THE DETERMINATION OF EXCHANGE RATES

THE DETERMINATION OF EXCHANGE RATES
CHAPTER 2 THE DETERMINATION OF EXCHANGE RATES

CHAPTER 2 OVERVIEW: PART I. EQUILIBRIUM EXCHANGE RATES
II. ROLE OF CENTRAL BANKS III. EXPECTATIONS AND THE ASSET MARKET MODEL

Part I. Equilibrium Exchange Rates
I. SETTING THE EQUILIBRIUM A. Exchange Rates market-clearing prices that equilibrate the quantities supplied and demanded of foreign currency.

Equilibrium Exchange Rates
B. How Americans Purchase German Goods 1. Foreign Currency Demand -derived from the demand for foreign country’s goods, services, and financial assets. e.g. The demand for German goods by Americans

2. Foreign Currency Supply: a. derived from the foreign country’s demand for local goods. b. They must convert their currency to purchase. e.g. German demand for US goods means Germans convert DM to US $ in order to buy.

occurs when the quantity supplied equals the quantity demanded of a foreign currency at a specific local price.

C. How Exchange Rates Change 1. Increased demand as more foreign goods are demanded, the price of the foreign currency in local currency increases and vice versa.

2. Home Currency Depreciation a. Foreign currency becomes more valuable than the home currency. b. Conversely, the foreign currency’s value has appreciated against the home currency.

3. Calculating a Depreciation: Currency Depreciation where e0 = old currency value e1 = new currency value Note: Resulting sign is always negative

Currency Appreciation

EXAMPLE: dm Appreciation If the dollar value of the dm goes from $0.64 (e0) to $0.68 (e1), then the dm has appreciated by = ( )/ .64 = %

EXAMPLE: US$ Depreciation We use the first formula, (e0 - e1)/ e1 substituting ( )/ .68 = % which was the US$ depreciation.

D. FACTORS AFFECTING EXCHANGE RATES: 1. Inflation rates 2. Interest rates 3. GNP growth rates

THE ROLE OF CENTRAL BANKS
I. FUNDAMENTALS OF CENTRAL BANK INTERVENTION A. Role of Exchange Rates: LINKS BETWEEN THE DOMESTIC AND THE WORLD ECONOMY

B. THE IMPACT OF EXCHANGE RATE CHANGES 1. Currency Appreciation: -domestic prices increase relative to foreign prices. - Exports: less competitive - Imports: more attractive

2. Currency Depreciation - domestic prices fall relative to foreign prices. - Exports: more competitive. - Imports: less attractive

C. Foreign Exchange Market Intervention 1. Definition: the official purchases and sales of currencies through the central bank to influence the home exchange rate.

2. Goal of Intervention: - to alter the demand for one currency by changing the supply of another.

D. The Effects of Foreign Exchange Intervention 1. Effects of Intervention: - either ineffective or irresponsible 2. Lasting Effect: - If permanent, change results

Part III. EXPECTATIONS I. WHAT AFFECTS A CURRENCY’S VALUE? A. Current events B. Current supply C. Demand flows * D. Expectation of future exchange rate

EXPECTATIONS II. Role of Expectations : A. Currency = financial asset
B. Exchange rate = simple relation of two financial assets

EXPECTATIONS III. Demand for Money and Currency Values: Asset Market Model A. Exchange rates reflect the supply of and demand for foreign-currency denominated assets.

EXPECTATIONS B. Soundness of a Nation’s Economic Policies
- a nation’s currency tends to strengthen with sound economic policies.

EXPECTATIONS IV. EXPECTATIONS AND CENTRAL BANK BEHAVIOR
- exchange rates also influenced by expectations of central bank behavior.

EXPECTATIONS A. Central Bank Reputations B. Central Bank Independence
C. Currency Boards

PARITY CONDITIONS AND CURRENCY FORECASTING
CHAPTER 4 PARITY CONDITIONS AND CURRENCY FORECASTING

CHAPTER OVERVIEW I. ARBITRAGE AND THE LAW OF ONE PRICE
II. PURCHASING POWER PARITY III. THE FISHER EFFECT IV. THE INTERNATIONAL FISHER EFFECT V. THE RELATIONSHIP BETWEEN THE FORWARD AND FUTURE SPOT RATE VI. CURRENCY FORECASTING

FIVE KEY THEORETICAL RELATIONSHIPS
D%e UFR IFE PPP forward discount or premium interest rate differential IRP expected inflation differential FE

PART I. ARBITRAGE AND THE LAW OF ONE PRICE
I. THE LAW OF ONE PRICE A. Law states: Identical goods sell for the same price worldwide.

