1. Foreign-Exchange Risk, Forecasting
Topic 3
Foreign-Exchange Risk, Forecasting

2. Foreign Exchange Risk, Forecasting
Why we need to be aware of Foreign Exchange Risk?
International business involves foreign exchange risk because the value of transactions is sensitive to changes in the exchange rate.
Why we need to forecast the future spot exchange rate?
Forecasting exchange rates is an important part of the decision-making process of international firms and investors.

3. Topics to be Covered Types of Exchange Risk
Hedging Against Foreign Exchange Risk
Foreign Exchange Risk Premium
Efficient Market
Evaluating the Performance of Foreign Exchange Forecasting

4. Types of Foreign Exchange Risk
Translation Exposure(转换风险)—also called accounting exposure, is the difference between foreign-currency-denominated assets and foreign-currency-denominated liabilities. P152
Translation exposure occurs when a foreign- currency-denominated balance sheet is translated into the parent company’s home currency.

5. Types of Exchange Rate Risk
Transaction Exposure （交易风险）—results from the uncertain domestic currency value of a foreign-currency-denominated transaction to be completed at some future date. P153
Transaction exposure occurs when the firm commits to a future transaction without hedging via forward instruments.

6. Economic Exposure（经济风险）—the risk to the value of the firm arising from exchange rate changes. This exposure is the most important to the firm.

7. 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).

8. Risk Premium (风险升水/风险溢价)
The foreign exchange risk premium is the difference between the forward rate and the expected future spot rate. (F – E*t +1)/Et that induce others to take the risk.
iUS=0.100, iUK=0.124, Et=$2.10, F = $2.05, What will you do under this circumstance?
But if your expectation of the future spot rate is
E*t +1 = $2.00? Would you take any action?

9. iUS=0.100, iUK +[(E*t+1 – Et )/Et ]=0.124 – 0.048=0.076
the difference is the risk premium
iUS – [(E*t+1 – Et )/Et ] – iUK = (F – E*t +1)/Et = 0.024

10. Risk Aversion (风险厌恶)
Risk aversion (风险厌恶) is the tendency of investors to prefer less risk to more risk. Risk aversion implies that people must be paid to take risk.

11. 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 (even to the rumors).
It’s a controversial issue of the high efficiency of the foreign exchange market.

12. Foreign Exchange Forecasting
Efficient Markets Approach
Financial Markets are efficient if prices reflect all available and relevant information.
If this is so, exchange rates will only change when new information arrives, thus:
E[St+1] =St
and
Ft = E[St+1| It]
Ft is the today’s forecast for tomorrow

13. Evaluation of Foreign Exchange Forecasting
Current spot rate: ￥120=$1
Current 12-m forward exchange rate: ￥115=$1
Mr. A forecast: ￥106=$1
Mr. B forecast: ￥116=$1
Future spot rate realized in 12-m: ￥113=$1
Whose forecast is better?

14. 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.

15. Performance of the Forecasters
Forecasting is difficult, especially with regard to the future.
As a whole, forecasters cannot do a better job of forecasting future exchange rates than the forward rate.
The founder of Forbes Magazine once said:
“You can make more money selling advice than following it.”