C ONTEMPORARY F INANCIAL M ANAGEMENT Chapter 18: Managing International Risk

I NTRODUCTION This chapter explores the factors that determine exchange rates, ways to forecast future exchange rates, aspects of foreign exchange risk, and ways of managing that risk. 2

F ACTORS A FFECTING E XCHANGE R ATES Supply and Demand Economic Conditions Inflation Interest rates Government trade policies Political stability Risk of expropriation 3

W HY E XCHANGE R ATES F LUCTUATE 4 Theories of Currency Fluctuation Interest Rate Parity Purchasing Power Parity Expectations Theory (Hypothesis) International Fisher Effect Absolute Relative

I NTEREST R ATE P ARITY Forward rate will differ from spot rate to offset interest rate differences If not covered, interest arbitrage will move rates back to parity 5

A BSOLUTE PPP: T HE L AW OF O NE P RICE Prices for a good will be the same after currency conversion It holds loosely for commodities Trade restrictions and taxes keep prices different between countries Consider the “Big Mac” index 6

R ELATIVE P URCHASING P OWER P ARITY Different rates of inflation will be offset by equal but opposite changes in expected future spot exchange rates Less restrictive than absolute PPP If inflation is higher in Germany than in Canada, then the Euro weakens relative to the Canadian dollar 7

E XPECTATIONS T HEORY The forward rate reflects the market expectation of the future spot rate Provides an unbiased estimate of the future spot rate Implication for managers Exchange rate forecasts are provided free from the marketplace Hedging is cost effective 8

I NTERNATIONAL F ISHER E FFECT Nominal (quoted) interest rates consist of a real interest rate plus the expected inflation rate IFE holds that in equilibrium real interest rates will be equal in different countries If not, then capital will flow to the country with the higher real interest rate until it reaches equilibrium 9

E XAMPLE 10 IFE IFE Inflation rates differ by 5½%. One-year future spot rate is 5½% The dollar weakens against yen. RPPP RPPP Higher Canadian inflation rates will cause a lower Canadian dollar. CDN Rate = 6% Japanese Rate = 0.5% Time Horizon = 1 year IRP IRP Dollar will sell at a 5½% discount.

E XCHANGE R ATES Exchange rates fluctuate over time in response to changing supply and demand In the case of the Peso Demand for Pesos decreased Supply of Pesos increased Value of Pesos decreased in relation to other currencies 11

F OREIGN E XCHANGE R ISK Transaction The potential for a change in value of a foreign-currency denominated transaction before the transaction is finalized Economic Changes to a firm’s cash flow due to changes in real exchange rates Translation Changes in the book value of assets and liabilities recorded on the Balance sheet due to changes in exchange rates 12

M ANAGING T RANSACTION E XPOSURE Do nothing Works for multinationals with many different foreign exchange exposures Invoice in currency of home country Shift the risk to another party Hedge Forward Contracts Money market 13

M ANAGING E CONOMIC E XPOSURE Shift production Increase productivity Outsource Reduce price sensitivity Change to markets with strong currencies 14

T RANSLATION R ISK SECTION 1650 OF THE CICA HANDBOOK Balance Sheet Assets & liabilities converted at date of Balance Sheet Equity accounts converted at historic rates Income Statement Converted on date of transaction or a weighted average of exchange rates Gains/losses not recognized on Income Statement until subsidiary is sold (or liquidated). 15

M AJOR P OINTS Supply and demand, economic conditions, government policy and political stability affect exchange rates. Under interest rate parity, forward rate will differ from spot rate to offset interest rate differences Absolute purchasing power parity suggests that rices for a good will be the same after currency conversion. 16

M AJOR P OINTS Relative purchase power parity suggests that different rates of inflation will be offset by equal but opposite changes in expected future spot exchange rates. Expecations theory suggests that the forward rate reflects the market expectation of the future spot rate. Under the international Fisher effect, nominal (quoted) interest rates consist of a real interest rate plus the expected inflation rate. 17