Business 4179

1
Business 4179

• Chapter 7
• International Investments and Diversification

2
Key Chapter Concepts

• Evans and Archer reducing systematic risk
• Global Stock Market Correlations
• Foreign Exchange Riskautomatic risk you assume
  when you invest globally.
• Covered Interest Arbitrage why violation of
  interest rate parity conditions may be temporary
• Purchasing Power Parity extension of interest
  rate parity a relative change in the prevailing
  inflation rate in one country will be reflected
  as an equal but opposite change in the value of
  its currency.
• Absolute purchasing power parity (follows from
  the law of one price)
• Relative purchasing power parity
• Exposure accounting (transaction and
  translation) and economic

3
Key Chapter Concepts

• Investments in emerging markets
• Reducing risks low correlations
• Special risks
• Incomplete accounting information
• Foreign currency risk
• Frauds and scandals
• Weak legal system
• Asymmetrical correlations
• Market microstructure considerations
• Liquidity risk
• Trading costs
• Market pressure
• Marketability risk
• Country risk
• Political Risk

4
Business 4179

• The International Monetary System

5
International Monetary System

• recent history of the international monetary
  system
• the gold standard (1821-1914)
• breakdown in the gold exchange standard (1925 -
  1931)
• Bretton Woods (1944) - International Monetary
  Fund and World Bank
• Post- Bretton Woods (1971 - present)
• free float (clean float)
• managed float approaches
• smoothing out daily fluctuations
• leaning against the wind
• unofficial pegging
• target-zone arrangements (EMS)
• fixed-rate system (Bretton Woods)

6
Key ConceptsThe International Monetary System

• there are four different mechanisms that
  determine exchange rates
• free float
• managed float
• fixed-rate system
• target-zone system
• under the latter three systems, governments
  intervene in the currency markets in one form or
  another to affect the real exchange rate --- and
  this has important implications for exchange risk
  management

7
Key Concepts - 2The International Monetary System

• regardless of the form of intervention, fixed
  rates dont remain fixed for long. Neither do
  floating rates. The basic reason that exchange
  rates dont stay fixed for long in either a
  fixed- or floating-rate system is that
  governments subordinate exchange rate
  considerations to domestic political
  considerations.
• the gold standard is a specific type of fixed
  exchange system, one that required participating
  countries to maintain the value of their
  currencies in terms of gold. Calls for a new
  gold standard remind us of the fundamental lack
  of trust in fiat money due to the historical
  unwillingness of the monetary authorities to
  desist from tampering with the money supply.

8
Key Concepts 3The International Monetary System

• intervention to maintain a disequilibrium rate is
  usually either ineffective or injurious when
  pursued over lengthy periods of time. Seldom, if
  ever, have policy makers been able to outsmart
  for any extended period the collective judgement
  of buyers and sellers.
• examining the U.S. experience since the
  abandonment of fixed rates, we find that
  free-market forces did indeed correctly reflect
  economic realities. The dollars value dropped
  sharply from 1973 to 1980 when the U.S.
  experienced high inflation and weakened economic
  conditions. It rose beginning in 1981 when
  American policies dramatically changed under the
  leadership of the Fed and a new president, and
  fell when foreign economies strengthened relative
  to the U.S. economy.

9
Terms and Definitions

• international monetary system
• refers to the set of policies, institutions,
  practices, regulations and mechanisms that
  determine the rate at which one currency is
  exchanged for another.
• Bretton Woods System (1946-1971)
• each government pledged to maintain a fixed, or
  pegged, exchange rate for its currency vis-a-vis
  the dollar or gold.

• price-specie-flow mechanism
• an automatic balance-of-payments adjustment
  mechanism under the Gold Standard system where
  gold would flow into a market with lower prices
  (greater money supply) and such countries money
  supplies would decline proportionately ensuring
  that exchange rates will remain fixed.

