Chapter 9
Measuring and Managing Real Exchange
Risk
QUESTIONS
1. As the vice president of finance for a U.S. firm, what do you say to your production
manager when he states, “We shouldn’t let foreign exchange risk interfere with our
profitability. Let’s simply invoice all our foreign customers in dollars and be done with
it.”
2. What do economists mean by pricing-to-market?
3. Why does a monopolist not charge the same price for the same good in two different
countries?
4. What determines how much a foreign producer allows the dollar price of a product sold
in the United States to be affected by a change in the real exchange rate?
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Answer: Pricing-to-market interacts with changes in the real exchange rate to prevent the full
pass-through of the change in the exchange rate to the change in the price of the good. If the
5. Why is the pass-through from changes in exchange rates to changes in the prices of
products not one-for-one?
6. Given that real exchange rates fluctuate, when would be the best time to enter the
market of a foreign country as an exporter to that market?
Answer: Firms often introduce new products in foreign markets when the foreign currencies
7. You have been asked to evaluate possible sites for an Asian production facility that will
manufacture your firm’s products and sell them to the Asian market. What real
exchange rate considerations should you entertain in your evaluation?
Answer: You must be aware of the strength or weakness of the real exchange rates in the
8. Why is it important for an exporter to understand the distinction between a temporary
change in the exchange rate and a permanent change in determining whether to
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respond to a real depreciation of the home currency with increased production or sales
out of inventories?
PROBLEMS
1. If there is 10% inflation in Brazil, 15% inflation in Argentina, and the Argentine peso
weakens by 21% relative to the Brazilian real, by how much has the peso strengthened
or weakened in real terms. What effect do you expect that this change in the real
exchange rate would have on trade between the two countries?
Answer: If s denotes the rate of change of the nominal exchange rate measured as Brazilian
2. Suppose that you have one domestic production facility that supplies both the domestic
and foreign markets. Assume that the demand for your product in the domestic market
is Q = 2,000 – 3P and in the foreign market, demand is given by Q* = 2,000 – 2P*.
Assume that your domestic marginal cost of production is 600. If the initial real
exchange rate is 1, what are your optimal prices and quantities sold in the two markets?
By how much will you change the relative prices of your product if the foreign currency
appreciates in real terms by 10%? What will you do to production?
Answer: From the domestic demand curve, we find that P = (2,000 – Q) / 3, and revenue
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price, multiplied by foreign sales, or by substituting P* = (2,000 – Q*) / 2, we find that
domestic real revenue from foreign sales equals
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3. How would you respond in Problem 2 if the marginal cost of production were
increasing? Why?
4. Suppose you are a monopolist who faces a domestic demand curve given by Q = 1,000 –
2P. Your domestic cost of production involves domestic costs per unit of 300 and a
foreign cost per unit produced of 150. If the real exchange rate is 1.1, what would be the
price you would charge and the quantity you would sell? How do these variables change
when the real exchange rate increases by 10%?
Answer: The monopolist will operate where marginal revenue equals marginal cost. Price is
(1,000 – Q) / 2, and total revenue is P × Q = (1,000 Q – Q2) / 2. Marginal revenue is therefore
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5. Use a program like Crystal Ball to generate Monte Carlo simulations of the profits of
Safe Air and Metallwerke under various contracting clauses.
These graphics indicate the profit margin with no inflation in either country and a standard
deviation of the dollar-euro exchange rate equal to 10%.
6. In 2008 Endo Pharmaceuticals, a U.S. firm, signed a five-year contracted with Novartis,
a Swiss firm, to obtain the exclusive U.S. marketing rights for Voltaren Gel, an anti–
inflammatory useful in treating osteoarthritis. Search the internet for information
about the contract. Who bore the real exchange risk?
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Searching for “Voltaren Gel aggreement” turned up this assessment from www.mmm–
online.com: