Question 23.1: In January 2009, when the exchange rate was $1.30 per euro, ...
In January 2009, when the exchange rate was $1.30 per euro, Manzini ordered parts for next year’s production from Campagnolo. They agreed to a price of 500,000 euros, to be paid when the parts were delivered in one year’s time. One year later, the exchange rate was $1.45 per euro. What was the actual cost in dollars for Manzini when the payment was due? If the price had instead been set at $650,000 (which had equivalent value at the time of the agreement: 500,000 euros × $1.30/euro), how many euros would Campagnolo have received?
PLAN
The price is set in euros, 500,000, but the $/€ exchange rate will fluctuate over time and the problem asks us to consider what would happen if it goes to $1.45/euro, which means that dollars are worth less (it takes more dollars to buy one euro). We can always convert between dollars and euros at the going exchange rate by multiplying the $/€ exchange rate by the number of euros or by dividing the number of dollars by the $/€ exchange rate.
EXECUTE
With the price set at 500,000 euros, Manzini had to pay ($1.45/euro) × (500,000 euros) = $725,000. This cost is $75,000, or about 12%, higher than it would have been if the price had been set in dollars.
If the price had been set in dollars, Manzini would have paid $650,000, which would have been worth only $650,000 ÷ ($1.45/euro ) = 448,276 euros to Campagnolo, or about 10% less.
EVALUATE
Whether the price was set in euros or dollars, one of the parties would have suffered a substantial loss. Because neither knows which will suffer the loss ahead of time, each has an incentive to hedge.