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1. /THE INTERNATIONAL FINANCIAL MARKETPLACE.docKey chapter concepts

forecasting future exchange rates


The equilibrium relationships discussed in the previous sections can be very useful to managers who need forecasts of future spot exchange rates. Although empirical evidence indicates that these relationships are not perfect, the financial markets in developed countries operate in a way that efficiently incorporates the effect of interest rate differentials in the forward market and the future spot exchange market. Therefore managers can use the information contained in forward rates and interest rates to make forecasts of the future spot exchange rates. These forecasts are useful, for example, when pricing products for sale in international markets, when making international capital investment decisions, and when deciding whether to hedge foreign currency risks.

Using Forward Rates


The simplest forecast of future spot exchange rates can be derived from current forward rates. If the one-year forward rate of exchange between dollars and yen is 110 yen/dollar, then this can be used as an unbiased estimate of the expected one-year future spot rate of exchange between dollars and yen. For example, if Boeing were negotiating the sale of a Boeing 737 airliner to Japan Air with delivery and payment to take place in one year, and if Japan Air insisted on a price quoted in yen, then Boeing could use this forward rate to convert its desired dollar proceeds from the transaction into yen. As we will see below, Boeing may want to hedge against the risk of a change in this exchange rate between the time the contract is signed and the time the plane is delivered and payment is received.

Using Interest Rates


Forward rates provide a direct and convenient forecast of future spot currency exchange rates. Unfortunately, forward quotes normally are not readily available beyond one year. Hence, if a manager needs a longer-term currency exchange rate forecast, forward rates are of little help. Fortunately, one can use observed interest rate differentials between two countries, and the general international Fisher effect (IFE) relationship lo make longer-term exchange rate forecasts. Recall from Equation 3.9 that the IFE relationship is given as



This relationship can be modified to cover more than one period into the future as follows:

(3.10)

For example, assume that the annual nominal interest rate on five-year U.S. Treasury bonds is 6 percent, and the annual nominal interest rate on five-year Swiss government bonds is 4.5 percent. Also, assume that the current spot exchange rate between dollars and Swiss francs (SFr) is $0.6955/SFr. What is the expected future spot rate in five years? It can be calculated using Equation 3.10 as follows:

S5/$0.6955 = (1 + 0.06)5 / (1+0.045)5

S5 = $0.7469

The IFE relationship predicts that the dollar will lose value relative to the SFr. The expected spot exchange rate in five years is $0.7469/SFr.

One could also use the PPP relationship to forecast future exchange rates. However, the advantage of the IFE relationship is that interest rates between two countries are readily observable for almost any maturity, whereas differential levels of future inflation are not. In order to use PPP to make exchange rate forecasts, one would first have to forecast the inflation rates in both countries. Hence it is normally desirable to use the IFE relationship when making longer-term exchange rate forecasts, such as might be needed when evaluating foreign long-term invest­ment projects with cash flows extending several years into the future.

foreign exchange risk


Foreign exchange risk is said to exist when a portion of the cash flows expected to be received by a firm are denominated in foreign currencies. As exchange rates change, there is uncertainty about the amount of domestic currency that will be received from a transaction denominated in a foreign currency. There are three primary categories of foreign exchange risk that multinational firms must consider.

1. Transaction exposure (short-term)

2. Economic (operating) exposure (long-term)

3. Translation (accounting) exposure

Transaction Exposure


Most firms have contracts to buy and sell goods and services, with delivery and payment to occur at some time in the future. If payments under the contract involve the use of foreign currency, additional risk is involved.

For example, General Electric is major producer of locomotives. Suppose that General Electric contracts with the Mexican government to sell 100 locomotives for delivery one year from now. General Electric wants to realize $400 million from this sale. The Mexican government has indicated that it will only enter into the contract if the price is stated in Mexican pesos (Ps). The one-year forward rate is Ps3.11/$. Hence General Electric quotes a price of Psl,244,000,000. Once the contract has been signed, General Electric faces a significant transaction exposure. Unless General Electric takes actions to guarantee its future dollar proceeds from the sale—that is, unless it hedges its position, for example, by selling Psl,244,000,000 in the one-year forward market—it stands to lose on the transaction if the value of the peso weakens. Suppose that over the coming year the inflation rate in Mexico rises significantly beyond what was expected at the time the deal was signed. According to relative PPP, the value of the peso can be expected to decline, say to Ps4/$. If this happens, General Electric will receive only $311 million (Psl,244,000,0007 Ps4/$) rather than the $400 million it was expecting.

