Pass‐through and Exposure

Abstract

Firms differ in the extent to which they "pass through" changes in exchange rates into foreign currency prices and in their "exposure" to exchange rates-the responsiveness of their profits to changes in exchange rates. Because pricing affects profitability, a firm's pass-through and exposure should be related. This paper develops models of exporting firms under imperfect competition to study these related phenomena. From these models we derive the optimal pass-through decisions and the resulting exchange rate exposure. The models are estimated on eight Japanese export industries using both the price data pass-through and financial data for exposure. EXCHANGE RATES CAN HAVE A MAJOR inf luence on the pricing behavior and profitability of exporting and importing firms. Firms differ in the extent to which they "pass through" the change in exchange rates into the prices they charge in foreign markets. They also differ in their "exposure" to exchange ratesthe responsiveness of their profits to changes in exchange rates. Previous papers have studied either pass-through or exposure, but none has studied these two phenomena together. Yet, because pricing directly affects profitability, the exposure of a firm's profits to exchange rates should be governed by many of the same firm and industry characteristics that determine pricing behavior. This paper develops models of firm and industry behavior that are used to study these closely related phenomena together. It also provides estimates of pass-through and exposure behavior using data from Japanese export industries.To examine pass-through behavior and exchange rate exposure, we model a firm with sales to a foreign export market. This exporting firm competes with a foreign firm in that export market. The costs of the exporting firm are based primarily in the local~domestic! currency, while the foreign firm

Resolving the exposure puzzle: The many facets of exchange rate exposure

“…In the preceding analysis, we analyze the effect of product market competition on foreign exchange rate exposure with the naive assumption that the gross profit margin is a sufficient statistic for describing a firm's level of overall competitiveness. In this section, we present a more realistic model of the foreign exchange rate exposure of a global firm in a globally competitive market based on the results of Bodnar, Dumas, and Marston (2002).…”

“…In a recent paper, Bodnar, Dumas, and Marston (2002) derive a model of FX exposure that explicitly incorporates industry competition and optimal export pricing behavior. Specially, BDM develop a model of exporting firms under duopoly to study exchange rate exposure and pass-through behavior of firms.…”

“…Here we present a more realistic model of the foreign exchange rate exposure of a global firm in a globally competitive market based on the results of Bodnar, Dumas, and Marston (2002). While the BDM model very precisely examines the effect of competition and the currency denomination of costs on exchange rate exposure, its empirical relevance is limited by simplifying assumptions.…”

“…Empirical studies document significant effects of exchange rate changes on firm cash flows, sales, and competitive positions in product markets (e.g., Hung, 1992;Williamson, 2001). Similarly, theoretical models (such as Bodnar, Dumas, and Marston, 2002) predict that many firms should have significant exchange rate exposures.…”

“…Section 2 motivates our analysis with a brief case study of the global automotive industry. Section 3 develops our global competition model for foreign exchange rate exposures and pass-through based on Bodnar, Dumas and Marston (2002). This global competition model is estimated for the sample of manufacturing firms in Section 4.…”