Chapter 16 Foreign Exchange Risk, Forecasting, and International Investment

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Topics to be Covered Types of Exchange Risk Hedging Against Foreign Exchange Risk Foreign Exchange Risk Premium Efficient Market Foreign Exchange Forecasting Diversified Portfolio Home Bias Direct Foreign Investment Capital Flight and Capital Inflows Bank Lending and Financial Crisis

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Exchange Risk International business involves foreign exchange risk because the value of transactions is sensitive to changes in the exchange rate. Forecasting exchange rates is an important part of the decision-making process of international firms and investors.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Types of Foreign Exchange Risk Translation Exposure—also called accounting exposure, is the difference between foreign-currency- denominated assets and foreign-currency- denominated liabilities. Transaction Exposure—results from the uncertain domestic currency value of a foreign-currency- denominated transaction to be completed at some future date. Economic Exposure—the risk to the value of the firm arising from exchange rate changes. This exposure is the most important to the firm.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Illustration of Types of Exchange Rate Risk Refer to Table 16.1 Translation exposure occurs when a foreign- currency-denominated balance sheet is translated into the parent company’s home currency. When the foreign currency depreciates relative to the home currency, then the owner’s equity falls. Transaction exposure occurs when the firm commits to a future transaction without hedging via a forward contract. Economic exposure is the vulnerability of future profitability to exchange rate changes.

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Ways of Hedging Against Exchange Rate Risk The forward, futures, or options market. Invoicing in the domestic currency. Speeding (slowing) payments of currencies expected to appreciate (depreciate). Speeding (slowing) collection of currencies expected to depreciate (appreciate).

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Risk Premium The foreign exchange risk premium is the difference between the forward rate and the expected future spot rate.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Risk and Risk Aversion The risk associated with an asset is the contribution of that asset to the overall portfolio risk of an investor. Risk aversion is the tendency of investors to prefer less risk to more risk. Risk aversion implies that people must be paid to take risk.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Effective Return Differential From the covered interest parity relation, the effective return differential between a U.S. asset and a U.K. asset is written as: i US – [(E* t+1 – E t )/E t ] – i UK = (F – E* t +1 )/E t The effective return differential is equal to the percentage difference between the forward and expected future spot rate. If the differential is positive, then there is a positive risk premium on the domestic currency.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Efficient Market An efficient market is a market where prices reflect all available information. In the foreign exchange market, this means that spot and forward exchange rates will adjust quickly to new information. With an efficient market, the forward rate will differ from the expected future spot rate by only a risk premium.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Long Position vs. Short Position Long Position—buying currency for future delivery. Short Position—selling currency for future delivery.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Foreign Exchange Forecasting While a smaller forecasting error is preferable to a larger error, it is more important to be on the correct side of a forward rate than to have a small forecast error. The closer you are to the actual rate from the correct side, the more money you can make. If you cross beyond the actual rate (on the wrong side), you lose money. Although some advisory services may offer forecasts better than the forward rate, this is not evidence of a lack of market efficiency.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved International Investment and Diversified Portfolios International investment is partly motivated by interest differentials among countries. Another incentive is the desire to hold diversified portfolios. Diversified portfolios are assets denominated in several currencies. By diversifying and selecting different assets (of different countries) for a portfolio, an investor can reduce the variability of the portfolio.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Diversified Portfolios (cont.) The return on the portfolio, Rp, is a weighted average of the returns on the individual assets, R A and R B : where a is the share of portfolio devoted to asset A and b is asset B’s share. The expected future return on the portfolio is then determined by the expected future returns on the individual assets:

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Variability of the Portfolio Variance—a measure of the dispersion of a variable about its mean. Covariance—a measure of how two variables fluctuate together about their means. The variance of the portfolio is given by:

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Systematic Risk vs. Nonsystematic Risk Systematic Risk—the risk common to all investment opportunities. Nonsystematic Risk—the risk that can be eliminated through diversification.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Home Bias Home Bias—the empirical finding that investors prefer domestic securities to foreign securities. Why might home bias exist?  Taxes  Transaction costs  Small gains from international diversification

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Direct Foreign Investment Direct Foreign Investment—the spending of domestic firms for establishing foreign operating units. Motives for direct foreign investment:  Technology transfer  Economies of scale  Appropriation of foreign market

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Direct Investment vs. Bank Lending From the late 1970s to early 1980s, bank lending as a source of funds for developing countries grew and dominated direct investment. In the mid-1980s, bank lending fell due to non-repayment problems and financial crises in some countries (e.g., Mexico) that led to contagion effects, or spill-over effects to other countries.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Direct Investment (cont.) Advantages of direct investment vs. bank loans and portfolio investment include:  Direct investment is not as sensitive to short-term changes in economic conditions  More funds go to actual investment in productive resources  It may involve new technologies and expertise not available in the recipient country  Losses are sustained by the foreign firm and not the domestic government

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Capital Flight Capital Flight—refers to large capital outflows resulting from unfavorable investment conditions in a country. Unfavorable investment conditions include political or financial crisis, tightening of capital controls, tax increases, or fear of a domestic currency devaluation. Refer to Table 16.2

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Capital Inflow Issues Capital inflows can be both a blessing and a curse. The capital inflows can help poor countries with their infrastructure and economic development efforts as well as provide diversification opportunities for foreign investors. However, large capital inflows can also lead to:  Appreciation of the recipient country’s currency and resulting loss of export competitiveness  Increase in money supply and associated inflationary pressures in the recipient country.

Copyright © 2007 Pearson Addison-Wesley. All rights reserved International Lending and Crises Examples of recent financial crises:  Latin American debt crisis in 1980s  Asian financial crisis of 1997–98  Russian bond default of 1998  Argentine financial crisis of 2002 Refer to Table 16.3

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Copyright © 2007 Pearson Addison-Wesley. All rights reserved Causes of Asian Financial Crisis External Shocks Domestic Macroeconomic Policy Domestic Financial System Flaws

Copyright © 2007 Pearson Addison-Wesley. All rights reserved Warning Indicators of Future Crises Fixed Exchange Rates Falling International Reserves Lack of Transparency