effect in restricting foreign banks from entering than do ofﬁcial barriers.’ To take a concrete example, foreign banks were allowed to establish subsidiaries in Sweden in 1986 and branches in 1990. Yet, at the end of 1996 the share of foreign banks in lending to households was only 0.43 percent.16 Observations such as these lead Deutsche Bank (1996, p. 5),

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for instance, to conclude that ‘In retail banking economic barriers to entry to foreign markets will continue to play a major role … Therefore we do not expect that EMU, or the single market, will spur a way of mergers and acquisitions in retail banking in Europe.’ A comprehensive study of mergers and acquisitions in banking within and across borders within the EU is Vander Vennet (1996). He studies 422 domestic and 70 cross-border acquisitions for the period 1988–93. With respect to cross-border acquisitions he summarizes his ﬁndings as follows (p. 1552): ‘Transnational acquirers are very large, well-diversiﬁed institutions … the target banks exhibit signiﬁcantly inferior operational efﬁciency levels over the entire pre-acquisition period … The results for the acquired credit institutions show a marked drop in the interest margin (a signiﬁcant difference of –0.6 between the pre- and post-acquisition averages). The probable explanation is that foreign acquirers tend to change the pricing behavior of the target bank. Especially when a retail bank with a branch network is acquired by a foreign bank, the acquirer acts within a penetration strategy and often launches an intensive campaign to attract additional business.’ The establishment of foreign major players on national markets thus appears to inject some competitive pressure into sheltered domestic markets – even though this has had little overall effect this far. At the time of Vander Vennet’s study there had been no transnational mergers between ‘equals’. In, for instance, the proposed transnational merger between Generale Bank of Belgium and AMRO in 1989, cultural differences and diverging shareholder objectives were blamed for the failure. Perhaps the most publicized transnational merger to happen to date is the one between Sweden’s Nordbanken and Finland’s Merita – as with other transnational mergers so far, it is essentially a regional affair. We still have quite a way to go before we see pan-European giants roaming the earth. To sum up, within retail banking, the common market is putting some pressure on prices through entrance of new actors onto nationally dominated markets, but the effect of the common market has so far been very gradual and one has to look carefully to see the effects. Vives (1991) is a good overview of theories related to these issues. The business of investment banking and wholesale banking is increasingly internationalized, a process which EMU is likely to speed up. When it comes to equity trading, the disappearance of exchange rate volatility within the Euro area in combination with lower barriers to trade is thought likely to lead to very large changes in the structure. Deutsche Bank (1996, p. 1), for instance, makes the appraisal

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that ‘EMU will increase competition among ﬁnancial centres; London will remain Europe’s principal ﬁnancial centre, and Paris and Frankfurt will compete for the role of the benchmark issuer of government bonds. many smaller bourses must specialize, cooperate or perish.’ Frankel (1996, p. 37) takes a similar view: ‘With currency costs and risks removed, and government-imposed currency matching requirements on pension funds rendered meaningless, the positive network externalities and economies of scale in trading service provision should swamp any remaining beneﬁts to, or barriers supporting, trading fragmentation along national lines. Thus, the forces for concentrating trading – at least within different market structures (e.g. continuous auction, call auction, and dealer market) – will be very strong.’ The point is that in markets where customers are big, volumes large, and thus the gains of searching for the best deal large (such as on equity markets and in investment banking), EMU is likely to exert a substantive pressure. On markets such as these small transaction costs can make a large difference. You do not expect rule-of-thumb behavior to be very important. On retail markets and in banking services to small and medium sized ﬁrms, where customers are small, with limited resources to communicate effectively over large distances, and faced with graver problems related to asymmetric information (how do I know you will not take the money and run?), the pressure of EMU is likely to be much more gradual.

13.4

OPERATING EXPOSURE – SUMMING UP

We have now discussed a number of different issues relating to how operating exposure will change as EMU is introduced and begins to have an impact. We have discussed the role of the euro and how pricechanging patterns and exposure can be affected as the way that currencies will impact you and your competitors changes. We have emphasized that EMU is created by a number of countries that have had ﬁxed exchange rates. The EMS has meant that there also has been little intra-Euroland exchange rate variability before the creation of EMU. A key aspect of operating exposure is the ability to segment markets – here we pointed out that the role of the common currency itself is likely to be limited, whereas the common market program and a potentially tougher stance by the European competition authorities are likely to matter. Lower trading costs and fewer market access restrictions within the EU are likely to lead to some relocation and

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concentration of industries. To some extent this would be a result of the elimination of nominal exchange rate volatility within Euroland. We also discussed the potential for increased competitive pressure – lowering markups and lowering variability. A point to note is that the lower markups are, the less possibility will there be to absorb cost or exchange rate ﬂuctuations in markups. In effect the most important issue for the exposure of ﬁrms is how the monetary policy in Europe will be conducted: it is hard to discuss the changing face of exchange rate exposure without discussing the changing face of monetary policy. This is what we turn to next.

14 Macroeconomic Issues and their Implications for Exposure We have now applied the concepts from Part II, on economic exposure, to a discussion of EMU and how operating exposure will change. The driving force for operating exposure change is the likelihood that relevant (real) exchange rates will become much more predictable in most industries. There is less exchange rate risk. You should not put the book down, however, without reading the present chapter. Remember that economists are pretty much nonplussed as to what drives exchange rates in the short to medium run. This point should not be taken too far though – we know that ultimately exchange rates are driven by fundamentals (as indeed are other asset prices such as stock prices). We also know that when a country is hit by adverse shocks it can ease the adjustment process by having access to an independent monetary policy and the exchange rate instrument. Given that prices and wages tend to be sticky, expansionary monetary policy can increase the level of activity in the domestic economy if a country is faced with a recession. Similarly, monetary policy can be used to cool down an overheating economy. The issue of to what extent that monetary policy can affect any real variables is not entirely resolved, but it is fair to say that the common wisdom amongst economists is that monetary policy can substantially affect the real economy in the short to medium run. Going very deep into the reasons for price and wage stickiness would take the book too far aﬁeld.

14.1 OPTIMUM CURRENCY AREAS AND ASYMMETRIC SHOCKS The ability of monetary policy to affect the real economy is the very basis of what is known as the theory of optimum currency areas. Thinking about what areas should have a common monetary policy goes back to Robert Mundell (1961). Calmfors et al. (1997) provide a thorough recent application with respect to whether Sweden should 141

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join EMU. The positive aspect of having the same currency is that it makes trade easier, at least to some extent, thus bringing the beneﬁts that are associated with increased trade.1 On the other hand, if prices and wages are sticky, making an adjustment of the relative price between traded and nontraded goods (the real exchange rate) is much easier by using the nominal exchange rate than by letting wages and prices adjust directly. Monetary policy can be used to stabilize the domestic economy – for instance, a monetary tightening can be used to try to reign in a bullish economy. Furthermore, a booming economy will tend to have an appreciating exchange rate which aids in cooling it down. If you are always subject to the same shocks as other nations with which you share monetary policy, you lose nothing by having a common monetary policy. If you are subjected to different (asymmetric) shocks from others in the currency area, the loss of monetary autonomy will typically be associated with greater variability of the real economy (for instance, investment, demand, employment) in this framework. Hence the great emphasis on ‘asymmetric shocks’ in the debate about whether EMU is a good thing or not. The more asymmetric shocks, the less suited are two countries to form a monetary union. The more likely are business cycles to be out of tune, and the more likely are nations to have diverging monetary needs. Nevertheless there are other ways to deal with the easing of adjustment to asymmetric shocks. Take the US, for instance: clearly an oilproducing state such as Texas is subject to different shocks than, say, a New England idyll like Vermont. Not only may states be subject to different shocks, they may also react differently to the same shock. The effect of drastic increases in the price of crude are likely to have a very different impact in oil producers such as Alaska or Texas in comparison to ‘Motor City’ – Detroit. Bumper crops around the world will affect Iowa differently from Massachusetts. We have no idea how the US would look if it did indeed have different currencies: it might work better; but what we do know is that it works decently, for the US is by far the world’s strongest economy. How then are asymmetric shocks handled? In the US they are typically handled by two mechanisms of which Europe has precious little – mobility of workers across regions and ﬁscal transfers. High unemployment and a depressed situation in a US region prompts people to move out of the region; in addition, there is provision for ﬁscal redistribution in the federal tax system. Similarly, a booming region will postpone shortages and inﬂationary pressure when it experiences inﬂows of workers. It is well established