10
Four Policy Alternatives to Devaluationin a
Fixed-Rate System

• in order for a fixed-rate system to work -EACH
  MEMBER MUST ACCEPT THE GROUPS JOINT INFLATION
  RATE as its own.
• Policy Alternatives include
• Foreign Borrowing to maintain an overvalued
  currency will lead to a balance of payments
  deficit....this is only a temporary solution to a
  persistent payments deficit problem...foreign
  money can be withdrawn as easily as it was
  brought in.
• Austerity must be used to bring about a lower
  rate of domestic inflation and this can
  strengthen the currencys value.
• Wage and Price Controls while politically
  palatable, reflects the lack of political resolve
  to address the core domestic economic problems
  through appropriate fiscal and monetary policy.
• Exchange Controls supercede the allocative
  function of the foreign exchange
  market...examples include

11
Examples of Currency Control MeasuresInternation
Monetary System

• restriction or prohibition of certain remittance
  categories such as dividends or royalties
• ceilings on direct foreign investment outflows
• controls on overseas portfolio investments
• import restrictions
• required surrender of hard-currency export
  receipts to central bank
• limitations on prepayments for imports
• requirements to deposit in interest-free accounts
  with central bank, for a specified time, some
  percentage of the value of imports and/or
  remittances
• foreign borrowings restricted to a minimum or
  maximum maturity
• ceilings on granting of credit to foreign firms
• imposition of taxes and limitations on
  foreign-owned bank deposits
• multiple exchange rates for buying and selling
  foreign currencies, depending on category of
  goods or services each transaction falls into

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Business 4179

• The Foreign Exchange Market

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Foreign Exchange Markets

• permit transfers of purchasing power denominated
  in one currency to another (ie. trade one
  currency for another)
• necessary for international trade
• are by far the largest financial markets in the
  world - driven by the growth in international
  trade

14
Key Points

• the foreign exchange market is where the trading
  of currencies takes place -- it exists to make
  foreign trade possible because exporters may
  require payment for their goods or services in
  the currency of their country...not the currency
  of the buyer
• participants in the spot foreign exchange market
  is any two parties will to agree to exchange one
  currency for another....
• the FEM is a two tiered market - the interbank
  market in which major banks trade with each
  other, and the retail market where banks deal
  with their commercial customers.
• SWIFT stands for Society for Worldwide Interbank
  Financial Telecommunications - which is an
  international bank communications network that
  electronically links large commercial banks,
  central banks, foreign exchange brokers and
  traders. Large MNCs deal through brokers into
  the market.

15
Key Points

• there is a need for a clearing system so that net
  balances can be cleared between financial
  institutions....just like there is a need for a
  domestic cheque-clearing system...just like there
  is a need for a stock-clearing system.
• CHIPS (Clearing House Interbank Payments System)
  links about 150 depository institutions...at the
  close of each business day the debit and credit
  positions of each institution is netted out and
  the net differences between institutions settled
  by sending or receiving FedWire transfers.
• the FEM is the largest market in the world
  involving hundreds of trillions of s annually.

16
Key Points

• a direct exchange rate quote gives the home
  currency price of a certain quantity of foreign
  currency quoted. Canadian dollar is worth 0.64
  U.S.
• an indirect quote, quotes the value of the
  domestic currency in terms of a foreign currency.
  U.S. dollar is 1.35 Canadian.
• bid-ask spreads is who dealers are
  compensated...the spread depends on the depth and
  breadth of the market for that currency as well
  as the currencys volatility.

17
Key Points

• the trading of foreign currencies is necessary
  for foreign trade to take place...the currency of
  one country must be exchanged for the currency of
  another to pay for goods and services imported.
• the foreign exchange market is electronically
  linked network of banks, foreign exchange brokers
  and dealers who bring together buyers and sellers
  of foreign currency.
• the FEM is two-tiered....the interbank market
  where major banks trade with each other...and the
  retail market where banks trade with their
  customers.
• the spot market facilitates transactions.
• the forward market locks in future rates to
  permit hegding strategies to avoid exchange rate
  risk.

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The Interbank Market

• is the wholesale market in which major banks
  trade with one another.

19
Business 4179

• The Determination of Exchange Rates

20
Key Points

• absent government intervention, exchange rates
  respond to the forces of supply and demand,
  which, in turn, depend on relative inflation
  rates, interest rates, and GNP growth rates
• Monetary policy is crucial. If the central bank
  expands the money supply at a faster rate than
  money demand, the purchasing power of the money
  declines both at home (inflation) and abroad
  (currency depreciation)
• the healthier the economy is, the stronger the
  currency is likely to be.
• exchange rates are crucially affected by
  expectations of future exchange rate changes,
  which depend on forecasts of future economic and
  political conditions.

