1. Michael Melvin and Stefan Norrbin
International Money & Finance Chapter 8: Foreign Exchange Risk and Forecasting
Michael Melvin and Stefan Norrbin

2. Outline of Chapter 8 Types of foreign exchange risk
Translation exposure
Transaction exposure
Economic exposure
How to hedge against risks
Foreign exchange risk premium
Market efficiency
Foreign exchange forecasting

3. Foreign Exchange Risk
Foreign exchange risk – the variability of the firm’s value arises from uncertainty about the future exchange rates.
Foreign Exchange Risk Exposure – the degree to which a company is affected by exchange rate changes.
International assets and liabilities in foreign currencies could bring profits or losses to the firm depending on the future directions of exchange rates.

4. Three Types of Foreign Exchange Risk
Translation exposure
Accounting exposure from translating financial statement from one currency to another currency.
Transaction exposure
Exposure from the uncertain currency value of a foreign-denominated transaction to be completed at some future date.
Economic exposure
Exposure from changes in exchange rates to the firm’s present value of future cash flows.

5. Translation Exposure
Translation exposure – the difference between foreign-currency-denominated assets and foreign-currency-denominated liabilities.
Translation is the process of expressing financial statements from one currency to another currency.
For example, the IBM-France subsidiary translates its euro-denominated balance sheet into dollars to be included in the IBM headquarter’s balance sheet.

6. Example: Translation Exposure
Assets
Liabilities
Equity
IBM France (in euro)
€11,000,000
€5,000,000
€6,000,000
IBM France: Dollar Translation (if exchange rate $1 = €1)
$11,000,000
$5,000,000
$6,000,000
IBM France: Dollar Translation (if exchange rate $0.90 = €1)
$9,900,000
$4,500,000
$5,400,000
When the IBM Headquarter consolidates financial statements from France subsidiary, the statements have to be translated into dollars.
The exchange rate value affects the book value of the firm.
If the euro depreciates against the dollar, the equity of France subsidiary will fall (even though the branch may not incur any operations losses).
Note that the euro position of this firm is unchanged.
Equity is assets minus liabilities, which represent the accounting value of the firm.

7. Transaction Exposure This is contractual exposure.
Suppose that IBM-France has contracted to deliver goods to Japanese firm and allow 30-day credit for payment. Suppose the contract calls for the payment of ¥100,000 in 30 days.
The current exchange rate ¥100=€1. The IBM-France would get paid €1,000 (if exchange rate remains the same).
If the yen unexpectedly depreciates (¥200=€1), IBM-France would receive ¥100,000 that would be worth only €500. Thus, this transaction is not as profitable as originally planned on the contract day.
Had the contract been written to specify payments in euros, then the transaction exposure of IBM-France would have been eliminated. But, the Japanese firm would now have the transaction exposure.

8. Economic Exposure
Economic Exposure – the sensitivity of the dollar value (domestic currency) of future operating income to unexpected changes in exchange rate.
When a firm incurs costs and sells its products in foreign countries, exchange rate risk affects the firm’s revenues, cost, or both.
Thus, the firm’s future cash flows could increase or decrease from changes in exchange rate.

9. How to manage exposure?
Goal: to reduce variability of consolidated earning, obligations, and cash flows from foreign subsidiary to unanticipated changes in exchange rates.
How to reduce risk:
Hedge in forward, futures, or options markets
Invoice in the domestic currency
Rush payments of currencies expected to appreciate.
Rush collection of currencies expected to depreciate.

10. Risk
Imagine that you're a contestant on a TV game show. You have just won $10,000. The host offers you a choice: You can quit now and keep the $10,000, or you can play again. If you play again, there is a 0.5 probability that you will win again, and wind up with $20,000. If you play again and lose, you lose your $10,000 and take home nothing. Which one do you choose?**
Now ask yourself: How high would the payoff on the second game have to be to entice you to take the risk, rather than keep the sure $10,000? 
Most people are risk averse. When two options give the same expected returns, they will prefer the option with the lowest risk.
Risk aversion – preferring less risk to more risk and being willing to pay more money to take a risky option.
** The example of risk aversion is taken from Samuel Baker, Economic Interactive Tutorials, University of South Carolina, 2007.