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that worker mobility in Europe has been very low, even within countries, and the scale of ﬁscal transfer on a Euroland-wide level is of course very small in comparison with that of countries. The other way in which price adjustment can be handled is, obviously, by adjusting prices. The role for monetary policies stems from price rigidities in the ﬁrst place: make prices more ﬂexible and the problem is solved. This is what lies behind the periodic calls for more ﬂexible prices and labor markets as EMU springs into life. An implication of the above kind of discussion is the following: For reduction of exchange rate risk not to increase risk ‘somewhere else’ (as in aggregate demand or interest rate risk), we require that exchange rates are driven mainly by noise. If the real exchange rates were only driven by real shocks (German reuniﬁcation, disappearance of exports markets as happened to Finland, shocks to productivity, oil shocks, earthquakes, and what have you), and wages and prices were sticky, it would clearly make for greater risk for a given country. This point was forcefully argued in Friedman (1953). Having a ﬂoating exchange rate may lower total risk at hand. Since we do have a very hard time predicting exchange rates based on fundamentals, it does indeed appear as if exchange rates to a considerable extent are driven by noise in the short run. This does not necessarily kill Friedman’s argument, however, as long as there are some large real (asymmetric) shocks. What has this got to do with a ﬁrm? The argument has been made for the economy as a whole. Do not jump to the conclusion that the risks faced by exporters are the same as for society at large. They typically are not, but the general point should not be forgotten. Greater real variability will affect, for instance, domestic demand or access to credit: variables that will affect you as a ﬁrm. Take the following example – you are a Spanish ﬁrm catering mainly to the domestic market. You produce in Spain with a large share of domestic inputs. You face competition from a French ﬁrm and are thus exposed to exchange rates as long as the ESP/FFR rate is allowed to adjust. Assume now that both countries are part of the EMU but that for some reason wages increase at a faster rate in Spain than in the EMU area as a whole. The result is the same as when under an over-valued exchange rate, domestically produced goods are expensive relative to imported goods. Without access to independent monetary policy the way to correct the relative wage difference is through having wage cuts in Spain, or (much slower) to have lower wage increases in Spain than in France until productivity adjusted wages are back in equilibrium.

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This is likely to be a very drawn out process, lasting several years. A ﬂoating exchange rate would tend to depreciate in such a situation. Is it riskier to have a ﬂoating exchange rate in a situation such as this? The point is important – the lack of independent monetary policy can lead to very prolonged misalignments of the real exchange rate (price of imports relative to the price of domestic goods). It would have been dangerous to believe that no operating exposure remained. Remember that operating exposure depends on the real exchange rate – there will perhaps be no ‘surprises’ in intra-EMU real exchange rates but there will at least be some prolonged misalignments with near certainty. Real exchange rates become more stable – for good and for bad. EMU notwithstanding, the European countries will continue to be just that – countries – for at least some time to come, with their own wage negotiations, their own laws, their own language, and their own culture. I will exemplify with the case of Sweden. Figure 14.1 shows the Swedish trade-weighted real (adjusted by consumer price indexes) and nominal exchange rates during the period from 1980 onwards. The story is brieﬂy this. Sweden had a ﬁxed exchange rate against a basket of currencies up until May 1991, after which it had a ﬁxed exchange rate against the ecu. The krona has ﬂoated since November 1992, there was a rapid depreciation following the decision to ﬂoat. In addition there were devaluations in 1981 and 1982. All these depreciaFigure 14.1

Nominal and real exchange rate, Sweden, 1980–97

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tions are clearly visible in the diagram where a higher value is associated with a weaker exchange rate. We note that the jumps in the nominal exchange rates coincide with jumps in the real exchange rate – my reading, and that of most economists, is that clearly nominal exchange rate policy (monetary policy) has the power to affect the real exchange rates. The ﬁgure has more to tell: from 1982 to 1992 Sweden had a ﬁxed exchange rate. This shows up as the virtually straight line during this period of the nominal exchange rate. We can also see that during this same period Sweden had a higher rate of inﬂation than most of its major trading partners – this is the reason for the continuing appreciation of the real exchange rate during this period. Prices increased more rapidly in Sweden than in our trading partners and the nominal exchange rate did not compensate for this. In a situation such as the early 1990s the real exchange rate was overvalued. It was expensive to produce in Sweden but cheap to import and cheap to travel. There was a ‘cost crisis’. Basically there are two ways to adjust the real exchange rate – one is depreciation, the jump seen in the picture, the other is lowering prices and wages, in reality to have a lower level of inﬂation than your trading partners. The point is that no variation in the nominal exchange rate does not necessarily mean that the real exchange rate is stable. However, we should end by noting that a common monetary policy within the EMU will limit the potential for divergences in inﬂation within Euroland. One of the shocks that the European Central Bank (ECB) will have to deal with if the common currency does lead to price equalization across Euroland is the creation of EMU in itself. By deﬁnition price equalization means that some prices have to increase and/or others decrease. Expensive countries would face a downward pressure on prices whereas cheaper countries would face an upward pressure. If a ﬁrm has been able to segment different markets and has had different prices on these markets a price equalization should lead to goods becoming more expensive for the weaker group – the customers in the cheap country would face rising prices. Remember for instance that pre-tax car prices differed by as much as 50 percent within the EU. How does one deﬁne Euroland price stability under these circumstances? Another asymmetric shock associated with the creation of EMU is the convergence of interest rates. Falling interest rates are associated with stimulation of the economy. So those countries that had much higher interest rates than Germany and the core in preEMU times, such as Italy, have had and will have a very expansionary (‘monetary’) policy – something that normally is assumed to drive up

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prices. Figure 14.2 illustrates with the long-term interest rates (government bond yield) from Italy, the Netherlands, and Spain. In the southern periphery of Euroland, Italy, Portugal, Spain, the creation of EMU will very possibly be associated with higher inﬂation – leading to overvalued real exchange rates. A common monetary policy having different effects in different EMU countries is another example of asymmetric shocks. Depending on the characteristics of the economies, a change in monetary policy, in the interest rate, will have a different impact. In 1995, ﬁnancial liabilities of the household sector ranged from 58 percent of GDP in Spain to 24 percent in Italy. Corporate bonds outstanding ranged from 61.2 percent of GDP in Germany to 3.2 percent in Ireland. Tax structure, the size of the public sector, and share of energy consumption imported are other structural differences within Euroland.2 An often stated observation is that in the UK some 85 percent of mortgage loans are taken at a variable interest rate, whereas in France the corresponding ﬁgure is only 10 percent. It is obvious that this will affect the speed with which monetary policy can affect the real economy and the demands of households. One should remember that the share of mortgage loans taken at a ﬁxed rate is no law of nature – change the rules of the game and the behavior of agents will change, but typically only over time.