21
Key Points.....

• in order to achieve certain economic or political
  objectives, governments often intervene in the
  currency markets to affect the exchange rate.
  Although the mechanics of such intervention vary,
  the general purpose of each variant is basically
  the same
• to increase the market demand for one currency by
  increasing the supply of another
• alternatively, the government can control the
  exchange rate directly by setting a price for its
  currency and then restricting access to the
  foreign exchange market
• a crucial factor which helps explain the
  volatility of exchange rates is that with a fiat
  money there is no anchor to a currencys value,
  nothing around which beliefs can coalesce. Since
  people are unsure what to expect, any new piece
  of information can dramatically alter their
  beliefs.

22
Important Terms

• devaluation/depreciation
• a decrease in the stated par value of a pegged
  currency / a decrease in the value of a floating
  currency
• appreciation/revaluation
• an increase in the value of a a floating currency
• pegged currency
• one whose value is set by the government
• floating currency
• one whose value is set primarily by market forces
• monetize the deficit
• financing the public-sector deficit by buying
  government debt with newly created money.

• equilibrium exchange rate
• is the exchange rate when demand and supply for
  the currency are equal
• fiat money
• currency that is not backed by a specific asset
  (eg. gold)
• foreign exchange market intervention
• official purchases and sales of foreign exchange
  that nations undertake through their central
  banks to influence the relative value of their
  currencies.
• monetary base
• currency in circulation plus bank reserves

23
Important Terms...

• unsterilized intervention
• the monetary authorities have not insulated their
  domestic money supplies from the foreign exchange
  transactions.
• sterilized market intervention
• is achieved by adding or subtracting reserves
  from the banking system to neutralize the impact
  of intervention and thereby insulate the country
  from inflationary/deflationary pressures created
  by increases or decreases in the money supply.

24
Appreciation/Depreciation

• Amount of Currency
• Appreciation New dollar value of DM - Old
  dollar value of DM
• (Depreciation) Old Dollar value of DM
• e(1) - e(0) / e(0)
• The reciprocal relationship of the two currencies
  is found using the following formula
• e(0) - e(1) / e(1)
• page 44 in text

25
The Special Character of Money

• money has a value because people accept it as a
  medium of exchange
• the value of money depends on its purchasing
  power
• money provides
• a store of liquidity
• a store of value
• the demand for money depends on
• its ability to maintain its value (purchasing
  power)
• the demand for assets denominated in that
  currency
• exchange rates reflect therelative demands for
  two moneys.

26
Parity Conditions in International Finance and
Currency Forecasting

• Business 4179

1
27
Stronger C Pinching Profitsee Financial Post
Article - February 8, 1997

• in the last six months C has gone from U.S.
  0.7268 to 0.7405
• effects
• Inco - higher operating costs ... accounted for
  in U.S. it spends 1.1 billion/yr. in operating
  costs...a rise in the Canadian dollar by U.S.
  0.01 costs US 13 million (pretax) in added
  costs!
• A 500 million forward contract reduces the
  impact of a U.S.0.01 shift in the C to about
  U.S. 9 million in added costs.
• Falconbridge and Noranda a strengthening C
  lowers their U.S. denominated export earnings.

28
Five Key Relationships

• purchasing power parity (PPP)
• Fisher effect (FE)
• International Fisher effect (IFE)
• Interest rate parity (IRP)
• Forward rates as unbiased predictors of future
  spot rates (UFR)

2
29
The Law of One Price

• in competitive markets, characterized by many
  buyers and sellers having low-cost access to
  information,exchange-adjusted prices of
  identical tradable goods and financial assets
  must be within transaction costs of equality
  worldwide.
• international arbitrageurs prevent all but
  trivial deviations from equality.

