Question

What is the “exchange rate pass through”? What is its relevance for hedging?

Answer 1

The exchange rate pass through is the rate or elasticity (economics term) by which the prices of particular imports are affected in terms of domestic currency with change in prices of the foreign currency from which its importing a particular commodity. If the rate is high there is higher inflation on imported goods . For example if india imports a pen from the U.S. which cost $2 today .or 140 INR. Today Exchange rate is 70 INR for $1. If in future the dollar appreciates to 100INR for $1 and now the pen cost $2.5 so to conclude the dollar has appreciated with respect to INR by 42.9 % and price of pen got increased by 25 % so the pass through rate is 25/42.9 = 0.582

Which implies for 1% change in exchange rate price if pen has increased by 58.2 %

It is relevent for hedging because goods or services with high pass through rate should be hedged in advanced with help of derivatives contracts because their prices will get affected higher in terms of exchange rate fluctuations and can affect revenues and profits drastically.

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