Figure 14.2 Long-term government bond yields, Italy, Netherlands, and Spain, 1990–8

Macroeconomic Issues 14.2

147

A COMMON MONETARY POLICY

The point we have made so far in this chapter regards the exposure associated with asymmetric shocks (the shock being ‘too-high’ wage settlements, price equalization, or an asymmetric response to common monetary policy). The second point that we would like to make about monetary policy in the EMU is that it is a giant institutional change: a number (eleven) of (still) sovereign nations with conﬂicting needs and perhaps interests will share and determine a common monetary policy. Monetary policy will be conducted by an institution that may feel the need to show itself to be tough (a credible inﬂation ﬁghter), and that is likely to lack popular support in large tracts of Europe. The ideas behind EMU range from a leftist urge to take power away from ﬁnancial markets to a more liberal standpoint emphasizing a level playing ﬁeld for business. These are views that are likely to clash in efforts to inﬂuence the ECB. The body deciding monetary policy will be the 11-man governing council. It consists of the heads of the central banks within EMU. The day-to-day running of monetary policy will be taken care of by an executive board headed by a president and will consist of six members appointed for 8-year nonrenewable terms.3 There is a risk of an overly loose monetary policy as well as an overly tight one.4 These risks are further accentuated by uncertainty as to how the monetary transmission mechanism will operate in this new environment. There will be uncertainty as to how rapidly monetary policy will affect the real economy. There has been much focus on the credibility of the ECB. The background, which goes back to an article by Kydland and Prescott (1977), is intuitively the following. Governments want to surprise wage-setters by using expansionary monetary policy. They wish to do so because they want to increase employment beyond its ‘natural’ level. Wagesetters, not stupid enough to be systematically fooled, realize the incentive for governments to play this trick, and thus they demand higher wages to begin with. In equilibrium you will have a higher rate of inﬂation without achieving higher employment. If governments could commit not to fool wage setters this would imply lower inﬂation without affecting average employment levels. One way to try to credibly commit to low inﬂation is to delegate monetary policy to someone who doesn’t have to win elections, or who has a greater aversion to inﬂation and cares less about unemployment than the government – an independent central bank (Rogoff, 1985, also coined the phrase ‘conservative central banker’ with the exact meaning of delegating

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monetary policy to someone attaching a higher weight to inﬂation and a lower weight to unemployment than the rest of society). This is the background for having an independent central bank – the empirical and theoretical literature on the issue is huge; see for instance Persson and Tabellini (1990). For these reasons the doggedness of Jacques Chirac in pushing for a French head of the ECB was seen as a very bad signal for the independence of the central bank. I believe that the public debate has been too focused on credibility, though, and less alert on other issues. I would also see the long negotiations in Brussels over who should lead the ECB as a bad signal of how the ECB will be able to conduct a coordinated and active policy. Let us take a highly simpliﬁed story to illustrate the issue. Suppose you know that you have a penchant for eating at night and a weight problem. You put a lock on the fridge and give the key to your wife. She doesn’t like you fat so she’ll open it less often than you would. She will open it sometimes, though, so you don’t starve. This way you will be better off by delegating fridge policy to someone else. Now imagine that you are eleven fat guys having given the keys away to a committee of wives – your wives may be credible, but there may be huge disagreement on the correct policy nevertheless. You all have to open the fridge at the same time, but some of you guys are starving while others certainly do not need another bite. If the wives care most about their own husbands, fridge policy can get pretty messy. Let me tell you a little tale from the Great Depression in the United States. This version of the story comes from Friedman and Schwartz (1963, pp. 299–300). They describe the events: From the cyclical peak in August 1929 to the cyclical trough in March 1933, the stock of money fell by over a third … The monetary collapse was not the inescapable consequence of other forces, but rather a largely independent factor which exerted a powerful inﬂuence on the course of events. The failure of the Federal Reserve System to prevent the collapse reﬂected not the impotence of monetary policy but rather the particular policies followed by the monetary authorities, … The contraction is in fact a tragic testimonial to the importance of monetary forces. They give their interpretation later: The explanation for the contrast between Federal Reserve policy before 1929 and after, and hence for the inept policy after 1929,

Macroeconomic Issues

149

that emerges from the account in the earlier sections of this chapter is the shift of power within the System and the lack of understanding and experience of the individuals to whom the power shifted … The form which the power shift took – from New York as dominant of a ﬁve-man committee to New York as the head of an executive committee administering policies adopted by the twelve governors – also had an important effect. A committee of twelve men, each regarding himself as an equal of all the others and each the chief administrator of an institution established to strengthen regional independence, could much more easily agree on a policy of drift and inaction than on a coordinated policy involving the public assumption of responsibility for decisive and large-scale action. (1963, pp. 411–15) It should be noted that this version of the story is not uncontroversial. For instance economic historian Peter Temin of MIT has argued (1989, p. 26) that ‘It is no secret that the Federal Reserve pursued a deﬂationary policy in the early 1930s. It is also true that the Federal Reserve had been crafted to be independent of the federal administration. I want to argue, however, that Federal Reserve policy was part of a general governmental policy of deﬂation. It was not an artifact of the structure or personalities of the Federal Reserve system itself’. No matter what one’s view of this episode, the general lesson is that the personalities and the composition of a central Bank board have the potential to matter. At least in the interpretation of some serious observers (Milton Friedman is not an amateur in the ﬁeld of monetary economics), the personalities and the composition of the monetary committee were central to the development of the depression. Think of EMU countries being hit by a common shock. For some reason the different members of the ECB board, coming from different countries, have different views on the correct policy action. Say that we have a stock market collapse common to all Europe. Half the board are of the view that stock market events should not inﬂuence monetary policy. The other half defend the view that this is the time for a monetary expansion to counteract the contraction implicit in a stock market collapse. Status quo ensues. Is the scenario unreasonable? I do not think so. Paul Krugman (1993b, pp. 178–9) gives the view of him and many others on the stock market crash of 1987: ‘By purely ﬁnancial measures, the crash of 1987 was every bit as bad as the initial ﬁnancial panic in 1929 … In 1987 the Federal Reserve chose not to repeat its previous mistake. Faced with the stock crash, it

150

Exchange Rates and the Firm

rapidly expanded the supply of base money. The rest is already history. Instead of a Depression, there was faster growth in the year following the crash than in the year before.’ Would the ECB act as forcefully? Let us hope so. Think of the much praised monetary policy of the Federal reserve in the 1990s. Independent central bank policy also takes shape from different views on the shocks affecting the economy, the lags of monetary policy, and many other factors. Alan Greenspan states, ‘I wish I could say that there is a bound volume of immutable instructions on my desk on how effectively to implement policy to achieve our goals of maximum employment, sustainable economic development, and price stability. Instead, we have to deal with a dynamic continuously evolving economy whose structure appears to change from business cycle to business cycle … This process is not easy to get right at all times, and it is often difﬁcult to convey to the American people, whose support is essential to our mission.’5 What I am saying is that monetary policy is not some machine which can be put in ‘price stability mode’, after which everything is ﬁne. So why all this talk of monetary policy? The issue is that exchange rates depend on monetary policy. Change monetary policy (EMU) and you will change exchange rate risk. Changing monetary policy also changes the other risks facing ﬁrms – interest rate risk and macroeconomic risk in general. The point is not that we are bound to have a depression as EMU goes ahead. The point is that there are many uncertainties about how monetary policy will work within EMU when put to the test. This carries its own risks that one should not be blind to. Times of uncertainty are not the best in which to be highly leveraged, for instance. One fact to remember is that monetary policy is more likely to be geared to the needs of the central powers of Euroland (such as Germany, with 35 percent of Euroland GDP, and France, 22 percent of Euroland GDP) than to the needs of the small guys on the block (such as Ireland, at 1 percent of Euroland GDP). This would point in the direction of having lower macrorisks in the major countries of EMU than in the smaller countries (all depending on correlations between shocks over countries). The role of Euroland in the world may change relative to the sum of the present EMU-to-be countries. This regards issues such as whether the ECB should be part of the G-7, the cooperation between the largest industrial economies. This has the potential to affect monetary policy and macroeconomic exposure outside EMU. That is, one must

Macroeconomic Issues

151

consider the political ramiﬁcations on the international scene of European monetary integration – an issue that must fall outside the scope of the present book.