3
30
Key Point 1

• inflation is the logical outcome of an expansion
  of the money supply in excess of real output
  growth
• ih uh - gyh gvh
• Where ih the domestic inflation rate
• uh rate of domestic money supply growth
• gyh the growth in real domestic GNP
• gvh the change in the velocity of the
  domestic money supply

4
31
Key Point 2

• the international parallel to inflation is
  domestic currency depreciation relative to
  foreign currencies if there is a difference in
  relative inflation rates.
• this is purchasing power parity (PPP)
• the foreign exchange rate must decline by
  (approx.) the difference between the domestic and
  foreign rates of inflation.

5
32
Key Point 3

• although the prediction that real interest and
  exchange rates will remain constant over time is
  a reasonable one ex ante
• ..ex post we find that these rates wander all
  over the place.
• a changing real exchange rate is the most
  important source of exchange risk for companies

6
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Key Point 4

• three additional equilibrium relationships tend
  to hold in international financial markets
• purchasing power parity
• the Fisher effect
• international Fisher effect
• these equilibrium relationships are at the heart
  of a working knowledge of international financial
  management.

7
34
Key Point 5

• Six points about exchange rate forecasting
• the foreign exchange market is no different from
  any other financial market in its susceptibility
  to being profitably predicted.
• it is difficult to outperform the markets own
  forecasts of future exchange rates as embedded in
  interest and forward differentials. While
  interest rates and forward rates provide unbiased
  forecasts of future exchange rates, these
  forecasts are highly inaccurate.
• those who have inside information about events
  that will affect the value of a currency or of a
  security should benefit handsomely.
• those without inside information will have to
  trust to luck or to the existence of a market
  imperfection, such as government intervention, to
  earn above average risk-adjusted profits.
• continued.

8
35
Point 5.

• given the widespread availability of information
  and the many knowledgeable participants in the
  foreign exchange market, only the latter
  situation (government manipulation of exchange
  rates) holds the promise of superior returns from
  currency forecasting. This is because when
  governments, for political purposes, spend money
  to control exchange rates, that money flows into
  the hands of those who bet against the
  government. The trick is to predict government
  actions.
• continued..

9
36
Point 5 ..

• the black market rate is a good indicator of
  where the official rate is likely to go if the
  monetary authorities give in to market pressure.
• although the official rate can be expected to
  move toward the black-market rate, we should not
  expect to see it coincide with that rate because
  of the bias induced by government sanctions.
• the black-market rate seems to be most accurate
  in forecasting the official rate one month hence,
  and is progressively less accurate as a
  forecaster of the future official rate for longer
  time periods.

10
37
Predicting Canada/U.S. Exchange Rate

• Current Exchange Rate
• Cper US 1.3479 or 74.19
• Current U.S. inflation rate 3
• Current Canadian inflation rate 1
• ih - if (e1 - e0) / e0 single-period model
• The exchange rate change during a period should
  equal the inflation differential for that same
  time period.
• What is likely to happen to the Canadian dollar
  over the next year?
• .01 - .03 (e1 - 1.3479) / 1.3479
• -0.02 (1.3479) 1.3479 1.32094 or 75.70
  U.S.

But what if the U.S. CPI is over- stating real
U.S. inflation by 1.1 percentage points?
38
Predicting Canada/U.S. Exchange

• What does the actual forward rate tell us?
• Our prediction 1.32094 U.S. 0.757 per C
• 1-yr forward rate 1.3204 U.S. 0.7573 per C
• PRETTY CLOSE!!
• Maybe the market is using slightly different
  estimates of the inflation rates in both
  countries.
• The article out of the Los Angeles Times
  concerning the U.S. CPI seems to think that U.S.
  inflation is over-stated by 1.1. Do you think
  the market is disagreeing with the article?...or
  is there another explanation?....perhaps the
  Canadian CPI overstates inflation in the same
  way?...

39
Relative Inflation is what is important

• in our example we assumed
• ih 1
• if 3
• the current spot rate is a known fact 1.3479
• we could get -2 using
• 0 - (2)
• -1 - (1)
• 2 - (4)
• therefore, what is important to the market is
  not reported CPI in Canada less reported CPI for
  the U.S.......it is the markets estimate for
  inflation in Canada less the markets estimate of
  inflation in the U.S.

therefore the difference is -2
40
What about Longer Term Forecasts?