ARBITRAGE AND THE LAW OF ONE PRICE
B. Theoretical basis: If the prices after exchange-rate adjustment were not equal, arbitrage of the goods ensures eventually they will worldwide.

C. Five Parity Conditions Result From These Arbitrage Activities 1. Purchasing Power Parity (PPP) 2. The Fisher Effect (FE) 3. The International Fisher Effect (IFE) 4. Interest Rate Parity (IRP) 5. Unbiased Forward Rate (UFR)

D. Five Parity Conditions Linked by 1. The adjustment of various rates and prices to inflation.

2. The notion that money should have no effect on real variables (since they have been adjusted for price changes).

E. Inflation and home currency depreciation: 1. jointly determined by the growth of domestic money supply; 2. Relative to the growth of domestic money demand.

F. THE LAW OF ONE PRICE - enforced by international arbitrage.

PART II. PURCHASING POWER PARITY
I. THE THEORY OF PURCHASING POWER PARITY: states that spot exchange rates between currencies will change to the differential in inflation rates between countries.

PURCHASING POWER PARITY
II. ABSOLUTE PURCHASING POWER PARITY A. Price levels adjusted for exchange rates should be equal between countries

II. ABSOLUTE PURCHASING POWER PARITY B. One unit of currency has same purchasing power globally.

III. RELATIVE PURCHASING POWER PARITY A. states that the exchange rate of one currency against another will adjust to reflect changes in the price levels of the two countries.

1. In mathematical terms: where et = future spot rate e0 = spot rate ih = home inflation if = foreign inflation t = the time period

2. If purchasing power parity is expected to hold, then the best prediction for the one-period spot rate should be

3. A more simplified but less precise relationship is that is, the percentage change should be approximately equal to the inflation rate differential.

4. PPP says the currency with the higher inflation rate is expected to depreciate relative to the currency with the lower rate of inflation.

B. Real Exchange Rates: the quoted or nominal rate adjusted for a country’s inflation rate is

C. Real exchange rates 1. If exchange rates adjust to inflation differential, PPP states that real exchange rates stay the same.

C. Real exchange rates 2. Competitive positions: domestic and foreign firms are unaffected.

PART III. THE FISHER EFFECT (FE)
states that nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations. R = a + i

THE FISHER EFFECT B. Real Rates of Interest
1. Should tend toward equality everywhere through arbitrage. 2. With no government interference nominal rates vary by inflation differential or rh rf = ih - if

THE FISHER EFFECT C. According to the Fisher Effect,
countries with higher inflation rates have higher interest rates.

THE FISHER EFFECT D. Due to capital market integration globally, interest rate differentials are eroding.

THE FISHER EFFECT D. Capital market integration
has homogenized markets around the world

CAPITAL MARKET SEGMENTATION
DU.S. Real interest rates SU.S. Drw Srw aus arw credit

CAPITAL MARKET INTEGRATION
DU.S. + Drw = DW Real interest rates SU.S. + Srw = SW aw credit

PART IV. THE INTERNATIONAL FISHER EFFECT (IFE)
I. IFE STATES: A. the spot rate adjusts to the interest rate differential between two countries.

THE INTERNATIONAL FISHER EFFECT
IFE = PPP + FE

B. Fisher postulated 1. The nominal interest rate differential should reflect the inflation rate differential.

B. Fisher postulated 2. Expected rates of return are equal in the absence of government intervention.

C. Simplified IFE equation: (if rf is relatively small) rh - rf = e1 - e0 e0

D. Implications of IFE 1. Currency with the lower interest rate expected to appreciate relative to one with a higher rate.

D. Implications of IFE 2. Financial market arbitrage: insures interest rate differential is an unbiased predictor of change in future spot rate.

