Suppose a bottle of French wine is priced in France at 1000 Euros. If the e = $1/€, the cost to an American is €1000 x ($1 / €) = $1000. Conclusion: __________________ . If the Euro appreciates ($ depreciates), will the French wine be more or less expensive? __________________ Proof: if e = $1.20 / €, the cost to an American is €1000 x ($1.20 / € ) = $1200. If the Euro depreciates ($ appreciates), will the French wine be more expensive or less? __________ Proof: if e = $.80 / €, the cost to an American is €1000 x ($.80 / €) = $800. Therefore, the price could fluctuate between $800-$1200, depending on currency movements.
POINT: if the dollar is strong (weak), French wine is cheaper (more expensive) for an American. The value of the $ in relation to the € will affect the price of foreign goods for an American. When the dollars appreciates, foreign goods/assets/services are CHEAPER. When the dollar depreciates, foreign goods/assets/services are MORE EXPENSIVE.
SUMMARY of the Advantages/Disadvantages of a Strong/Weak Currency:
1. Strong dollar = Weak foreign currency:
a. Advantages: foreign goods and services are cheap, including foreign travel. Helps the import sector of the economy, companies that sell foreign goods (Toyota dealers). Helps U.S. companies buying foreign inputs. Helps U.S. consumers - imports are cheaper.
b. Disadvantages: U.S. exports are expensive, including tourism in U.S. Hurts the export sector, companies that sell abroad, makes them less competitive. Hurts the import-competing sector - GM, for example (Toyotas from Japan are now cheaper). Domestic goods are less competitive overseas and here, because strong $ = weak foreign currency.
2. Weak dollar = Strong foreign currency:
a. Advantages: Helps the U.S. export sector. Our goods and services are cheap overseas, including tourism in US. Helps the import-competing sector like GM, domestic goods are more competitive (Toyotas made in Japan are more expensive).
b. Disadvantages: Hurts the import sector of the economy (BMW and Toyota dealers). Hurts US companies buying foreign inputs (50% of imports are inputs and NOT finished goods). Hurts U.S. consumers - imports are more expensive, e.g. oil, coffee, bananas, German wine and beer, foreign travel, diamonds, for example.
The examples above illustrate CURRENCY RISK - the possibility of an adverse exchange rate movement. Currency risk is an important consideration for almost all businesses because 1) most companies either buy foreign inputs or sell their output in other countries, 2) exchange rates are unpredictable and 3) contracts for purchases (imports, foreign inputs) and sales (export) are made far in advance. If a contract is stated in a foreign currency, one party is exposed to currency risk.
Example: U.S. computer manufacturer (importer) agrees by contract to buy computer parts in 6 months from a firm in Japan for ¥100,000 /unit. If the ex-rate ¥100 /$ in 6 months, the parts cost $1000. If the ex-rate is ¥80 / $ ($ weakens) the price is $1250/unit. Currency risk for the importer is that the dollar might depreciate over the next six months, meaning that it becomes more expensive to buy ¥ and more expensive to buy the foreign import.
Risk can work both ways: if the ex-rate is 125¥ / $ (dollar appreciates, Yen depreciates) in 6 months, the cost is only $800. In this case, the dollar got stronger, so it became cheaper to buy Yen, and the foreign product (priced in a fixed amount of Yen) became cheaper. Ex-rate volatility (currency risk) means the cost of parts could range between $800-1250 over the next 6 months for the U.S. manufacturer. Imagine if you were building a house, it would be complete in 6 months, and the range for the final cost was between $80,000-125,000! RISK FOR THE IMPORTER: They have to buy Yen 6 months from now to buy the imported product, they are worried that the $ will get weaker, making it more expensive to buy...
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