• Lets try to forecast the future spot exchange
  rate that will exist for the Canadian dollar in
  U.S. terms three years from now.
• Current 3-yr. forward rate U.S. 1.2994
  0.7696 per C
• e3 current spot rate (1 ih) / (1 if)n
• 1.3479(1.01)/(1.03)3
• 1.3479 (0.9805825)3
• 1.3479(0.9428714)
• U.S. 1.2708963 0.7868 per C
• Now we have a greater discrepancy between our
  models prediction and the forward rate in the
  market today. Can you think of reasons for a
  difference between THE UNBIASED MARKET ESTIMATE
  SUPPLIED BY THE FORWARD RATE? Is there an
  implicit assumption in our model? What is it?

41
What about Longer Term Forecasts?

• Lets try some adjustments to our model.
• Current 3-yr. forward rate U.S. 1.2994
  0.7696 per C
• e3 current spot rate (1 ih) / (1 if)3
• 1.3470 (x1)(x2)(x3)
• 1.3470 (1.01/1.03)(1.01/1.02)(1.01/1.01)
• 1.3470 (.9806)(.9902)(1)
• 1.3079 0.765 per C
• Try again
• 1.347(1.01/1.03)(1.01/1.02)(1.01/1.017)
• 1.347(.9806)(.9902)(.9931)
• 1.2989 0.7698 per C
• We could have solved for the implied rates for
  the second year, and then solved for it in the
  third year to build our forecast....anyway...I
  think you get the idea. The market is using some
  estimates of future relative rates of inflation
  to establish, in its unbiased opinion, what the
  future exchange rate should be.

Perhaps the market doesnt assume that the
relative inflation rates remain constant over
time!
This seems to tell us that the inflation
differential is expected to decrease in future
years.
42
Conclusions on PPP

• the law of one price is violated regularly in the
  short-term
• risks and costs of shipping goods internationally
• barriers to trade and capital flows exist
• prices of goods are sticky
• published measures of CPI may use different
  baskets of goods
• in the longer term...there is a relationship
  between relative inflation rates and exchange
  rates.
• the market has an uncanny way of determining the
  relative expected rates of inflation despite
  published data --- producing a robust estimate of
  future exchange rates expressed in the forward
  market.

43
The Fisher Effect

• explores the relationship between expected
  inflation and nominal and real interest rates.
• current rates are as follows

44
The Fisher Effect Explored

• in Business 2019 you learned
• nominal rate real rate of return
  expected inflation premium
• formally, in this chapter, you now know
• 1 nominal rate (1 RR)(1 expected
  inflation premium)
• 1 r (1 a)(1 i)
• r a i ai
• In Canada today the 91-day T-bill yield is
  2.83 nominal rate
• If expected inflation is 1, then what is the
  real return?
• 2.83 a 1 1a
• 2a 2.83 -1 2.83
• a 1.415 real rate of return

45
International Fisher Effect

• arbitrage ensures that real rates of return (a)
  are equalized across countries
• ah af
• therefore, in the absence of government
  intervention, differences in nominal rates
  between countries should solely be due to
  differences in expected inflation.
• the foregoing assumes capital market integration
  where money will flow unimpeded throughout the
  world to those places where there are higher real
  rates of return...this arbitrage action will
  ensure that real rates of return are equal
  throughout the world.

46
Factors Impeding Capital Market Integration

• differential tax policies between countries
• regulatory barriers to capital flow between
  countries
• perceptions of exchange rate risk by investors
  who then would be discouraged from seeking higher
  real rates of return elsewhere.
• If the foregoing is true, why did Canada have
  such high real rates of interest in the early
  1990s?
• - special risk factors? - Quebec referendum?
• - concerns about government commitment to
  fiscal and monetary policy

47
Business 4179

• Measuring Accounting Exposure

48
Exposure

• the degree to which a company is affected by
  exchange rates
• accounting exposure (translation) arises from the
  need to convert financial statements of foreign
  operations from local currencies to the home
  currency.

