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Business 4179


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Title: Business 4179

Business 4179
  • Chapter 7
  • International Investments and Diversification

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

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

Business 4179
  • The International Monetary System

International Monetary System
  • recent history of the international monetary
  • the gold standard (1821-1914)
  • breakdown in the gold exchange standard (1925 -
  • 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)

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

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
  • 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.

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.

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.

Four Policy Alternatives to Devaluationin a
Fixed-Rate System
  • in order for a fixed-rate system to work -EACH
    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

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
  • 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

Business 4179
  • The Foreign Exchange Market

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

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.

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 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.

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
  • 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.

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
  • the spot market facilitates transactions.
  • the forward market locks in future rates to
    permit hegding strategies to avoid exchange rate

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

Business 4179
  • The Determination of Exchange Rates

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.

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

Important Terms
  • devaluation/depreciation
  • a decrease in the stated par value of a pegged
    currency / a decrease in the value of a floating
  • 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
  • monetary base
  • currency in circulation plus bank reserves

Important Terms...
  • unsterilized intervention
  • the monetary authorities have not insulated their
    domestic money supplies from the foreign exchange
  • 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.

  • 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

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
  • money provides
  • a store of liquidity
  • a store of value
  • the demand for money depends on
  • its ability to maintain its value (purchasing
  • the demand for assets denominated in that
  • exchange rates reflect therelative demands for
    two moneys.

Parity Conditions in International Finance and
Currency Forecasting
  • Business 4179

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
  • 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.

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)

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
  • international arbitrageurs prevent all but
    trivial deviations from equality.

Key Point 1
  • inflation is the logical outcome of an expansion
    of the money supply in excess of real output
  • 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

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.

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

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

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.

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
  • continued..

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.

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

But what if the U.S. CPI is over- stating real
U.S. inflation by 1.1 percentage points?
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
  • Maybe the market is using slightly different
    estimates of the inflation rates in both
  • 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

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 is the markets estimate for
    inflation in Canada less the markets estimate of
    inflation in the U.S.

therefore the difference is -2
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
    implicit assumption in our model? What is it?

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
This seems to tell us that the inflation
differential is expected to decrease in future
Conclusions on PPP
  • the law of one price is violated regularly in the
  • 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
  • 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

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

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

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.

Factors Impeding Capital Market Integration
  • differential tax policies between countries
  • regulatory barriers to capital flow between
  • 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
  • - special risk factors? - Quebec referendum?
  • - concerns about government commitment to
    fiscal and monetary policy

Business 4179
  • Measuring Accounting 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

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.

Alternative Translation Methods....
  • Temporal Method
  • same as monetary/nonmonetary except that
    inventory is always translated at the historical
  • 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)

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

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
  • 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.

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.

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.

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

  • 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!

  • 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)
  • the extent to which a given exchange rate change
    will change the value of foreign-currency
    denominated transactions already entered into.
  • the change in the value of a firms foreign
    currency-denominated accounts due to a change in
    exchange rates.
  • the extent to which the value of the firm will
    change because of an exchange rate change.

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. .
Economic Exposure
  • accounting/translational exposure does not
    measure economic exposure
  • accounting measures focus on the effect of
    currency changes on previous decisions of the reflected in book values (historical
  • 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.

  • 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

Measuring Economic Exposure
  • Business 4179

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
  • Economic Exposure transaction exposure
    operating exposure

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.

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

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

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
  • 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
  • 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.

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
  • 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
  • based on PPP, therefore, gains or losses from
    exchange rate changes should be offset over time
    by differences in relative rates of inflation.

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.

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

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!
Business 4179
  • Managing Accounting Exposure

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.

  • 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.

Continual Hedging
  • a policy of continual hedging will not reduce
    fluctuations in earnings caused by currency
  • 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.

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.

Managing Economic Exposure
  • Business 4179

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

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.

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
  • to structure evaluation criteria such that
    operating managers are not rewarded or penalized
    for the effects of unanticipated real currency
  • to estimate and hedge whatever real operating
    exposure remains after the appropriate marketing
    and production strategies have been put in place.

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

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.