14.3

THE VOLATILITY OF THE EURO

There is one last question of importance pertaining to the variability of the euro vis-à-vis the US dollar and the yen. Will it become more or less volatile than the European currencies are today? In an interesting paper Harald Hau (1998) presents and tests hypotheses linked to the openness of countries. He studies a version of the next (?) theoretical work-horse in international monetary economics, that of Obstfeld and Rogoff (1995). Hau allows for a share of goods to be nontraded and his model has rigid wages. One of the predictions of his model is that the more closed a country is, the more volatile is the exchange rate. Very broadly the intuition is that the fewer prices that are affected by the exchange rate, the more the exchange rate will have to move following a monetary shock in order to restore money market equilibrium. So that more closed countries should have more volatile exchange rates. Hau tests the prediction on 54 countries and ﬁnds that it holds – even more so when he just looks at the 21 OECD countries. He studies volatility over periods ranging from one month to three years over 1979–96. In simple terms one can say that his model and empirical ﬁndings provide an example of Krugman’s (1989) statement that ‘The exchange rate moves so much because it matters so little.’ Betts and Devereux (1996) explore a similar model to Hau, but they let the share of prices set in the importers’ currency vary. A higher share of price-setting in the importers’ currency increases variability of the exchange rate in their model for the same reasons as in that of Hau. Substantive use of the euro for price-setting of Euroland’s imports would then work in the direction of higher volatility than is the case of the D-mark today. If one sees EMU as creating one large, relatively closed economy with monetary policy geared to the whole area’s needs, rather than to those of Germany, as has predominantly been the case under EMS, the move to EMU should be expected to raise volatility against the other world currencies. Given exposure, higher volatility will imply more variability in cash ﬂows for ﬁrms exposed to competition from outside Euroland. Summing up the section on monetary policy within EMU, what have we found? First of all, we note that nominal exchange rate

152

Exchange Rates and the Firm

variability within EMU will disappear but that the relative price of traded versus nontraded goods can still vary. We also note that creating a monetary union with 11 countries entails risks with regard to monetary policy. The implications for exchange rate exposure are that it might well be replaced by other exposures, at least in the medium run before new European institutions have emerged that are adapted to the new situation. Notably, business cycles are likely to have higher peaks and lower troughs. Finally, we have discussed what to expect as to the exchange rate variability of the euro – citing evidence that it might be higher than that of the D-mark today. This would lead to higher variability of cash ﬂows for ﬁrms with a euro exposure and for exposed Euroland ﬁrms. These points have been raised not because of some general euro-gloom; rather, I want to point to a number of potential pitfalls. Exchange rate exposure will become easier in many ways, and some aspects of it disappear – this is not to say that it is appropriate to let your guard down. It may just be a very smooth ride ahead. But then again, economics is not called the dismal science for nothing.

Notes CHAPTER 1: 1. 2. 3. 4. 5. 6. 7. 8.

Financial Times, 7 Nov. 1997, ‘Companies and Finance: Asia-Paciﬁc: Mitsubishi Motors Forecast Full-year Loss.’ Financial Times, 10 Dec. 1997, ‘Companies and Markets: Philip Morris to Restructure Kraft Foods.’ Financial Times, 29 Jan. 1998, ‘World Stock Markets: Swiss Shares Extend Record Run.’ Financial Times, 28 Jan. 1998, ‘Companies and Finance: the Americas: 3M Earnings Hit by Strong Dollar.’ Financial Times, 8 Aug. 1997, ‘Companies and Finance: UK: Strong Pound Hits UK Side of Reed Elsevier.’ For instance Aggarwal and Soenen (1989), George and Sroth (1991), Glaum (1990), and Lessard and Lightstone (1986). Bodnar, Dumas, and Marston (1998). Levi (1990), Sercu and Uppal (1995), and Shapiro (1992) are some examples. A technical overview, good but somewhat old, is Adler and Dumas (1983).

CHAPTER 2: 1. 2.

3. 4. 5.

INTRODUCTION

SETTING THE STAGE

For a discussion of efﬁcient markets and asset prices following random walks see for instance Brealey and Myers (1996), ch. 13. The data used are from the IFS data base maintained by IMF. Nominal exchange rates against the dollar are heading af.zf and consumer price indexes are heading 64. The relative depreciation is given by: log(exchange rate against dollar in 1996/exchange rate against dollar in 1973), where log denotes the natural logarithm. The relative rate of inﬂation is given by: log((consumer price index in the relevant country in 1996/ consumer price index in the relevant country in 1973)/( consumer price index in the US in 1996/ consumer price index in the US in 1973)). Figure 2.2 is inspired by Obstfeld (1995). The Economist, 11 April 1998, ‘Big Mac Currencies’, p. 70. See Holmström and Tirole (1997) for an analysis of how the worsening ﬁnancial status of intermediaries leads to pulling back credits and increasing interest rate spreads. Interesting pieces on the Asian crisis are found on Paul Krugman’s webpage: http://web.mit.edu/krugman/www and the ‘Asia crisis homepage’ at http://www.stern.nyu.edu/~nroubini/asia/AsiaHomepage

153

154

Notes

CHAPTER 3: 1.

Torniainen (1992) tries to catalog different deﬁnitions.

CHAPTER 4: 1.

2.

3. 4. 5. 6.

7.

SHOULD A FIRM MANAGE ITS EXPOSURE?

Good references on why hedging can be valuable are Dufey and Srinivasalu (1983), Smith and Stulz (1985), Eckl and Robinson (1990). More technical references are Froot, Scharfstein, and Stein (1993), Géczy, Minton, and Schrand (1997), and Nance, Smith, and Smithson (1993). See for instance Fazzari, Hubbard, and Petersen (1988). There has been some debate about their ﬁnding that investments by ﬁnancially more constrained ﬁrms are more sensitive to liquidity than ﬁnancially less constrained; see for instance Cleary (1998). The fact that liquidity affects investment for all types of ﬁrms is well established for US data. See Friberg (1998). Hermalin and Katz (1996) present a theoretical study of related issues and also provide a review of the literature. Svenska Dagbladet, 28 Jan. 1996, ‘Valutarisker Svårbedömd Post’ (Exchange Rate Risks Hard to Measure). Against this background it is interesting to follow the extensions made of Value at Risk (VaR) methodology to a corporate setting (as in Hayt and Song (1996), Turner (1996)). VaR analysis presents a measure of the maximum potential change in the value of portfolio at a speciﬁed conﬁdence level. JP Morgan’s ‘Riskmetrics’ homepage at http://www.jpmorgan.com/RiskManagement/RiskMetrcs.html is a good place to start. Hermalin and Katz (1996) discuss a number of issues and previous studies relating to the issue of informational asymmetries between owners and managers and risk management.

CHAPTER 5: HEDGING 1.

WHAT ARE THE ELEMENTS OF EXPOSURE?

THE INSTRUMENTS COMMONLY USED FOR

Covered interest parity can break down because of capital controls or transaction costs. Deviations from covered interest parity for major currencies are small and short-lived. Denote today’s date t and the maturity date T. Let Ft,T be the forward rate, et today’s spot rate, rt,T the domestic interest rate between t and T, and r*t,T the foreign interest rate for the same period. Covered interest parity then says that Ft,T = et,T (1 + rt,T )/(1 + r*t,T ).

Notes CHAPTER 6: 1. 2. 3. 4. 5. 6.

2. 3. 4.

5.

2.

