Short Run Exposure

The day-to-day fluctuations in exchange rates create short-run risks for international firms. Most such firms have contractual agreements to buy and sell goods in the near future at set prices. When different currencies are involved, such transactions have an extra element of risk.

4Actually, there will be a slight difference because we are using the approximate relationships. If we calculate the required return as 1.10 X (1 + .02) — 1 = 12.2%, then we get exactly the same NPV. See Problem 15 for more detail.

For example, imagine that you are importing imitation pasta from Italy and reselling it in the United States under the Impasta brand name. Your largest customer has ordered 10,000 cases of Impasta. You place the order with your supplier today, but you won't pay until the goods arrive in 60 days. Your selling price is $6 per case. Your cost is 8,400 Italian lira per case, and the exchange rate is currently Lit 1,500, so it takes 1,500 lira to buy $1.5

At the current exchange rate, your cost in dollars of filling the order is Lit 8,400/1,500 = $5.60 per case, so your pretax profit on the order is 10,000 X ($6 — 5.60) = $4,000. However, the exchange rate in 60 days will probably be different, so your profit will depend on what the future exchange rate turns out to be.

For example, if the rate goes to Lit 1,600, your cost is Lit 8,400/1,600 = $5.25 per case. Your profit goes to $7,500. If the exchange rate goes to, say, Lit 1,400, then your cost is Lit 8,400/1,400 = $6, and your profit is zero.

The short-run exposure in our example can be reduced or eliminated in several ways. The most obvious way is by entering into a forward exchange agreement to lock in an exchange rate. For example, suppose the 60-day forward rate is Lit 1,580. What will be your profit if you hedge? What profit should you expect if you don't?

If you hedge, you lock in an exchange rate of Lit 1,580. Your cost in dollars will thus be Lit 8,400/1,580 = $5.32 per case, so your profit will be 10,000 X ($6 — 5.32) = $6,800. If you don't hedge, then, assuming that the forward rate is an unbiased predictor (in other words, assuming the UFR condition holds), you should expect that the exchange rate will actually be Lit 1,580 in 60 days. You should expect to make $6,800.

Alternatively, if this strategy is not feasible, you could simply borrow the dollars today, convert them into lira, and invest the lira for 60 days to earn some interest. Based on IRP, this amounts to entering into a forward contract.

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