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"ABayesianApproachtoManagingForeignExchangeinInternationalSourcing"byVickery,ShawneeCarter,JosephR.D'Itri,MichaelInternationalJo

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A Bayesian Approach to Managing Foreign Exchange in International Sourcing

ACADEMIC JOURNAL ARTICLE

By Vickery, Shawnee; Carter, Joseph R.; D'Itri, Michael

International Journal of Purchasing and Materials Management , Vol. 28, No. 1 , Winter 1992
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Article excerpt
A Bayesian Approach to Managing Foreign Exchange in International Sourcing
The cost of a firm's finished goods is affected by exchange rates whenever a firm purchases imported goods or goods that are in turn
produced with imported materials. As American firms source abroad, changes in currency values can erode the profitability of
established products and markets. This article describes a Bayesian approach to managing foreign exchange which combines the use
of a forward rate forecast and an economic forecast in determining a viable strategy. The approach was specifically designed for firms
whose principal international activity is foreign sourcing.
INTRODUCTION
Over the last decade, the dollar volume of U.S. imports has been steadily increasing. This has occurred in spite of some significant
declines in the exchange rate value of the U.S. dollar. In 1989, for example, the value of U.S. imports was estimated to be 473 billion
dollars, one of the largest import volumes in history.[1] Should this trend continue, not only will the volume of imports increase, but
more and more U.S. firms will become importers of purchased goods from foreign suppliers.

As international sourcing activity increases for many American firms, the effective management of foreign exchange will become
more important to the cost competitiveness of these firms. A recent study has found that firms in North America, Europe, and
especially Japan are placing a strategic emphasis on lowering costs.[2] For many firms, purchased components and materials
represent a substantial portion of their total costs.[3] Changes in currency values can erode the profitability of established products
and markets, if the firms import materials used in those products.[4] Thus, the management of foreign exchange presents a
challenging opportunity for cost reduction for firms engaged in substantial foreign sourcing.[5]
There are three basic approaches to foreign exchange management:
1. Do nothing
2. A passive approach
3. An active approach
For an importer, a do nothing strategy converts all foreign currency cash outflows in the spot market as they occur. A passive strategy
for the importer is one in which either (1) all anticipated outflows of foreign currency are exchanged for domestic currency cash
outflows in the forward market, thereby hedging all foreign exchange positions, or (2) all sourcing contracts are negotiated for
payment in U.S. dollars, forcing the supplier to assume the foreign exchange risk.[6]
In contrast, an active strategy is one in which the importing firm selectively hedges its foreign exchange rate positions based on
exchange rate forecast information. This means that the firm at times may intentionally assume open positions in foreign exchange if
it anticipates a favorable movement in the exchange rate.[7]
Since the practice of maintaining open positions in foreign currencies assumes risk, the question arises as to why a firm should follow
an active strategy. The argument for an active strategy is based on the supposition that it can be more cost effective than a passive

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"ABayesianApproachtoManagingForeignExchangeinInternationalSourcing"byVickery,ShawneeCarter,JosephR.D'Itri,MichaelInternationalJo
one. From a purchasing standpoint, this means that an active strategy can result in lower landed costs for the importing firm.
Research suggests there is merit to an active approach if good exchange rate forecast information can be identified and used
correctly.[8] This article describes a Bayesian approach for determining a viable strategy for managing foreign exchange. It combines
the use of a forward rate forecast and an economic forecast provided by an exchange rate forecasting service. The approach was
specifically designed for firms whose principal international activity is foreign sourcing.
A BAYESIAN APPROACH FOR MANAGING FOREIGN EXCHANGE
Bayesian analysis is a probabilistic decision-making tool that can be used in situations where a manager has several alternative
courses of action, but is faced with a risk-filled set of future possibilities.

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