49
Alternative Translation Methods

• Current/Non current method
• current assets/liabilities are translated into
  the home currency using the current exchange rate
• noncurrent assets and liabilities are translated
  at historic exchange rate
• income statement is translated at the average
  exchange rate during the period with depreciation
  being based on historical.
• Monetary/Nonmonetary method
• monetary items (cash, A/R, A/P, long-term debt)
  are translated at the current exchange rate
• nonmonetary itmes (physcial assets and
  liabilities like inventory, fixed assets and
  long-term investments) are translated at
  historical exchange rates.
• choice of exchange rate hinges on the type of
  asset or liability.

50
Alternative Translation Methods....

• Temporal Method
• same as monetary/nonmonetary except that
  inventory is always translated at the historical
  rate.
• the choice of exchange rate depends on the
  underlying approach to evaluating cost
  (historical cost or market)?
• Current Rate Method
• all items on Balance Sheet and Income Statement
  are translated at the current rate. (Chartered
  Accountants of England and Wales and Scotland)

51
Key

• there is a wide disparity in results (of currency
  translation) for similarly situated firms when
  using different measures of translation exposure.

52
FASB No. 8

• uses the temporal method (1976)
• ie. if the cost base is historical - then the
  historical exchange rate is used
• ie. if the cost base is market - then the current
  exchange rate is used
• inventory is normally translated at the
  historical rate - but can be translated at the
  current rate if the inventory is shown on the
  balance sheet at market values.
• reserves for currency losses were disallowed.
• reserves were used to smooth/cushion the impact
  of sharp changes in currency values on reported
  earnings.
• with no reserves, reported earnings were more
  affected by exchange rate moves (currency
  translation effects) that the sales/costs/profits
  of the actual product lines.

53
FASB No. 52

• 1981 - a new translation standard
• the current method
• all foreign currency revenue and expense items on
  the income statement must be translated at either
  the exchange rate in effect on the date these
  items are recognized or at an appropriately
  weighted average exchange rate for the period
  (this fiscal year).
• translation gains and losses bypass the income
  statement and are accumulated in a separate
  equity account on the parents balance sheet
• cumulative translation adjustment (CTA)
• FASB-8 mixed the basis of translation thereby
  creating distortions on the consolidated
  accounting statements....because FASB-52 requires
  all assets and liabilities to be measured at
  current exchange rates, such a distortion should
  no longer occur.

54
FASB No. 52...

• with the CTA (cumulative translation adjustment)
  account...only realized changes in net income
  will be recorded on the income statement.
• MNCs will always be faced with translation gains
  and losses due to the sometimes wide fluctuations
  in exchanges
• FASB-52 appears to present a more accurate
  picture of the true financial position and
  results of operations by foreign subsidiaries.
• FASB-52 will reduce...but not eliminate an MNCs
  exposure to translation risk. The stockholders
  account is adjusted by the CTA....therefore, ROE
  and Debt/Equity ratios are affected.

55
Translation Exposure

• is just the difference between exposed assets and
  exposed liabilities.
• regardless of the translation method selected,
  measuring accounting exposure is conceptually the
  same.

56
FOCUS

• by far the most important feature of the
  accounting definition of exposure is the
  exclusive focus on the balance sheet effects of
  currency changes!
• this focus is misplaced since it has led firms to
  ignore the more important effect that these
  changes may have on future cash flows!

57
Definitions

• FUNCTIONAL CURRENCY
• as defined in FASB No. 52 - an affiliates
  functional currency is the currency of the
  primary economic environment in which the
  affiliate generates and expends cash. (see
  Exhibit 8.2, p. 243)
• TRANSACTION EXPOSURE
• the extent to which a given exchange rate change
  will change the value of foreign-currency
  denominated transactions already entered into.
• TRANSLATION EXPOSURE - ACCOUNTING EXPOSURE
• the change in the value of a firms foreign
  currency-denominated accounts due to a change in
  exchange rates.
• ECONOMIC EXPOSURE
• the extent to which the value of the firm will
  change because of an exchange rate change.

