Foreign exchange operating exposure and pass-through in a homogeneous product market

Abstract

Purpose

Operating exposure to foreign exchange risk and exchange rate pass-through are investigated in the context of a Cournot model of equilibrium in a homogeneous product market, i.e. an industry populated by N firms, which compete exclusively on the basis of quantities produced/marketed and where each firm optimizes its decision based on expectations regarding the actions of its rivals that in fact eventuate. Whereas one firm sources its product domestically, the remaining N−1 firms source their product in a foreign country. The paper aims to discuss these issues.

Design/methodology/approach

By invoking two simplifying assumptions, namely, constant marginal cost functions and a linear inverted demand curve, and then deriving the Cournot equilibrium, this paper obtains clear implications regarding the effect of a currency devaluation on the competitive positions of the industry’s N constituent firms as well as the pass-through effect on the industry price.

Findings

The N−1 firms that source the homogeneous product from a foreign country, which experiences a devaluation, gain, while the single competing firm that sources domestically loses, both market share and profit. Formulas are derived which elucidate this intuitive result. The extent of exchange rate pass-through on the resulting equilibrium price is gauged to be incomplete, consistent with extant empirical evidence. As the number of firms increases, the extent of exchange rate pass-through likewise increases, approaching a limiting situation of complete pass-through.

Originality/value

This paper is the first to examine the issues of exchange rate operating exposure and pass-through in the context of a Cournot model of competition, under the indicated two simplifying assumptions.

Citation

Schnabel, J.A. (2015), "Foreign exchange operating exposure and pass-through in a homogeneous product market", Managerial Finance, Vol. 41 No. 1, pp. 2-9. https://doi.org/10.1108/MF-12-2013-0349