McGraw-Hill/Irwin Copyright  2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 18: Forward Exchange and International Financial Investment.

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McGraw-Hill/Irwin Copyright  2009 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter 18: Forward Exchange and International Financial Investment

18-2 Exposure to Exchange Rate Risk You are exposed to exchange rate risk if the value of your income or wealth or net worth will change if exchange rates in the future change in ways that are not expected. You are exposed to exchange rate risk if the value of your income or wealth or net worth will change if exchange rates in the future change in ways that are not expected. Hedging is taking an action to reduce your exposure to exchange rate risk. Hedging is taking an action to reduce your exposure to exchange rate risk. Speculation is taking an action that increases your exposure to exchange rate risk, usually to try to profit from your belief about what future exchange rates will be. Speculation is taking an action that increases your exposure to exchange rate risk, usually to try to profit from your belief about what future exchange rates will be.

18-3

18-4 Covered Interest Parity As a result of pressure from covered interest arbitrage: Covered interest parity: The domestic return equals the overall return on a covered foreign investment. Covered interest parity: The domestic return equals the overall return on a covered foreign investment. That is, approximately: The forward premium on the foreign currency equals the difference between the domestic interest rate and the foreign interest rate. That is, approximately: The forward premium on the foreign currency equals the difference between the domestic interest rate and the foreign interest rate.

18-5 Uncovered International Financial Investment The investor is exposed to exchange rate risk, because the actual return depends on the actual value of the future spot exchange rate, which is uncertain at the time the investment is made. The investor is exposed to exchange rate risk, because the actual return depends on the actual value of the future spot exchange rate, which is uncertain at the time the investment is made. At the time the investment is made, the investor can use the expected future spot exchange rate to calculate the expected return to the uncovered foreign financial investment. At the time the investment is made, the investor can use the expected future spot exchange rate to calculate the expected return to the uncovered foreign financial investment.

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