By: Dr. Jui-Chi Huang, Assistant Professor of Economics
I am a fan of stand-up comedian Kathleen Madigan. She and I have at least two things in common: one is playing basketball and the other is that we have a true understanding of the concept of currency exchange. She describes her foreign currency exchange experience in her stand-up routine. Once while visiting Canada, when the money there was worth half the value of ours, Kathleen bought a pair of shoes, which were 50 percent off. She believed that the shoes should be free because “fifty minus fifty is nothing,” she explained. When she returned to the United States, she disputed the shoe charge with her credit card company. I think she was right. To prove that we are correct, I will reexamine how foreign currency exchange works and briefly explain my research on this topic.
Foreign exchange markets are like any other commodity market where people buy and sell goods and services. In a foreign exchange market, people are buying and selling currency as a commodity. The value of currency is determined by the supply of and demand for it. A commodity is purchased with money, while currency is purchased with another country’s currency, such as one U.S. dollar in exchange for two Canadian dollars.
When a country moves from a closed economy to an open one, the domestic currency is paid to the foreign currency market in exchange for foreign currency to pay for foreign goods and services. Ceteris paribus, other things being equal, a higher supply of U.S. currency, for instance, would decrease the value of its currency in terms of Canadian currency. A higher demand for Canadian currency would increase the value of Canadian currency in terms of U.S. currency. A bilateral currency exchange relationship is formed by this goods-and-services trade.
The currency movement is linked to the relative economic power of two trading countries. The currency supply and demand activities, which determine the currency value, are the outcomes of relative economic performance. According to the monetary approach to exchange rate determination, there are three economic fundamentals which influence the relative currency value between two trading countries: income, interest rate, and money supply. Specifically, the stronger the economy in terms of income, measured usually by the gross domestic product (GDP), the stronger the currency will be, relative to its trading partner’s. The lower the interest rates, the stronger the currency will be, relative to its trading partner’s. This is because an increase in income or investment spending caused by lower interest rates raises the demand for domestic money and thus causes an appreciation of its currency. In addition, printing more money, which increases the money supply relative to that of the trading partner’s, creates inflation and causes currency depreciation.
Essentially, the differentials of these three economic fundamentals between two trading countries determine the relative currency value–the exchange rate. Therefore, when the Canadian dollar was worth half the U.S. dollar, Canadian goods and services should have been half free because it took only a half of a U.S. dollar to buy a whole Canadian dollar.
To put things in perspective, if the United States buys goods and services from Canada, the United States has to supply U.S. dollars in exchange for Canadian dollars to pay for them. This trade would depreciate the U.S. dollar and appreciate the Canadian dollar. The tricky thing is that when the U.S. dollar depreciates, it hurts American consumers buying Canadian goods and services, while it is good for American exporters competing in the Canadian market due to the stronger Canadian dollar. On the other hand, when the U.S. dollar appreciates, American consumers are better off with the stronger U.S. dollar paid to buy Canadian goods and services, while it hurts American exporters selling to Canadian markets.
So, which is better: appreciation or depreciation? Well, this enters the territory of politics and we won’t go there. Eventually, the United States would import less from Canada, which in turn would result in a stronger U.S. dollar. A stronger U.S. dollar would make Canadian goods and services cheaper for Americans, and thus Americans would buy more Canadian goods and services. In this scenario, we started out importing more from Canada and now we are back to where we were–importing more from Canada. The U.S. dollar value movement is influenced by the ability to buy more or buy less with the same amount of U.S. dollars. Currency appreciation and depreciation usually follow one another.
The exchange rate movement is very volatile due to the nature of trading fluctuations. And, trading fluctuations are caused by the constantly changing income and preferences in the two trading countries. While currency value is determined by trades, trades in turn can be influenced by the currency movement. A particular trade influenced by the current movement is trade pricing. My research interest is in strategic trade pricing due to exchange rate changes, which is called “exchange rate pass-through.”
Trade pricing is primarily determined by production cost, product substitutability, and destination market structure–the ability to mark up or increase the profit margin. In a perfectly competitive destination market, which does not exist in the real world, the pricing decision would depend solely on production cost because the possible markup is squeezed to zero due to perfect competition. In an imperfectly competitive destination market, product substitutability and destination market structure govern the ability of exporters to compete in market share and to make profits. The less competitive the market, the greater the profits the exporters can obtain. In the exchange rate fluctuation environment, the future value of a trade contract may be uncertain, which presents a risk to exporters. This risk is called currency conversion risk or exchange rate risk.
An appreciation of an exporter’s currency over the contract period may create a currency conversion loss to the exporter when the contract is denominated in the trading country’s currency. Studies show that in the long run, the exchange risk will exist for both trading partners no matter what currency denomination is used in the trade contract. In this situation, the exporter can choose to pass the currency conversion loss completely into its own currency prices in the next contract (complete exchange rate pass-through or complete pass-through), to absorb the loss to keep its price unchanged (zero pass-through), or to settle for some combination of these two (incomplete pass-through).
Studies have shown that the average degree of exchange rate pass-through is about 60 percent–an incomplete pass-through. Theoretically, the incomplete exchange rate pass-through phenomenon may be caused by the incomplete understanding of product differentiation or market structure (thus the level of competition), and empirically by the nonstationarity property of time-series data, simultaneity functional structure, dynamic adjustment, asymmetric response to exchange rates and costs, aggregation bias, data proxies, or other factors. My research focuses on the impact of exchange rate uncertainty on exchange rate pass-through, to demonstrate why hedging behavior, an investment position intended to offset potential currency conversion losses, is an essential element in international pricing modeling.
Technically, the risk associated with fluctuations in currency exchange rates is usually managed by the use of derivative financial instruments to economically hedge or reduce exposure to the exchange risk. These financial instruments could include forward contracts, futures contracts, currency options, or currency swaps. For example, a U.S. exporter facing exchange risk (the trade value contracted in foreign currency, say the Canadian dollar) could enter a forward contract that obligates the exporter to sell 10 million Canadian dollars one year from now in exchange for U.S. dollars at the current forward rate of two Canadian dollars per U.S. dollar. In one year, when this exporter’s trading partner pays the 10 million Canadian dollars to the U.S. exporter, the forward contract ensures that it is exchanged for the U.S. dollar at an exchange rate of two Canadian dollars per U.S. dollar, thus yielding 5 million U.S. dollars (10,000,000/2), no matter what happens to future exchange rates. Therefore, the trade value is hedged or protected.
Let us come back to the Canadian shoe story. The 50 percent off shoes reveal that the shoe market in Canada was very competitive and the retailers were willing to sell them for half price, so… “half free.” Along with the other “half free” from the twice-stronger U.S. dollar, Kathleen’s Canadian shoes should have been free. A full refund for Kathleen, please!