11. Foreign Exchange Risk Premium
In the “uncovered interest rate parity,” we assume that the forward rate is the unbiased predictor of the future spot exchange rate.
So, should the 90-day forward rate be equal to expected spot rate in 90 days, FS/£ = Set+90?
If banks worry about the ability to diversify risk, then they might charge a premium, just like insurance companies.
FS/£ = Set+90 ± risk premium
For example, a bank may charge FS/£ = 2.30, even if Set+90 = So, the bank wants a 0.10 risk premium on the pound.

12. Uncovered Interest Rate Parity
From “Covered Interest Rate Parity” (CIRP), we have:
𝑖 𝑈𝑆 − 𝑖 𝑈𝐾 = ( 𝐹 $/£ − 𝑆 𝑡 ) 𝑆 𝑡
If F$/£=Set+1, then
𝒊 𝑼𝑺 − 𝒊 𝑼𝑲 = ( 𝑺 𝒕+𝟏 𝒆 − 𝑺 𝒕 ) 𝑺 𝒕
Expected premium
This condition is called “Uncovered Interest Rate Parity (UIRP).”

13. What if F$/£ ≠ Set+1 From F$/£=Set+1
𝒊 𝑼𝑺 − 𝒊 𝑼𝑲 = ( 𝑺 𝒕+𝟏 𝒆 − 𝑺 𝒕 ) 𝑺 𝒕
What if the forward rate contains a premium?
if F$/£ ≠ Set+1
F$/£ = Set+1 ± risk premium
expected £ banks charge for uncertainty
value in this currency
We will calculate the size of the risk premium.

14. Computing the Risk Premium
We can compute the size of the premium (in percent) by using CIRP and the expected exchange rate change:
CIRP: 𝑖 𝑈𝑆 − 𝑖 𝑈𝐾 = ( 𝐹 𝑡 − 𝑆 𝑡 ) 𝑆 𝑡 (1)
Expected change: ( 𝑆 𝑡+1 𝑒 − 𝑆 𝑡 ) 𝑆 𝑡 (2)
Subtract (2) from both sides of (1):
𝑖 𝑈𝑆 − 𝑖 𝑈𝐾 − 𝑆 𝑡+1 𝑒 − 𝑆 𝑡 𝑆 𝑡 = 𝐹 𝑡 − 𝑆 𝑡 𝑆 𝑡 − 𝑆 𝑡+1 𝑒 − 𝑆 𝑡 𝑆 𝑡 = 𝐹 𝑡 −𝑆 𝑡+1 𝑒 𝑆 𝑡
risk premium

15. Three types of premium (in percent)
Forward premium
( 𝐹 𝑡 − 𝑆 𝑡 ) 𝑆 𝑡
Expected premium
( 𝑆 𝑡+1 𝑒 − 𝑆 𝑡 ) 𝑆 𝑡
Risk premium
𝐹 𝑡 −𝑆 𝑡+1 𝑒 𝑆 𝑡
Note that forward premium less the expected premium must be equal to the risk premium.

16. Example: Calculating the risk premium
ius = 11%
iuk = 1%
S$/£ = 2.00
F$/£ = 2.20
Set+1,$/£ = 2.40
How much is a risk premium charged by banks?

17. Example: Calculating the risk premium
ius = 11%, iuk = 1%, S$/£ = 2.00, F$/£ = 2.20, Set+1,$/£ = 2.40
Forward premium
( 𝐹 𝑡 − 𝑆 𝑡 ) 𝑆 𝑡,$/£ ×100= 2.20− ×100=10%
Expected premium
( 𝑆 𝑡+1 𝑒 − 𝑆 𝑡 ) 𝑆 𝑡,$/£ ×100= 2.40− ×100=20%
Risk premium
𝐹 𝑡 −𝑆 𝑡+1 𝑒 𝑆 𝑡 ×100= 2.20− ×100=−10%

18. Compare two returns in this example
Normally, the expected returns from holding the U.S. bonds and the U.K. bonds are:
iUS iUK + forward premium on the pound
11% % + 10% =11%
But when we replace the forward premium with the expected premium, we get:
iUS iUK + expected premium on the pound
11% % + 20% =21%
So, the forward return is less than what we would expect the U.K. bonds to yield.
Why are investors willing to accept lower return on the pound than they expect?

