© 2004 by Nelson, a division of Thomson Canada Limited Chapter 18: Managing International Risk Contemporary Financial Management

© 2004 by Nelson, a division of Thomson Canada Limited 2 Introduction  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.

© 2004 by Nelson, a division of Thomson Canada Limited 3 Factors Affecting Exchange Rates  Supply and Demand  Economic Conditions Inflation Interest rates  Government trade policies  Political stability Risk of expropriation

© 2004 by Nelson, a division of Thomson Canada Limited 4 Why Exchange Rates Fluctuate Theories of Currency Fluctuation Interest Rate Parity Purchasing Power Parity Expectations Theory (Hypothesis) International Fisher Effect Absolute Relative

© 2004 by Nelson, a division of Thomson Canada Limited 5 Interest Rate Parity  Forward rate will differ from spot rate to offset interest rate differences  If not covered, interest arbitrage will move rates back to parity

© 2004 by Nelson, a division of Thomson Canada Limited 6 Absolute PPP: The Law of One Price  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

© 2004 by Nelson, a division of Thomson Canada Limited 7 Relative Purchasing Power Parity  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

© 2004 by Nelson, a division of Thomson Canada Limited 8 Expectations Theory  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

© 2004 by Nelson, a division of Thomson Canada Limited 9 International Fisher Effect  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

© 2004 by Nelson, a division of Thomson Canada Limited 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. Example CDN Rate = 6% Japanese Rate = 0.5% Time Horizon = 1 year IRP IRP Dollar will sell at a 5½% discount.

© 2004 by Nelson, a division of Thomson Canada Limited 11 Exchange Rates  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

© 2004 by Nelson, a division of Thomson Canada Limited 12 Foreign Exchange Risk  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

© 2004 by Nelson, a division of Thomson Canada Limited 13 Managing Transaction Exposure  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

© 2004 by Nelson, a division of Thomson Canada Limited 14 Managing Economic Exposure  Shift production  Increase productivity  Outsource  Reduce price sensitivity  Change to markets with strong currencies

© 2004 by Nelson, a division of Thomson Canada Limited 15 Translation Risk  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).

© 2004 by Nelson, a division of Thomson Canada Limited 16 Major Points  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.

© 2004 by Nelson, a division of Thomson Canada Limited 17 Major Points  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.