PART V. THE RELATIONSHIP BETWEEN THE FORWARD AND THE FUTURE SPOT RATE
I. THE UNBIASED FORWARD RATE A. States that if the forward rate is unbiased, then it should reflect the expected future spot rate. B. Stated as ft = et

PART VI. CURRENCY FORECASTING
I. FORECASTING MODELS A. have been created to forecast exchange rates in addition to parity conditions. B. Two types of forecast: 1. Market-based 2. Model-based

CURRENCY FORECASTING MARKET-BASED FORECASTS:
derived from market indicators. A. The current forward rate contains implicit information about exchange rate changes for one year. B. Interest rate differentials may be used to predict exchange rates beyond one year.

CURRENCY FORECASTING MODEL-BASED FORECASTS:
include fundamental and technical analysis. A. Fundamental relies on key macroeconomic variables and policies which most like affect exchange rates. B. Technical relies on use of 1. Historical volume and price data 2. Charting and trend analysis

THE FOREIGN EXCHANGE MARKET
CHAPTER 7 THE FOREIGN EXCHANGE MARKET

CHAPTER OVERVIEW I. INTRODUCTION
II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. THE SPOT MARKET IV. THE FORWARD MARKET V. INTEREST RATE PARITY THEORY

PART I. INTRODUCTION I. INTRODUCTION A. The Currency Market:
where money denominated in one currency is bought and sold with money denominated in another currency.

INTRODUCTION B. International Trade and Capital Transactions: - facilitated with the ability to transfer purchasing power between countries

INTRODUCTION C. Location 1. OTC-type: no specific location 2. Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications

PART II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET A. Participants at 2 Levels 1. Wholesale Level (95%) - major banks 2. Retail Level - business customers.

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
B. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2nd business day

2. Forward Market: - transactions take place at a specified future date

C. Participants by Market 1. Spot Market a. commercial banks b. brokers c. customers of commercial and central banks

2. Forward Market a. arbitrageurs b. traders c. hedgers d. speculators

II. CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) - used in U.S. for electronic fund transfers.

B. FedWire - operated by the Fed - used for domestic transfers

III. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market

B. Results: 1. Reduces cost of trading 2. Threatens traders’ oligopoly of information 3. Provides liquidity

IV. SIZE OF THE MARKET A. Largest in the world 1995: $1.2 trillion daily

B. Market Centers (1995): London = $464 billion daily New York= $244 billion daily Tokyo = $161 billion daily

PART III. THE SPOT MARKET
I. SPOT QUOTATIONS A. Sources 1. All major newspapers 2. Major currencies have four different quotes: a. spot price b. 30-day c. 90-day d. 180-day

THE SPOT MARKET B. Method of Quotation 1. For interbank dollar trades:
a. American terms example: $.5838/dm b. European terms example: dm1.713/$

THE SPOT MARKET 2. For nonbank customers: Direct quote
gives the home currency price of one unit of foreign currency. EXAMPLE: dm0.25/FF

THE SPOT MARKET C. Transactions Costs 1. Bid-Ask Spread
used to calculate the fee charged by the bank Bid = the price at which the bank is willing to buy Ask = the price it will sell the currency

THE SPOT MARKET 4. Percent Spread Formula (PS):

THE SPOT MARKET D. Cross Rates
1. The exchange rate between 2 non - US$ currencies.

THE SPOT MARKET 2. Calculating Cross Rates
When you want to know what the dm/ cross rate is, and you know dm2/US$ and .55/US$ then dm/ = dm2/US$  .55/US$ = dm3.636/ 

THE SPOT MARKET E. Currency Arbitrage 1. If cross rates differ from
one financial center to another, and profit opportunities exist.

THE SPOT MARKET 2. Buy cheap in one int’l market,
sell at a higher price in another 3. Role of Available Information

THE SPOT MARKET F. Settlement Date Value Date: 1. Date monies are due
2. 2nd Working day after date of original transaction.

THE SPOT MARKET G. Exchange Risk 1. Bankers = middlemen
a. Incurring risk of adverse exchange rate moves. b. Increased uncertainty about future exchange rate requires

THE SPOT MARKET 1.) Demand for higher risk premium
2.) Bankers widen bid-ask spread

PART II. MECHANICS OF SPOT TRANSACTIONS
SPOT TRANSACTIONS: An Example Step 1. Currency transaction: verbal agreement, U.S. importer specifies: a. Account to debit (his acct) b. Account to credit (exporter)

MECHANICS OF SPOT TRANSACTIONS
Step 2. Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1.

MECHANICS OF SPOT TRANSACTIONS
Step 3. Settlement Correspondent bank in Hong Kong transfers HK$ from nostro account to exporter’s. Value Date. U.S. bank debits importer’s account.