THE EVIDENCE

Thorbecke (1997) is an interesting study of how monetary policy affects stock prices. Jorion uses the MERM index previously published by the International Monetary Fund. Kennedy (1992) is an excellent intuitive overview of econometric methods. Grossman and Levinsohn (1989) relate the return on capital invested in six US industries to the prices of competing imports. The analysis is related to the exchange rate exposure literature but is founded in quite different reasoning, that of Stolper–Samuelson in classic Heckscher– Ohlin trade theory. I mention it here as an example of the potential interest of incorporating insights from classical trade theory and general equilibrium into the pretty straightforward and descriptive exchange rate exposure literature. Svenska Dagbladet, 28 Jan. 1996, ‘Valutarisker Svårbedömd Post’ (Exchange Rate Risks Difﬁcult to Estimate).

CHAPTER 8: 1.

ECONOMIC EXPOSURE

Börsveckan, 11 Dec. 1995, ‘Lindvallen invaderas’ (Invasion of Lindvallen). A more thorough analysis would take into account the weather and amount of snow. Chemical Market Reporter, 14 July 1997, ‘UK Company Margins are Hit by Strong Pounds.’ Ibid. The discussion of VW is inspired by Aggarwal and Soenen (1989). The market share data are from Kadiyali (1997). A deeper question is of course why, if the devaluation is expected, wages and other prices do not adjust? This amounts to asking why PPP doesn’t hold. We will not pursue the issue further, but refer the reader to Chapter 2 for a discussion.

CHAPTER 7: 1.

155

CONTRACTUAL EXPOSURE

Finanstidningen, 22 Aug. 1995, ‘Fallisemanget hade Kunnat Undvikas Enligt Forskare; Liten Brist i Slites Konkurs’ (The Failure could have been Avoided According to Researcher; Small Deﬁcit in Slite Bankruptcy). Göteborgsposten, 19 Oct. 1996, ‘Johan i Hallen till Styckning’ (Johan i Hallen is taken to the Butcher).

156

Notes

CHAPTER 9: THE MECHANISMS AND WHAT CAN BE DONE ABOUT THEM 1. 2. 3.

4. 5. 6. 7.

8. 9. 10. 11.

12.

13. 14.

For simplicity disregard the cost of setting up new hedges in period t for securing future cash ﬂows. Financial Times, 16 April 1998, ‘Coca-Cola Hurt by Dollar’s Strength’. Another issue that we will not try to cover here regards if an asset manager should hedge portfolios and at what horizon. A interesting study is Froot (1993) – using 200 years of data he ﬁnds that hedging will typically reduce variability of returns in the short run, whereas for someone with a longer holding horizon (ﬁve years or more in Froot’s data), hedging might increase risk: essentially the reason is that PPP will hold on longer horizons. Shell, annual report 1997, p. 36. Svenska Dagbladet, 28 Jan. 1996, ‘Valutarisker Svårbedömd Post’ (Exchange Rate Risks Difﬁcult to Estimate). The less often mentioned fourth role is that as standard of deferred payment. Donnenfeld and Zilcha (1995) study negotiation over the invoicing currency when both parties have some negotiating power in different setups. Their focus is on the volume of trade and how it is affected by the invoicing currency. A study of the more general issue of whether ﬁrms should set price or quantity when faced with uncertainty is provided by Klemperer and Meyer (1986). Annual report 1992. Knetter (1997) uses the prices of The Economist to try to answer some questions about the law of one price. Levy et al. (1998) is an impressive attempt at quantifying menu costs in supermarkets. They ﬁnd (p. 791) that ‘The menu costs average $105,887/year per store, comprising 0.70 percent of revenues, 35.2 percent of net margins, and $0.52/price change.’ This type of behavior is by no means unique to the study of pricesetting. The literature originally developed with the study of optimal inventories. The methodologies involved have been applied to a large number of ﬁelds within economics; see for instance Dixit and Pindyck (1993). This description is based on material collected for Asplund and Friberg (1998). There may have been some adjustment that was not properly recorded, and the exact dates when the new prices took effect are somewhat approximate, but this does not change the fundamental pattern. The exchange rate used in Figure 9.7 is from a ﬁnancial source and the spread is thus somewhat smaller than on Viking Line, this will not affect the results in any major way as the example of Cognac prices show. The large changes in 1991–2 are due to the devaluation of the Finnish marka in November 1991, and then the ﬂoating of the marka in September 1992 and of the Swedish krona in November 1992. The other jumps in the ﬁgure are due to price changes.

Notes 15. 16. 17. 18.

19.

20. 21. 22. 23.

24. 25. 26. 27. 28. 29. 30. 31. 32. 33. 34.

157

Dagens Industri, 17 Nov. 1997, ‘Hellre stabil Euro än osäker krona’ (Rather Stable Euro than Uncertain krona). This draws on Asplund, Eriksson, and Friberg (1997). The perhaps clearest theoretical article is Rotemberg (1982). Good early theoretical references are Dornbusch (1987) and Krugman (1987). Feenstra (1989) also is very good, but more technical. The empirical literature is excellently surveyed in Goldberg and Knetter (1997). Dornbusch (1987) is the standard reference for this. Feenstra, Gagnon, and Knetter (1996) study another form of competition, in prices, and reach much the same conclusion. The caveat being that they ﬁnd the possibility of nonlinear pass-through ﬁrst decreasing as the market share from a source country increases, and then increasing. Their predictions are largely borne out in their study of a number of automobile markets. The theoretical model of Bodnar, Dumas, and Marston (1998), on the other hand, predicts that the larger the market share of the foreign ﬁrm (only one ﬁrm from each country in their model), the less will the foreign ﬁrm pass exchange rate changes on to prices. See Martin (1993), ch. 5 for an excellent overview. Financial Times, 8 Dec. 1997, ‘World Pulp and Paper: the European Industry: Strategies are Redeﬁned.’ Financial Times, 8 Dec. 1997, ‘World Pulp and Paper: Rich Parents Cushion Volatility: Using Different Techniques, both Sappi and Mondi are Growing Signiﬁcantly.’ Dagens Industri, 4 Dec. 1992, ‘Leverantörer höjer priserna efter kronfallet … men alla kunder är inte beredda att betala’ (Suppliers Raise Prices after the Fall of the Krona … But all Customers are not Prepared to Pay). An excellent overview of competition when there are switching costs is Klemperer (1995). Froot and Klemperer (1989) is an application to international trade. Financial Times, 24 Sept. 1997, ‘Companies and Finance: Asia-Paciﬁc: Struggling for Form on Home Ground: as their Exports Surge, Japanese Carmakers have been Hit by a Slump in Domestic Demand.’ Goldberg and Knetter (1997) and Menon (1995) are thorough surveys. Feenstra, Gagnon, and Knetter (1996). One paper that does examine the choice of quality and pass-through jointly is Goldberg (1995). She does so for the US car market. Financial Times, 21 April 1998, ‘Curb Sought for US Online Music Sales’ discusses UK industry fears of US low-price competition through the internet. Horn and Shy (1996) make a theoretical analysis of this issue. ‘Publishing with Macmillan, a Guide for Authors’, brochure 1997. Mello et al. (1995) is an interesting (but complex) theoretical model of production ﬂexibility for a multinational ﬁrm and the interaction with hedging decisions. Financial Times, 8 Dec. 1997, ‘World Pulp and Paper: the European Industry: Strategies are Redeﬁned’. Ibid.

158 35. 36. 37.

Notes Financial Times, 31 March 1992, ‘International Company News: BMW Looks at Potential Production Site in US’. Just to name a few: better penetration of foreign markets, beneﬁting from low production costs, or seeking better access to specialized knowledge. It is not necessarily the case that a quota hurts you – Berry, Levinsohn, and Pakes (1998) ﬁnd that Japanese proﬁts were basically unaffected by the ‘voluntary export restriction’.

CHAPTER 10: 1. 2. 3.

Annual report 1996. Cited in The Financial Times, 19 Aug. 1992, ‘International Capital Markets: UK Institutional Investors Warned of Risks in Foreign Exchange’. Schuster (1996) provides an analysis of Sweden.