19. Does this mean that the markets are inefficient?
A market is efficient if prices reflect all available information.
That is, the forward and spot rates will quickly adjust to new information so that no investor can make profit consistently from foreign exchange trading.
On average, your profits and losses even out.
With the efficient market, the forward rate would differ from the expected future spot rate only by a risk premium.

20. Foreign Exchange Forecasting
If a forward rate does not perfectly reflect the expected future spot rate, whoever could forecast more accurately than the rest of the market could make enormous profits.
We will focus on how to judge a good forecast. Also, from a firm’s point of view, should we buy a forward contract or not?
Ex: A Japanese firm has to pay $1,000,000 in 90 days.
S$/¥ =120
F$/¥ = 115
Se$/¥ = ?
Should the firm buy forward contract?
Need to forecast Se$/¥ and compare your forecast to F$/¥ .

21. Forecasting styles Two general forecasting techniques:
Structural forecast
It is a fundamental-based model using information that believe to be importance to changes in exchange rates, such as fiscal and monetary policy, international trade flow, and political stability.
IHS Global Insight’s structural model. The model is a large number of behavioral equations (>1,000 equations in each model) to forecast the exchange rate and other economic variables.
Atheoretical, mechanical forecast
This is a technical trading model. It uses the path of the exchange rate movements in the past to predict the future level.
Use wave models and charts to capture empirical patterns and regularities of the exchange rate.

22. How well does the forward rate forecast the future spot rate?
In real world data, the forward rate tends to follow the movements of the current spot rate. It does not forecast the future spot rate well at all.
In this hypothetical example, when the dotted line of the forward rate exceeds the solid line of the current spot rate, then the pound is expected to appreciate.
In this example, F > S most of the time, so there is a forward premium on the pound almost the whole time.
However, the spot rate (S) swings down many times in the graph. Often, the forward rate forecasts the incorrect direction of the spot rate.

23. What is a good forecast?
How should we judge a forecast of the future spot rate?
A good forecast should be on the “correct side” in relative to the forward rate in order to determine the right hedging strategy.
The “correct side” means that the forecast makes us choose correctly whether to use the forward market or not.
Note that being close does not matter.
For example, Forecasted Set+1 < Ft → expected future spot rate lowers than the forward rate → then we should not use the forward market and wait to use the spot rate in the future.

24. Example: Compare 2 competing exchange rate forecasts
A Japanese firm has to pay $1 million in 90 days
Current situation:
Spot rate: St = 120 ¥/$
Forward rate: Ft = 115 ¥/$
Decisions:
Buy forward now, if Set+1 > Ft
Wait and buy spot in 90 days, if Ft > Set+1
Two forecasts:
Forecast A: Set+1 = 106 → wait
Forecast B: Set+1 = 116 → buy forward
Suppose the spot rate 90 days from now would turn out to be: St+1 = 113.
Which one is a good forecast?

25. Example (continued) A Japanese firm has to pay $1 million in 90 days.
Two forecasts:
Forecast A: Set+1 = 106 → wait
Forecast B: Set+1 = 116 → buy forward at Ft = 115 ¥/$
Suppose the dollar actually costs 113 yens in the spot market 90 days from now, St+1 = 113.
If we follow each forecast, we would pay
Forecast A: wait → ¥ 113 million
Forecast B: buy forward → ¥ 115 million
A is a “better” forecast.
Although B is the closest forecast (small forecasting error), but the forecast A saves the firm some money. Thus, from the firm’s point of view, the forecast A is a “good” forecast.

26. Conclusions
Foreign exchange risk includes translation exposure, transaction exposure, and economic exposure.
The foreign exchange risk premium is the difference between the forward exchange rate and the expected future spot exchange rate.
The difference between the return on a domestic asset and the effective return on a foreign asset depends on the risk of the assets and the degree of risk aversion.
The effective return differential is equal to the risk premium in the forward exchange market.

27. Conclusions
If a positive risk premium on the domestic currency exists, investors would be willing to hold foreign investments even if the foreign investments yield lower expected returns than the domestic investments.
In an efficient market, prices reflect all available information. If the foreign exchange market is efficient, the forward exchange rate would differ from the expected future spot exchange rate only by a risk premium.
For multinational firms, a good forecast is not necessarily minimizing forecasting errors, but it should be on the correct side of the forward exchange rate.