PART III. THE FORWARD MARKET
I. INTRODUCTION A. Definition of a Forward Contract an agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.

THE FORWARD MARKET 2. Purpose of a Forward: Hedging
the act of reducing exchange rate risk.

THE FORWARD MARKET B. Forward Rate Quotations 1. Two Methods:
a. Outright Rate: quoted to commercial customers. b. Swap Rate: quoted in the interbank market as a discount or premium.

THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM OR DISCOUNT
= F-S x x 100 S n where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract

THE FORWARD MARKET C. Forward Contract Maturities 1. Contract Terms
a. 30-day b. 90-day c. 180-day d. 360-day 2. Longer-term Contracts

PART IV. INTEREST RATE PARITY THEORY
I. INTRODUCTION A. The Theory states: the forward rate (F) differs from the spot rate (S) at equilibrium by an amount equal to the interest differential (rh - rf) between two countries.

INTEREST RATE PARITY THEORY
2. The forward premium or discount equals the interest rate differential. (F - S)/S = (rh - rf) where rh = the home rate rf = the foreign rate

3. In equilibrium, returns on currencies will be the same i. e. No profit will be realized and interest parity exists which can be written (1 + rh) = F (1 + rf) S

B. Covered Interest Arbitrage 1. Conditions required: interest rate differential does not equal the forward premium or discount. 2. Funds will move to a country with a more attractive rate.

3. Market pressures develop: a. As one currency is more demanded spot and sold forward. b. Inflow of fund depresses interest rates. c. Parity eventually reached.

C. Summary: Interest Rate Parity states: 1. Higher interest rates on a currency offset by forward discounts. 2. Lower interest rates are offset by forward premiums.

INTERNATIONAL FINANCING AND INTERNATIONAL FINANCIAL MARKETS
CHAPTER9 INTERNATIONAL FINANCING AND INTERNATIONAL FINANCIAL MARKETS

CHAPTER OVERVIEW: I. CORPORATE SOURCES AND USES OF FUNDS II. NATIONAL CAPITAL MARKETS AS INTERNATIONAL FINANCIAL CENTERS III. THE EUROMARKETS IV. INTEREST RATE AND CURRENCY SWAPS V. DEVELOPMENT BANKS

I. CORPORATE SOURCES AND USES OF FUNDS
A. 3 General Sources of Funds: 1. Internally-generated cash 2. Short-term external funds 3. Long-term external funds

CORPORATE SOURCES AND USES OF FUNDS
B. Forms of Securities 1. Equity 2. Debt: the most preferred form

C. Debt Instruments Used 1. Commercial Bank Loans 2. Bonds a. Publicly issued b. Privately issued

D. Financial Markets v. Financial Intermediaries 1. Securitization a. Definition: replacing bank loans with securities issued in public markets.

b. Reflects reduction in access costs due to 1.) Technological improvements 2.) Globalization

E. Globalization of Financial Markets -has led to 1. Global center competition 2. Regulatory arbitrage

II. NATIONAL CAPITAL MARKETS AS INTERNATIONAL CENTERS
II. NATIONAL CAPITAL MARKET AS INTERNATIONAL CENTERS A. Principal Functions of Financial Centers -between savers and borrowers 1. To transfer purchasing power 2. To allocate funds

NATIONAL CAPITAL MARKETS AS INTERNATIONAL CENTERS
B. International Financial Market 1. Development of most important: a. London b. New York c. Tokyo

2. Other Centers for Intermediaries a. Singapore b. Hong Kong c. the Bahamas

3. Prerequisites to be a financial center a. political stability b. minimal government interventions c. legal infrastructure d. financial infrastructure

C. Foreign Access to Domestic Markets 1. The Foreign Bond Market a. Extension of domestic market b. Issues floated by foreign cos. or governments c. Examples: yankee bonds, samurai bonds

c. Three Major Types of Foreign Bonds 1.) Fixed rate 2.) Floating rate 3.) Equity related

2. The Foreign Bank Market a. Extension of domestic markets b. Important funding source: Japanese banks for U.S. firms

3. The Foreign Equity Market a. Cross listing internationally can 1.) diversify risk 2.) increase potential demand 3.) build base of global owners.