58
Conceptual Diagram
Sales in France
Sales in Britain
U.S. Sub based in Germany
Revenues in pounds
Revenues in Francs
Costs in marks. Sales in Germany in DM, in France
in FF, and in Britain in sterling. No U.S. sales.
Financial Reporting in U.S. dollars
Functional Currency - marks Transaction exposure
to FF and British pounds. Accounting/transla
tion exposure to the exchange rate
between DM and U.S. .
59
Economic Exposure

• accounting/translational exposure does not
  measure economic exposure
• accounting measures focus on the effect of
  currency changes on previous decisions of the
  firm...as reflected in book values (historical
  costs)
• economic exposure is the extent to which the
  value of the firm - as measured by the present
  value of expected cash flows - will change when
  exchange rates change.
• there is good reason to believe that in efficient
  markets...that it is the economic exposure which
  is relevant.

60
Conclusions

• as long as there is complete disclosure, it
  probably doesnt matter which translation method
  that is used.
• in notes to financial statements the economic
  consequences of the exchange rate changes can be
  explained.

61
Measuring Economic Exposure

• Business 4179

62
Economic Exposure

• the extent to which the value of the firm - as
  measured by the present value of expected future
  cash flows - will change when exchange rates
  change.
• Economic Exposure transaction exposure
  operating exposure

63
Transaction Exposure

• you know this from previous chapters...including
  strategies to address the issue.
• this exposure occurs after a firm is established
  - after it has engaged in foreign
  currency-denominated sales or purchases.

64
Operating Exposure

• the effects that currency fluctuations have on
  future revenues and costs.

65
Exchange Rates

• Nominal exchange rate - actual spot rate.
• Real exchange rate - the spot rate adjusted for
  relative price level changes since a base period.
• et (et)(1 if,t)/(1 ih,t)
• where et the real exchange rate (home
  currency per one unit
• of foreign currency) at time t
• et the nominal exchange rate (home currency
  per one unit of foreign currency) at time t
• if,t the amount of foreign inflation between
  times 0 and t
• ih,t the amount of domestic inflation
  between times 0 and t

66
Importance of the Real Exchange Rate

• it is important to not focus on nominal exchange
  rate changes, but instead on changes in the
  purchasing power of one currency relative to
  another.
• because currency changes are usually preceded by
  or accompanied by changes in relative price
  levels (inflation) between two countries, it is
  impossible to determine exposure to a given
  currency change without considering
  simultaneously the offsetting effects of these
  price changes.
• the real exchange rate changes because inflation
  is not offset by exchange rate changes.
• only foreign-currency-denominated contractual
  cash flows are affected by nominal currency
  changes.
• noncontractual operating cashflows are affected
  only by real currency changes.
• the impact of real exchange rate changes on a
  firm depends on the location of that firms
  markets, tis sources of inputs, and its degree of
  flexibility in shifting its marketing and
  production efforts.

67
Myth 1

• Exchange rate changes always increase the
  riskiness of MNCs.
• devaluations (revaluations) are usually preceded
  by higher (lower) rates of inflation - hence it
  is clearly inappropriate to evaluate only the
  devaluation phase of an inflation-devaluation
  cycle
• eg. devaluation is probably the best corrective
  for an exporter or for a company selling locally
  that is facing stiff import competition. In
  either case, inflation will likely lead to an
  erosion of dollar profit margins which can only
  be reversed if a local currency devaluation
  occurs.
• based on PPP, therefore, gains or losses from
  exchange rate changes should be offset over time
  by differences in relative rates of inflation.

68
Myth 1...

• if nominal currency changes smooth out the profit
  peaks and valleys caused by differing rates of
  inflation, devaluations or revaluations should
  actually reduce earnings variability for MNCs.
• only if currency changes involve real exchange
  rate changes does risk increase.

69
Myth 2

• Multinational firms are more subject to exchange
  risk than are domestic companies.
• the MNC may be subject to less exchange risk than
  an exporter...given the MNCs greater ability to
  adjust its marketing and production operations on
  a global basis.
• the MNC has the option of increasing production
  in a nation whose currency has devalued and and
  decreasing production in a country whose currency
  has revalued.
• the ability to shift production depends on many
  factors, including the power of the unions
  involved.

70
Measuring Economic Exposure

• because the value of the firm is equal to the
  present value of future cash flows, accounting
  measures of exposure that are based on changes in
  the book values of foreign currency assets and
  liabilities need bear no relationship to reality.