One well-documented example of the potential consequences of transaction exposure is the case of Laker Airlines. In the late 1970s, in the face of growing demand from British tourists traveling to the United States, Laker purchased several DC-10 aircraft and financed them in U.S. dollars. This transaction ultimately led to Laker's bankruptcy because Laker's primary source of revenue was pounds sterling, whereas its debt costs were denominated in dollars. Over the period from the late 1970s to 1982, when Laker failed, the dollar strength­ened relative to the pound sterling. This had a devastating effect because (1) the strong dollar discouraged British travel to the United States, and (2) the pound sterling cost of principal and interest payments on the dollar-denominated debt increased.

Managing Transaction Exposure. A number of alternatives are available to a firm faced with transaction exposure. First, the firm may choose to do nothing, and simply accept the risk associated with the transaction. Doing nothing works well for firms with extensive international transactions that may tend to cancel each other out. For example, if General Electric has purchased goods or services from Mexican firms that require the payment in approximately the same number of pesos as it expects to receive from the sale of the locomotives, then it is not necessary to do anything to counter the risk arising from a loss in value of the peso relative to the dollar.

A second alternative is to invoice all transactions in dollars (for a U.S.-based firm). This avoids any transaction risk for the U.S. firm, but shifts this risk to the other party.


Table 3-5. Example of Transaction Exchange Rate Risk






AMOUNT OF

TRANSACTION

DATE

EXCHANGE RATE

U.S. Dollars

British Pounds

Purchase date

$1.69/pound

$3,380,000

£2,000,000

Payment date

$1.74/pound

$3,480,000

£2,000,000

For example, in September 1992, in a period of extreme volatility of European currencies, Dow Chemical announced that it would use the German mark as the common currency for all of its European business transactions. This action shifts currency risks from Dow to its customers who do business in other currencies. When a firm is considering this alternative, it needs to determine whether this strategy is competitively possible, or whether parties on the other side of the transaction may resist or perhaps insist on a lower price if they are forced to bear all of the transaction risk. In Dow's case, analysts and competitors doubted that customers would be willing to bear all of the exchange rate risk and fell that Dow would ultimately abandon this strategy.

Two hedging techniques that are possible for a U.S. company to protect itself against transaction exposure are:

  • Execute a contract, in the Forward exchange market or in the foreign exchange futures market.

  • Execute a money market hedge.

Consider a situation in which Westinghouse purchases materials from a British supplier, Commonwealth Resources, Ltd. Because the amount of the transaction (£2 million) is stated in pounds, Westinghouse bears the exchange risk. This example of transaction exposure is illustrated in Table 3-5. Assume that Commonwealth Resources extends 90-day trade credit to Westinghouse and that the value of the pound unexpectedly increases from $1.69/pound on the purchase date to $1.74/pound on the payment date. If Westinghouse takes the trade credit extended to it, the cost of, the purchase effectively increases from $3.38 million to $3.48 million (that is, £2,000,000 x $1.74/pound).

First, Westinghouse could execute a contract in the forward exchange market to buy £2 million at the known 90-day forward rate, rather than at the uncertain spot rate prevailing on the payment date. This is referred to as a forward market hedge. Assume, for example, that the 90-day forward rate is $1.7()/pound. Based on this rate, Westinghouse effectively would be able to exchange $3.4 million (that is, £2,000,000 x $1.70/pouiid) 90 days later on the payment date when it is required to pay for the materials. Thus, Westinghouse would be able to take advantage of the trade credit and, at the same time, hedge against foreign exchange risk.

A second hedging technique, called a money market hedge, involves Westinghouse borrowing funds from its bank, exchanging them for pounds at the spot rate, and investing them in interest-bearing British securities to yield £2 million in 90 days. By investing in securities that mature on the same date the payment is due to Commonwealth Resources (that is, 90 days after the purchase date), Westinghouse will have the necessary amount of pounds available to pay for the materials. The net cost of this money market hedge to Westinghouse will depend on the interest rate on the funds it borrows from its bank relative to the interest rate on the funds it invests in securities. If the conditions of interest rate parity are satisfied, these two hedging techniques are equivalent.

Other transaction risk reduction strategies include the use of options on foreign currencies (discussed in Chapter 19) and negotiating a risk-sharing contract between the two parties to a transaction in which the both parties agree in advance to share in some way the financial consequences of changes in value between the affected currencies.

For large multinational companies, there will be many international transac­tions involving many different currencies. Attempting to hedge separately the transaction exposure for each international transaction would be time consum­ing and inefficient. For example, consider Sara Lee Corporation which has operations both in Italy and France. The Italian subsidiary makes purchases in France that require French francs. At the same time the French subsidiary makes purchases in Italy that require Italian lira. To the extent that these transactions offset, no hedge is necessary. Multinational firms often make thousands of overlapping transactions using different currencies. Thus it is a complex matter to keep track of net currency exposures and avoid hedging against risks that do not really exist when one takes the consolidated corporate view, rather than the narrow subsidiary view of exchange risk.
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