D. Downside of Global Financial Markets -abrupt shifts in capital flows

II. THE EUROMARKETS II. THE EUROMARKETS
-the most important international financial markets today. A. The Eurocurrency Market 1. Composed of eurobanks who accept/maintain deposits of foreign currency 2. Dominant currency: US$

THE EUROMARKETS B. Growth of Eurodollar Market
caused by restrictive US government policies, especially 1. Reserve requirements on deposits 2. Special charges and taxes 3. Required concessionary loan rates 4. Interest rate ceilings 5. Rules which restrict bank competition.

THE EUROMARKETS C. Eurodollar Creation involves 1. A chain of deposits
2. Changing control/usage of deposit

THE EUROMARKETS 3. Eurocurrency loans
a. Use London Interbank Offer Rate: LIBOR as basic rate b. Six month rollovers c. Risk indicator: size of margin between cost and rate charged.

THE EUROMARKETS 4. Multicurrency Clauses
a. Clause gives borrower option to switch currency of loan at rollover. b. Reduces exchange rate risk

THE EUROMARKETS 5. Domestic vs. Eurocurrency Markets
a. Closely linked rates by arbitrage b. Euro rates: tend to lower lending, higher deposit

THE EUROMARKETS D. Eurobonds
bonds sold outside the country of currency denomination. 1. Recent Substantial Market Growth -due to use of swaps. a financial instrument which gives 2 parties the right to exchange streams of income over time.

THE EUROMARKETS 2. Links to Domestic Bond Markets
arbitrage has eliminated interest rate differential. 3. Placement underwritten by syndicates of banks

THE EUROMARKETS 4. Currency Denomination a. Most often US$
b. “Cocktails” allow a basket of currencies 5. Eurobond Secondary Market -result of rising investor demand 6. Retirement a. sinking fund usually b. some carry call provisions.

THE EUROMARKETS 7. Ratings a. According to relative risk
b. Rating Agencies Moody’s, Standard & Poor 8. Rationale For Market Existence a. Eurobonds avoid government regulation b. May fade as market deregulate

THE EUROMARKETS E. Eurobond vs. Eurocurrency Loans 1. Five Differences
a. Eurocurrency loans use variable rates b. Loans have shorter maturities c. Bonds have greater volume d. Loans have greater flexibility e. Loans obtained faster

THE EUROMARKETS F. Note Issuance Facility (NIF)
1. Low-cost substitute for loan 2. Allows borrowers to issue own notes 3. Placed/distributed by banks

THE EUROMARKETS G. NIFs vs. Eurobonds 1. Differences:
a. Notes draw down credit as needed b. Notes let owners determine timing c. Notes must be held to maturity

IV. INTEREST RATE AND CURRENCY SWAPS
A. INTEREST RATE SWAPS 1. Definition an agreement between 2 parties to exchange US$ interest payments for a specific maturity on an agreed notional amount.

INTEREST RATE AND CURRENCY SWAPS
a. Notional principal: a reference amount used only to calculate interest expense but never repaid. b. Maturities: less than 1 to over years

2. Types of Interest Rate Swaps a. Coupon swap b. Basis swap 3. Usage: to reduce risk potential and costs.

B. Currency Swaps 1. Definition two parties exchange foreign-currency- denominated debt at periodic intervals. 2. Purpose: similar to parallel loan

3. Differences of a Currency Swap: a. Currency swap is not a loan b. No interest expense; no balance sheet entry c. The right to offset any non-payment is more firmly establish

4. Similarities between Interest Rate and Currency Swaps a. Avoid exchange rate risk b. Exchange rate is only a reference to determine amounts exchanged

5. Economic Benefits of Swaps when arbitrage prohibited, they provide long-term financing.

V. DEVELOPMENT BANKS V. DEVELOPMENT BANKS A. General Purpose
founded by governments to help finance very large infrastructure projects.

DEVELOPMENT BANKS B. Types of Development Banks
1. World Bank Group includes a. International Bank for Reconstruction and Development b. International Development Association c. International Finance Corporation

DEVELOPMENT BANKS B. Types of Development Banks (con’t)
2. Regional Development Banks finance industry, agricultural, and infrastructure projects 3. National Development Banks concentrate on a particular industry or region.