The past is not a factor in the establishment of
a value today, apart from what the past can
reveal about the future!
71
Business 4179

• Managing Accounting Exposure

72
Transaction Exposure

• arises when a company is committed to a foreign
  currency-dominated transaction.
• since the transaction will result in a future
  foreign currency cash inflow or outflow, any
  change in the exchange rate between the time the
  transaction is entered into and the time it is
  settled in cash will lead to a change in the
  dollar (HC) amount of cash flow.

73
Hedging

• cannot provide protection against expected
  exchange rate changes.
• firms ordinarily cope with anticipated currency
  changes by engaging in forward contracts,
  borrowing locally, and adjusting their pricing
  and credit policies....however, there is reason
  to question the value of much of this activity.
• the basic value of hedging is to protect a
  company against unexpected exchange rate changes.
  Because such changes are unpredictable...they
  are impossible to profit from.

74
Continual Hedging

• a policy of continual hedging will not reduce
  fluctuations in earnings caused by currency
  changes.
• it is true that a U.S. company selling to French
  customers, say, can fix the dollar value of its
  franc revenues for the next three months or so,
  perhaps up to one year. For anything beyond
  that, however, the firm faces exchange risk, even
  if it plans on using the forward market
  consistently, since it must roll these forward
  contracts over. Several studies have shown that
  the volatility of rates in the forward and spot
  markets, as measured by the standard deviation,
  is about the same.

75
Continual Hedging

• a policy of continual hedging transfers
  fluctuations in reported income due to
  translation gains or losses into earnings
  variations caused by changes in interest and
  forward rates.

76
Managing Economic Exposure

• Business 4179

77
Managing Economic Exposure

• what is the proper role of financial management?
• to the extent that a firm is operating in
  efficient financial markets, the primary exposure
  management objective, of financial executives
  should be to arrange their firms finances in
  such a way as to minimize the real effects of
  exchange rate changes.
• the major burden of coping with exchange risk
  must be borne by the marketing and production
  people because they deal in imperfect product and
  factor markets where their specialized knowledge
  provides a real advantage.
• competitive exposures - those arising from
  competition with firms based in other currencies
  - are longer-term, harder to quantify, and cannot
  be dealt with solely through financial hedging
  techniques.

78
Key Points

• since currency risk affects all facets of a
  firms operations, it should not be the concern
  of financial managers alone. Top executives
  should incorporate exchange rate expectations
  into non-financial decisions.
• operating managers should develop market and
  production initiatives that help to ensure
  profitability over the long run. They should
  also devise anticipatory or proactive, rather
  than reactive, strategic alternatives in order to
  gain competitive leverage internationally.
• the key to effective exposure management is to
  integrate currency considerations into the
  general management process.
• managers trying to cope with actual or
  anticipated exchange rate changes must first
  determine whether the exchange rate change is
  real or nominal. Nominal changes can be ignored.
  Real changes must be responded to.

79
Key Points ....

• if real, the manager must first assess the
  permanence of the change.
• real exchange rate movements that narrow the gap
  between current rate and the equilibrium rate are
  likely to be longer lasting that are those that
  widen the gap.
• neither, however, will be permanent. Rather,
  there will be a sequence of equilibrium rates,
  each of which has its own implications for the
  firms marketing and production strategies.
• the role of the financial executive in an
  integrated exchange risk program is fourfold
• to provide local operating management with
  forecasts of inflation and exchange rates
• to identify and highlight risks of competitive
  exposure
• to structure evaluation criteria such that
  operating managers are not rewarded or penalized
  for the effects of unanticipated real currency
  changes
• to estimate and hedge whatever real operating
  exposure remains after the appropriate marketing
  and production strategies have been put in place.

80
Marketing and Production Decisions

• short-run/long-run product pricing (based on
  market share or profit margin objectives)
• penetration pricing
• price skimming
• price elasticity of demand
• economies to scale
• market selection
• market segmentation
• promotional strategy
• product strategies

• location of manufacturing facilities
• input mix
• shift output among plants
• raising productivity
• shorten product development cycles

81
Financial Management of Exchange Risk

• the role of financial management is to structure
  the firms liabilities in such a way that during
  the time the strategic operational adjustments
  are under way, the reduction in asset earnings is
  matched by a corresponding decrease in the cost
  of servicing these liabilities.