CHAPTER 11: 1.

2.

2. 3.

2.

ACCOUNTING EXPOSURE AND EMU

The Independent, 26 March 1998, as quoted in ‘EMU Newsline – March 1998’, available at http://www.kpmg.co.uk/uk/direct/manage/emunews/ mar98.html#corp Financial Times, 20 Feb. 1998, ‘Monetary Turmoil’. The Economist, 9 May 1998, ‘Euro Neurosis’.

CHAPTER 13: 1.

A BRIEF BACKGROUND

A good place to ﬁnd links is the European Commission’s Euro-site at http://europa.eu.int/euro. Other good sites (linked) are the Bank of England, Deutsche Bank’s EMU watch, the Federation of European Accounting Experts (FEE), IBM, and KPMG management consulting. The discussion of Marks & Spencer is based largely on the description found on the website of the Bank of England, http://www.bankofengland.co.uk/euroiss6.htm

CHAPTER 12: 1.

ACCOUNTING EXPOSURE

ECONOMIC EXPOSURE

The Economist, 11 April 1998, ‘An Awfully Big Adventure – A Survey of EMU’, p. 20. For instance, he co-authored the article on speculative attacks in the latest edition of the Handbook of International Economics, Garber and Svensson (1995).

Notes 3. 4. 5. 6.

7. 8. 9. 10.

11. 12. 13.

14. 15. 16.

159

Euromoney, Aug. 1997, ‘Is Stage III Attackable?’. Euromoney, April 1998, ‘SS Euro – Sinking the Unsinkable’. International Monetary Fund (1997) contains a number of contributions and discussion of the future role of the euro in the international monetary system. Volkswagen has decided to appeal to the European Court but, at time of writing, the process is not yet ﬁnished, so the ﬁnal outcome is uncertain. What is clear is a will on the part of the commission to clamp down on market segmentation. Press release, 28 Jan 1998; IP/98/94 in the RAPID database accessible from the homepage of the Commission competition authority: http://europa.eu.int/en/comm/dg04/dg4home.htm Press release by the European Commission 13 Feb. 1998; IP/98/154 in the RAPID data base at http://europa.eu.int/en/comm/dg04/ dg4home.htm Dagens Medicin, 23 May 1998, ‘Importerat Losec tar över i Sverige’ (Imported Losec takes over in Sweden). Real exchange rates are often deﬁned as the relative price between traded and nontraded goods. Real exchange rates can ﬂuctuate also when there is a common currency, but since to a very large extent they are driven by nominal exchange rate variations, they will become much more stable when there is a monetary union. We will discuss related issues in Chapter 14. Krugman (1991) discusses location of industries in an easy-to-read account. Krugman and Venables (1996) is more technical but covers similar ground. Lucas, 1988, p. 39. Krugman (1993a) draws out the implications of such relocation for whether Europe will be an optimal currency area – these kinds of mechanisms would lead to national economies being less diversiﬁed and hence more exposed to sector-speciﬁc shocks. Frankel and Rose (1997) evaluate this argument. Financial Times, 6 Nov. 1997, ‘Caterpillar Unshaken by Slow Crawl Towards the Euro.’ Financial Times, 24 July 1997, ‘Survey – Inward Investment Into the UK: Economic and Monetary Union: Two Sides to One Currency.’ Sveriges Riksbank (1997a).

CHAPTER 14: MACROECONOMIC ISSUES AND THEIR IMPLICATIONS FOR EXPOSURE 1. 2. 3.

This positive effect has been very hard to support empirically: see Friberg and Vredin (1997) for an overview of empirical evidence. Pennant-Rea et al. (1997) provide a discussion. In the ﬁrst round they will serve shorter terms so that the whole executive board doesn’t have to be changed at one time. Vice-Chairman Christian Noyer of France will serve 4 years, Sirkka Hämäläinen of

160

4. 5.

Notes Finland 5 years, Germany’s Otmar Issing 8 years, Italy’s Tommaso Padoa Schioppa 7 years, and Spain’s Eugenio Domingo Solans 6 years. Whether Wim Duisenberg will serve the full 8 years or retire ‘voluntarily for personal reasons’ after 4 remains to be seen. An interesting study of ECB policy is Dornbusch, Favero, and Giavazzi (1998). Alan Greenspan, speech presented at the American Enterprise Institute for Public Policy Research, Washington DC, Dec. 6, 1996.

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Index 3M, 1 ABB, 68, 92, 106 accounting exposure, 22, 23, 39, 55, 103–8, 116–18 accounts receivables, 21, 54, 120 Adler, M., 3, 20, 41, 42, 57, 153 adjustment costs, 73–7 advertising, 3, 85 Aggarwal, R., 55, 107, 155 Airline industry, 63 Amihud, Y., 48 Andrade, G., 27 appreciation, 11, 17, 83, 99, 142 arbitrage, 12, 14, 34, 75, 86–90, 126–32 Asplund, M., 77, 156, 157 Astra, 50, 131, 132 asymmetric information, 24, 30, 88, 139 asymmetric price adjustment, 82–3, 84, asymmetric shocks, 121, 141–6 Atlas Copco, 104 balance sheet, 22, 104, 116 banking industry, 18, 52, 137–8 bankruptcy, 1, 27, 32, 54, 55, 94, 121 Barings, 65 Bartov, E., 48, 49, 50 Belgium, 55, 56, 107, 117, 120, 138 Belk, P.A., 64, 65, 106 Bergström Instruments, 76 Berry, S., 158 Betts, C., 151 Big Mac, 15, 16 Bitler, R., 70 BMW, 53, 96, 99 Bodnar, G.M., 3, 48, 49, 50, 52, 86, 153 bond markets, 117 Booth, L., 48 Bordo, M., 122

brands, 89, 90, 92, 96 Brealey, R.A., 30, 64, 65, 153 Calmfors, L., 141 Campa, J., 98 Canada, 9, 48, 51, 67, 69, 89, 91, 99 car industry, 52, 64, 83, 89, 97, 98, 130, 131, 134, 145 Cardo, 63, 65 cash ﬂows and exposure, 21 Caterpillar, 135 Chamberlain, S., 52 chemical industry, 40 Chow, E.H., 48, 50 Cleary, S., 153 Cloetta, 64, 68, 69, 71, 76 clustering, 134–5 Coca-Cola, 1, 62, 63 Collier, P., 107 collusion, 79, 80–3, 97 concave functions, 25, 28, 57, 69 concentration, 114, 134, 140 contractual exposure, 21–2, 25, 35, 39, 54–6, 63–4, 68, 119–22 convex functions, 32, 58, 70, 90 Copeland, T.E., 63 Coppé, B., 57 cost of inputs, 16, 19, 43, 91–3, 132–3 covered interest parity, 34, 61 currency of denomination, 63, 66, 123 current account, 3, 73 current rate method, 104 current/noncurrent method, 104 customer markets, 81, 96–7 De Marzo, P., 30 De Vries, C., 68 debt, corporate, 18, 19, 24, 31, 40, 104–8, 117 Delors, J., 113 demand function, 68–70, 78–80, 97–8, 85 Denmark, 111, 128