MEASURING ECONOMIC EXPOSURE
CHAPTER 11 MEASURING ECONOMIC EXPOSURE

CHAPTER OVERVIEW I. Foreign Exchange Risk and Economic Exposure
II. The Economic Consequences of Exchange Rate Changes III . Identifying Economic Exposure IV. Calculating Economic Exposure V. An Operational Measure of Exchange Rate Risk

Part I. Foreign Exchange Risk and Economic Exposure
A. Economic exposure focuses on the impact of currency fluctuations on firm’s value. 1 . Expectations about the fluctuation must be incorporated in all basic decisions of the firm.

FOREIGN EXCHANGE RISK AND ECONOMIC EXPOSURE
2. Definitions: a. Accounting exposure impact on firm’s balance sheet b. Economic exposure 1.) Transaction 2.) Operating

THE REAL EXCHANGE RATE

B. Real Exchange Rates and Risk 1. Nominative v. real exchange rates real rate has been adjusted for price changes. 2. Hobson’s Choice: when faced with a change in real value, do you keep price constant (changing sales) or change prices (change profits)

3. SUMMARY a. the economic impact of a currency change depends on the offset by the difference in inflation rates or the real exchange rate. b. It is the relative price changes that ultimately determine a firm’s long-run exposure.

PART II. THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES
II. ECONOMIC CONSEQUENCES A. Transaction exposure 1. On-balance sheet 2. Off-balance sheet

THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES
II. ECONOMIC CONSEQUENCES (con’t) B. Operating Exposure : real rate change 1. Pricing flexibility is key. 2. Product differentiation 3. Substitution of inputs

THE ECONOMIC CONSEQUENCES OF EXCHANGE RATE CHANGES
II. SUMMARY The sector of the economy in which the firm operates; the sources of the firm’s inputs; and fluctuations in the real exchange rate delineate the firm’s true economic exposure.

PART III. IDENTIFYING ECONOMIC EXPOSURE
III. CASE STUDIES OF ECONOMIC EXPOSURE A. ASPEN SKIING COMPANY 1. Firm’s exchange rate risk affected its sales revenues.

A. ASPEN SKIING COMPANY (con’t) 2. Although there was no translation risk, the global market with its exchange rate risk and its competitors impacted market demand

B. PETROLEOS MEXICANOS (PEMEX) 1. The firm’s exchange rate risk affected cost but not revenues. 2. Economic impact a. Revenues: none b. Costs: decreased c. Net effect: increased US$ flows

IDENTIFYING ECONOMIC EXPOSURE
C. TOYOTA MOTOR COMPANY 1. Exchange rate risk affected BOTH revenues and costs. 2. Flow back effect: previously exported goods return with increased domestic competition. 3. Lower profit margins domestically

PART IV. CALCULATING ECONOMIC EXPOSURE
IV. A quantitative assessment of economic exposure depends on underlying assumptions concerning: A. future cash flows; B. sensitivity to exchange rate changes.

PART V. AN OPERATIONAL MEASURE OF EXCHANGE RISK
V. NEED FOR A WORKABLE APPROACH A. Regression Analysis 1. Variables a. Independent: changes in parent’s cash flows b. Dependent: Average nominal exchange rate change.

AN OPERATIONAL MEASURE OF EXCHANGE RISK
B. REGRESSION EQUATION -approach based on the operational definition of the exchange risk faced by a parent or one of its affiliates: -a company faces exchange risk to the extent that variations in the dollar value of the unit’s cash flows are correlated with variations in the nominal exchange rate

where CFt = CFt - CFt-1 is the dollar value of total affiliate(parent) cash flows in period t EXCHt = EXCHt - EXCHt-1 equals the average nominal exchange rate during period t u = a random error term

1. Output measures: a. Beta coefficient (b) measures the association of changes in cash flows to exchange rate changes.

b. the higher the percentage change of cash flow to changes in exchange rates, the greater the economic exposure (higher beta values).

VI. SUMMARY: A. The focus of the accounting profession on the balance sheet impact of currency changes has led to ignoring the important impact on future cash flows.

B. For firms incurring costs and selling products in foreign countries, the net effect of currency changes may be less important in the long run.

C. To measure exposure properly, you must focus on inflation-adjusted or real exchange rates instead of nominal or actual exchange rates.

D. It is difficult in practice to determine what the actual economic impact of a currency change will be.

CHAPTER 12 INTERNATIONAL FINANCING AND INTERNATIONAL FINANCIAL MARKETS