Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-1 Chapter 5 The Nature of Foreign Exchange Risk 5.1Exposure to Currency Risk 5.2The Real Exchange Rate 5.3The Effect of Changes in Real Exchange Rates 5.4The Empirical Behavior of Exchange Rates 5.5Exchange Rate Forecasting 5.6Summary Appendix 5-A Real Exchange Rates in Continuous Time

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-2 A taxonomy of exposures to forex risk F Economic exposure: change in the value of all future cash flows due to unexpected changes in exchange rates  Transaction exposure: change in the value of contractual cash flows  Operating exposure: change in the value of non-contractual cash flows F Translation exposure: changes in financial statements due to unexpected changes in exchange rates (also called accounting exposure) Real assets Monetary assets Common equity Monetary liabilities

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-3 A survey of corporate treasurers and financial officers Do you agree or disagree with the following statements? Mean score “Managing transaction exposure is important.”1.4 “Managing economic exposure is important.”1.8 “Managing translation exposure is important.”2.4 Key: 1= strongly agree,... 3=neutral,... 5= strongly disagree Source: Kurt Jesswein, Chuck C.Y. Kwok, William R. Folks, Jr., “Adoption of Innovative Products in Currency Risk Management: Effects of Management Orientations and Product Characteristics,” Journal of Applied Corporate Finance, Fall Transaction exposure is viewed as the most important currency risk exposure

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-4 Change in the nominal exchange rate EXAMPLES 0 ¥/$ = ¥100/$, E[p ¥ ] = 0%, E[p $ ] = 10% RPPP  E[S 1 ¥/$ ] = S 0 ¥/$ (1+ p ¥ )/(1+ p $ ) = ¥90.91/$ ¥130/$ ¥120/$ ¥110/$ ¥100/$ ¥90/$ ¥80/$ t=0t=1 + In real (purchasing power) terms, the dollar has appreciated by (¥110/$)/(¥90.91/$)  1 = +.21, or 21 percent more than expected. S t ¥/$ Actual S 1 ¥/$ = ¥110/$ E[S 1 ¥/$ ] = ¥90.91/$

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-5 The law of one price and the international cost of living Location Cost Tokyo136.2New York94.5 Singapore 109.3Montreal69.4 Berlin74.0Moscow93.4 London101.4Paris91.1 Zurich100.0Mexico City62.1 Seoul96.7Taipei86.1 Buenos Aires72.4Shanghai85.5 Hong Kong95.2Sydney79.2 Source: Union Bank of Switzerland, 1997.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-6 The real exchange rate F The real exchange rate adjusts the nominal exchange rate for differential inflation since an arbitrarily defined base period. F Change in the real exchange rate is defined by: 1+x t d/f = (S t d/f / S t-1 d/f ) [(1+p t f )/(1+p t d )] where x t d/f = % change in the real exchange rate S t d/f = the nominal spot rate at time t p t c = inflation in currency c during period t

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-7 Percentage changes in real exchange rates X t d/f = level of the real exchange rate x t d/f = (S t d/f / S t-1 d/f ) [(1+p t f )/(1+p t d )]  1 = [(¥110/$)/(¥100/$)][(1.10)/(1.00)] = 1.21, or a 21% increase 130% 120% 110% 100% 90% 80% t=0t=1 + Real value of the dollar has appreciated by 21 percent. X t ¥/$ X 1 ¥/$ = X 0 ¥/$ (1+ x 1 ¥/$ ) = 1.21 = 121% Base: X 0 ¥/$ = 1.00 = 100%

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-8 Real value of the dollar ( ) Mean level = 100 for each series

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-9 The empirical behavior of exchange rates Statistical thinking will one day be as necessary for efficient citizenship as the ability to read and write. H.G. Wells

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-10 The behavior of nominal exchange rates F Exchange rate changes are approximately normally distributed at each point in time. F At each point in time, exchange rate variance is related to whether the most recent exchange rate changes have been large or small. (That is, variance is autoregressive.)

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-11 The behavior of real exchange rates F Deviations from purchasing power parity can be substantial in the short run. F Real exchange rates can take several years to return to equilibrium. F Real exchange rates are autoregressive (that is, they depend on previous levels).

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-12 Exchange rate forecasting F Market-Based Exchange Rate Forecasts »E[S t d/f ] = F t d/f »E[S t d/f ] = S 0 d/f [(1+i d )/(1+i f )] t »E[S t d/f ] = S 0 d/f [(1+p d )/(1+p f )] t F Model-Based Exchange Rate Forecasts »Technical analysis - uses the past history of exchange rates to predict future exchange rates »Fundamental analysis - uses macroeconomic data to predict future exchange rate changes

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-13 Continuous time finance (advanced) Recall that s t d/f = ln(1+s t d/f ) = ln(S t d/f /S t-1 d/f ) = ln(S t d/f )  ln(S t-1 d/f ) andp t d = ln(1+ p t d ) and p t f = ln(1+ p t f ) Continuously compounded change in the real exchange rate is x t d/f = ln(1+x t d/f ) = ln[(S t d/f / S t-1 d/f ) (1+ p t f )/(1+ p t d )] = ln(S t d/f ) - ln(S t-1 d/f ) + ln(1+ p t f ) - ln(1+ p t d )