169

170

Index

depreciation, 12, 13, 15, 25, 43, 44, 46, 47, 48, 55, 58, 69, 70, 83, 84, 90, 95, 126, 144, 145, 153 depression (1930s), 148–50 derivatives, 30, 31, 33–5, 55, 63, 107 devaluation, 40, 42 Devereux, M.B., 151 diversiﬁcation, 93, 94, 137 Dixit, A.K., 94 Dixon, R., 137 D-Mark, 9, 18, 20, 25, 41, 52, 54, 99, 112, 116, 120, 126, 128, 151, 152 Dolfe, M.Å., 105 dollar, US, 1, 3, 9, 11, 13, 19, 20, 21, 33, 34, 35, 41, 42, 44, 61, 63, 64, 68, 71, 73, 76, 82, 83, 84, 85, 87, 91, 94, 95, 97, 99, 103, 105, 106, 123, 124, 133, 151, 153 Donnenfeld, S., 156 Donnelly, R., 48, 51 Dornbusch, R., 157, 160 Dufey, G., 154 Dufﬁe, D., 30 Duisenberg, W., 147 Dumas, B., 3, 20, 41, 42, 52, 57, 60, 61, 63, 85, 86, 153, 157 Eaton, B.C., 97 ECB, (European Central Bank), 111, 118, 122, 123, 145, 147–51 Eckl, S., 154 economic exposure and EMU, 119–40 deﬁnition, 39 measurement, 46–7 economies of scale, 65, 99, 114, 132–6, 139 The Economist, 15, 71, 90, 117, 121, 153, 158 ecu, 4, 54, 72, 144 Eiteman, D.K., 22, 104 elasticity of demand, 78, 79, 84, 85 EMS (European Monetary System), 11, 112, 119, 133, 139, 151 EMU (Economic and Monetary Union and accounting exposure, 116–18 asymmetric shocks, 141–6

background, 111–14 common market, 112–14 economic exposure, 119–40 preparations, 114–15 monetary policy, 147–51 volatility, 151–2 Engel, C., 89 entry of ﬁrms, 98–9, 138 equity, 24, 105, 106, 107, 108, 117, 118, 138, 139 Ericsson, 15 Eriksson, R., 77, 157 EU (European Union), 4, 88, 89, 111, 113, 114, 118, 124, 130, 131, 132, 133, 134, 138, 139, 145 euro, 4, 111, 112, 114, 116, 117, 120, 121, 122, 123, 124, 125, 126, 130, 139, 151, 152 Euroland, 111–26, 133, 135, 139, 140, 143, 145, 146, 150, 151, 152 Euromoney, 122 exchange rate determination, 9–11 exchange rate exposure deﬁnitions, 20–2 should it be managed, 22–32 see also accounting, contractual, economic and operating exposures exchange rate surprises, 3, 5, 21, 33, 69 exchange rate variability, 2, 5, 20, 44, 130, 132, 135, 152 exclusive dealerships, 89 expected value, 25, 41, 69 Fazzari, S.R., 154 Federal Reserve, 148–9 Feenstra, R.C., 136, 157 ﬁnancial analysts, 4, 29, 50 ﬁnancial distress, 27, 28, 31, 32, 54 ﬁnancial markets, 5, 18, 27, 30, 41, 117, 124, 147 ﬁnancial statements, 20, 22, 103, 116 Financial Times, 1, 19, 71, 80, 82, 153 Finland, 73, 119, 121, 125, 127, 138, 143 ﬁxed costs, 3, 73, 76, 77, 80, 129; see also economies of scale

Index ﬁxed exchange rate, 4, 11, 18, 54, 144, 145 Flam, H., 89, 113 ﬂexibility, 35, 58, 59, 64, 82, 90–4, 98, 102, 132, 133 ﬂoating exchange rate, 5, 119, 143, 144 Flower, J., 104 Ford, 95 foreign currency loans, 55, 107 Fortune, 500, 30, 31, 32 forward, 30–1, 33, 55–6, 59, 60–5, 105 France, 51, 117, 143, 146, 150 franc, French, 5, 11, 112, 122 Frankel, J.A., 9, 10, 117, 139 franc, Swiss, 5, 9, 15 Friberg, R., 51, 69, 72, 77, 85, 86, 156, 157 Friedman, M., 143, 148–9 Froot, K.A., 15, 17, 30, 88, 95, 154, 156, 157 Fudenberg, D., 98 Fuji, 41, 52, 82, 85, 94 functional currency, 103, 106, 116 futures, 30–4, 65 Gagnon, J.E., 157 Garber, P.M., 122, 158 Gasoline industry, 76 Géczy, C., 31, 154 General Motors, 95 Gentry, W.M., 48 George, A.M., 153 Germany, 18, 51, 52, 54, 64, 83, 89, 90, 95, 99, 108, 111, 116–17, 122, 125–6, 129, 130–1, 143, 145, 146, 150–1 Gilbert, R.J., 99 Giovannini, A., 69 Glaum, 64, 65, 106, 153 GM (General Motors), 51 gold industry, 31–2 Goldberg, L.S., 98, 99 Goldberg, P.K., 83, 84, 157 Grassman’s law, 71 Greece, 111, 131, 132 Greenspan, A., 150 Grifﬁn, J.M., 48, 51 Grossman, G., 155

171

Hau, H., 151 He, J., 51 hedge, 2, 5, 23, 27–35, 39, 41, 46, 50, 54–6, 58, 60–6, 68, 86, 103–8, 120–1, 153 Hegbart, F., 64 Hermalin, B.E., 154 Hirschman, A.O., 75 Holmström, B., 153 Horn, H., 157 Howe, J.S., 52 Hubbard, G., 154 imported inputs, 19, 40, 44, 55, 86, 111, 134; see also cost of inputs Indonesia, 15, 18, 19, 45, 121 Industrial Organization, 2, 3, 52, 80, 98, 137 inﬂation, 12–5, 17–9, 68, 104–5, 144–9, 153 interest rate, 4, 9, 17, 34, 54, 107, 121, 143, 145–6, 150, 153 investment, 27, 31, 95, 98–9, 107, 135–9, 153 invoicing currency, 66–72, 92, 120–5 Japan, 41, 51, 99 Jevons, S., 66 Johan i Hallen, 54, 55 Jonung, L., 122 Jorion, P., 47, 65 Joshi, Y., 63 Jutterström, N., 64 Kadiyali, V., 83, 85 Kaplan, S.N., 27 Kaplanis, E.C., 64, 65 Katz, M.L., 154 Kearney, A.J., 27 Kennedy, M., 155 Kim, M., 15, 88 Kinnarps, 81 Klemperer, P., 96, 156, 157 Knetter, M.M., 83, 84, 85, 90, 156 Kodak, 41, 42, 52, 85, 106 Kolstad, C.D., 99 Korea, South, 18, 44, 69, 95

172

Index

KPMG, 115 Kraft, 1, 153 krona, Swedish, 4, 5, 12, 18, 21, 40, 50, 54, 55, 61, 68, 71, 73–6, 88, 107, 116, 127–9, 144 krona, Danish, 127–9 Krugman, P.R., 11, 95, 149, 151, 153, 157, 159 Kuala Lumpur, 16 Kydland, F., 147 Laker Airways, 94 law of one price, 12–5, 73, 74, 77, 78, 86–91, 127–32 Lee, W.Y., 48, 50 Lessard, D.R., 94, 153 Lewent, J.C., 27 Levi, M.D., 20, 22, 65, 153 Levinsohn, J., 136, 155, 158 Lightstone, J.B., 94, 153 Lindé, S., 51, 56 linear function, 24, 26, 28, 57, 58, 69, 78, 84, 86, 90, 102 Lipsey, R.G., 97 LKAB, 64 loans in foreign currency, 54, 55, 107 location, 40, 87, 115, 133, 134, 135 Lucas, R.E., 135, 159 macroeconomics, 2, 5, 17–9, 39, 44, 45, 52, 126, 141–52 Magee, S.P., 68 Malaysia, 15, 18 manufacturing industry, 1, 40, 49, 98, 134 marginal costs, 70, 82, 93, 132 market segmentation, see law of one price market share, 41, 64, 79, 81, 82, 83, 84, 86, 94, 97, 98, 126, 137 market value of a ﬁrm, 46–53 marking to market, 34 markka, Finnish, 73, 74, 75, 77, 119, 120, 121 Marks & Spencer, 115 markup, 58, 69, 84, 97, 98, 119, 136, 140 Marlboro, 74, 88, 127

