Looking for the answer to the question below related to Financial Management ?
Effect of falling domestic exchange rate ___________
|A. Reduces Profitability for importers
B. Increases Profitability for importers
The Correct Answer Is:
- A. Reduces Profitability for importers
The correct answer is A. Reduces Profitability for importers.
Why A (Reduces Profitability for Importers) is the Correct Answer:
When the domestic exchange rate falls, it means that the domestic currency has weakened relative to other currencies. This depreciation of the domestic currency has several implications, including a reduced profitability for importers. Here’s a detailed explanation of why A is the correct answer:
1. Increased Cost of Imports:
A falling domestic exchange rate makes it more expensive for importers to purchase foreign goods and services. This is because when the domestic currency is weaker, it takes more of it to buy the same amount of foreign currency needed to pay for imports. As a result, import costs increase.
2. Higher Import Costs:
Importers typically need to pay for goods and services from foreign suppliers in the supplier’s currency. When the domestic currency is weaker, importers must exchange more of their own currency to acquire the necessary foreign currency. This higher cost of acquiring foreign currency directly translates into higher import costs.
3. Squeezed Profit Margins:
The higher import costs squeeze profit margins for importers. To maintain the same selling prices and market competitiveness, importers may either absorb the increased costs or pass them on to consumers in the form of higher prices. Absorbing the costs can lead to reduced profitability, as the profit margin per unit of imported goods diminishes.
4. Competitive Disadvantage:
Importers may also face a competitive disadvantage in the marketplace when the domestic currency weakens. If their competitors are based in countries with stable or strengthening currencies, those competitors may offer similar products at lower prices due to lower import costs. This can result in a loss of market share for domestic importers.
5. Foreign Currency Debt:
Importers who have borrowed in foreign currencies may experience an increase in their debt burden as the domestic currency weakens. The higher exchange rate required to service the debt can lead to higher interest payments and overall debt-related expenses.
Why the Other Options are Not Correct:
B. Increases Profitability for Importers:
This option is incorrect because a falling domestic exchange rate does not increase profitability for importers. Instead, it reduces profitability, as explained above. The increased import costs and competitive challenges often result in lower profit margins for importers.
C. Exposure: “
Exposure” is a term related to foreign exchange risk, but it does not provide a direct explanation of the effect of a falling domestic exchange rate on importers’ profitability. Exposure refers to the degree to which a company is vulnerable to adverse exchange rate movements and may lead to potential gains or losses depending on the company’s hedging strategies and risk management practices.
“Economic” is a broad term and does not specifically address the impact of a falling domestic exchange rate on importers’ profitability. The effect of a depreciating domestic currency on importers is an economic consequence, but it does not provide a detailed explanation of how it affects profitability.
In conclusion, the correct answer is A because a falling domestic exchange rate increases the cost of imports for importers, which in turn reduces their profitability.
Importers face higher expenses when purchasing foreign goods and may encounter competitive disadvantages, all of which contribute to a decline in profitability. The other options do not accurately describe the specific financial impact on importers in this scenario.