Purdue Co. (based in the U.S.) exports cable wire to Australian manufacturers. I

Question

Purdue Co. (based in the U.S.) exports cable wire to Australian manufacturers. It invoices its product in U.S. dollars, and will not change its price over the next year. There is intense competition between Purdue and the local cable wire producers that are based there. Purdue's competitors invoice their products in Australian dollars and will not be changing their prices over the next year. The annualized risk-free interest rate is presently 8% in the U.S., versus 3% in Australia. Today the spot rate of the Australian dollar (AU$) is $.55. Purdue Co. uses this spot rate as a forecast of future exchange rate of the AU$. Purdue expects that revenue from its cable wire exports to Australia will be about AU$2 million over the next year. Using the spot rate to forecast the exchange rate of the AU$, what is the value of Purdue's Australian revenues in $US? If Purdue decides to use the international Fisher effect rather than the spot rate to forecast the exchange rate of the Australian dollar over the next year, what is the value of Purdue's Australian revenues in $US?

Explanation / Answer

If IFE exists, the forecasted change in the exchange rate is

ef = (1 + ih)/(1 + if) – 1

ef = 1.08/1.03 – 1 = 0.0485 or 4.85%.

According to the IFE, the Australian dollar is expected to appreciate. Since Purdue’s exports are denominated in U.S. dollars, it will be cheaper for Australian importers to purchase Purdue’s product. Purdue will have comparative (price) advantage over its competitors in Australia. Its market share is likely to increase, which will increase Purdue’s expected revenue from its exports.

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