Marston, R.C., 3, 52, 83, 85, 86, 153 Martin, S., 66, 74, 75, 97, 99, 137 medium of exchange, 66–7, 71, 123, 124 Meese, R., 9 Mello, A., 157 Menon, J., 84, 157 Mercedes, 53, 87 Merck, 27 mergers, 96, 137, 138 Metallgesellschaft, 65 Mexico, 45, 50, 51, 95 Meyer, M., 156 Miller, M., 23, 24 mining industry, 19, 31–2, 64 Minton, B.A., 31, 154 Mitsubishi, 1 Modigliani, F., 23, 24 Modigliani-Miller, 23 Moffett, M.H., 22, 104 monetary policy, 11, 17–18, 46, 111, 121, 122, 126, 140, 141–52 Monetary/Nonmonetary method, 104 money market hedge, 34 monopoly, 79, 81, 85, 132 Mundell, 141 Myers, S., 30, 153 Nance, D.R., 31, 154 Netherlands, 15, 21, 55, 56, 84, 87, 88, 106, 107, 125, 126, 128, 129, 130, 146, 15, 107 netting, 68 New Empirical Industrial Organization, 52 Ng, L.K., 51 non-traded goods, 14, 142, 152 Nordbanken, 54, 138 Nordström, H., 89 Nydahl, S., 51 Obstfeld, M., 151, 153 offsetting exposure, 23, 33, 105 Öhnell, 51, 56 Oi, W.Y., 90 Operating exposure, 20–4, 35, 39–45, 55, 57, 90, 114, 119, 122–40, 141, 144 option value, 94

Index options, 5, 30, 31, 33, 35, 55, 63, 64, 65, 106 Orange county, 65 owners, 23, 24, 28, 30, 114 Oxelheim, L., 19, 52, 53 Page, S.A.B., 71 Pakes, A., 158 Parallell imports, 126–32; see also law of one price parent ﬁrm, 22 Parsley, D.C., 129 pass-through, 3, 72–86 perfect competition, 3, 78, 79, 91 Persson, T., 148 Petersen, B., 154 pharmaceutical industry, 27, 50 Pindyck, R., 156 Popper, H., 52 Portes, R., 123, 124 portfolio management, 5, 23, 28, 61, 95, 117 Portugal, 72, 116, 133, 146 pound, British 1, 2, 5, 9, 12, 16, 40, 60, 84, 124 PPP (purchasing power parity), 11–17 preferences towards risk, 23 Prescott, E.C., 147 price adjustments, see pass-though price discrimination, 86–90, 126–32, see also law of one price price war, 77, 79 prices of stocks, see market valuation pricing behavior, 28, 138 Procter & Gamble, 95 product differentiation, 97–8 pulp and paper industry, 72, 80, 81, 97 purchasing power parity, see PPP quadratic adjustment costs, 77 R&D, 27, 80 random walk, 9, 10, 17, 21, 61 Rao, R.K.S., 68 real exchange rate, 5, 11–17, 35, 43, 48, 49, 61–2, 95, 143–5

173

Reed Elsevier, 1 regression analysis, 17, 46–53, 61 reporting currency, 103, 106, 116, 117 revenue, 21, 35, 40, 43, 57, 91, 99 Rey, H., 123, 124 risk, attitudes towards, 28–32, 68 Robinson, J., 153 Rogers, J., 89 Rogoff, K., 9, 15, 17, 88, 147, 151 Rose, A.K., 9, 10 Ross, D., 80, 81, 96, 97 Rotenberg, J., 48 rupiah, Indonesian, 19 S&P, 400, 31, 32 Sälen, 39, 40, 55 Samsung, 95 SAS, 127, 128 SCA, 66 Scania, 64 Scharfstein, D.S., 30, 154 Scherer, F.M., 80, 81, 96, 97 Schrand, C., 31, 154 Schuster, W., 158 Schwartz, A.J., 148 Sercu, P., 2, 20, 21, 103, 153 Shapiro, A.C., 2, 22, 97, 153 Sheehy, E., 48, 51 Shell, 65, 95, 102, 106 Shy, O., 157 Siemens, 116 SKF, 113, 114 ski resorts, 39–40, 55 Slade, M., 77 Slite, 54 Smith, C.W., 31, 80, 81, 154 Smithson, C.W., 31, 154 Soenen, L., 55, 107, 154 Solt, M.E., 48, 50 sourcing, 99–100, 133–6 Spain, 72, 116, 131, 143, 146 Srinivasalu, S.L., 153 Sroth, P., 153 SSAB, 71 Stein, J.C., 30, 95, 154 stock market valuation, see market valuation Stonehill, A.I., 22, 104

174

Index

strategic exposure, 22 Stulz, R., 48, 51, 154 subsidiaries, 5, 22, 39, 40, 103–7 surprise, 11, 15, 20, 33, 42, 147 survey evidence, 3, 4, 9, 17, 30, 32, 84, 105, 107, 115 Svenska Dagbladet, 29 Svensson, L.E.O., 158 Sveriges Finansanalytikers Förening, 50 swaps, 30, 31, 33, 34, 65, 97, 106, 108 Sweden, 4, 5, 12, 13, 18, 29, 39–40, 49–51, 54, 56, 63–4, 66, 71, 73, 76, 81, 88, 96, 104, 107, 108, 111, 116, 119, 127–8, 132, 135, 137, 138, 141, 144, 145 switching costs, see customer markets Switzerland, 5, 9, 15, 61, 106, 153 Tabellini, G., 148 TARGET, 120 tax, 22, 23, 24, 26–7, 32, 70, 103, 113, 116–18, 129, 146 Temin, P., 149 temporal method, 104 Thorbecke, W., 155 Tirole, J., 98, 153 Torniainen, A., 154 Toyota, 51, 82, 135 trade barriers, 12, 113, 134–6 trade credit, 33, 54, 55, 66–7, 121 transaction costs, 93, 96, 139 transaction exposure, 22, 54 translating, 103–5 Translation exposure, 22 Tufano, P., 31

104, 105, 106, 107, 111, 115, 116, 119, 131, 132, 135, 137, 146, 153 uncovered interest parity, 19 unemployment, 18, 142, 147, 148 UPM-Kymmene, 80 Uppal, R, 2, 20, 21, 103, 153 United States, 1, 3, 9, 11, 13, 15, 20, 30, 32, 33, 34, 41, 44, 48, 49, 50, 51, 52, 60, 61, 63, 67, 68, 69, 70, 71, 72, 74, 76, 77, 78, 79, 82, 83, 84, 85, 87, 89, 91, 94, 95, 96, 98, 99, 103, 104, 105, 106, 107, 108, 112, 113, 116, 120, 121, 122, 123, 124, 125, 126, 127, 129, 133, 134, 135, 142, 148, 151, 153 value at risk, 154 value of ﬁrms, see market valuation Vander Vennet, R., 138 vehicle currency, 67, 71, 124 Venables, A., 159 Viaene, J.-M., 68 Viking Line, 54, 73–5, 77, 90, 127–8 Vives, X., 138 Volkswagen, 41, 53, 89, 97–8, 130–1 voluntary export restrictions, 82, 99, 136 Volvo, 15, 52, 61, 64, 95 Vredin, A., 159 wages, 14, 16, 92, 133, 141–3, 145, 147, 151 Wei, S.-J., 129 Werner plan, 113 Wharton/CIBC Wood Gundy, 30, 55, 63–4, 107 Wihlborg, C., 19, 52, 53 Yen, Japanese, 9, 48, 76

UK, 4, 9, 12, 14, 16, 21, 33, 34, 39, 40, 44, 51, 54, 55, 60, 63, 64, 94, 99,

Zilcha, I., 156