Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-1

Chapter 5Chapter 5 The Nature of Foreign Exchange Risk The Nature of Foreign Exchange Risk

5.1 Exposure to Currency Risk

5.2 The Real Exchange Rate

5.3 The Effect of Changes in Real Exchange Rates

5.4 The Empirical Behavior of Exchange Rates

5.5 Exchange Rate Forecasting

5.6 Summary

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 riskA taxonomy of exposures to forex risk

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

Translation exposure: changes in financial statements due to unexpected changes in exchange rates (also called accounting exposure)

Realassets

Monetaryassets

Commonequity

Monetaryliabilities

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-3

A survey of corporate treasurersA survey of corporate treasurersand financial officersand 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 1995.

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 rateChange in the nominal exchange rate

EXAMPLE S0¥/$ = ¥100/$, E[p¥] = 0%, E[p$] = 10%

RPPP E[S1¥/$] = S0

¥/$ (1+ p¥)/(1+ p$) = ¥90.91/$

¥130/$

¥120/$

¥110/$

¥100/$

¥90/$

¥80/$

t=0 t=1

In real (purchasing power) terms, the dollar has

appreciated by (¥110/$)/(¥90.91/$)1 = +.21,

or 21 percent more than expected.

St¥/$

Actual S1¥/$ = ¥110/$

E[S1¥/$] = ¥90.91/$

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-5

The law of one priceThe law of one priceand the international cost of livingand the international cost of living

Location Cost Location Cost

Tokyo 136.2 New York 94.5

Singapore 109.3 Montreal 69.4

Berlin 74.0 Moscow 93.4

London 101.4 Paris 91.1

Zurich 100.0 Mexico City 62.1

Seoul 96.7 Taipei 86.1

Buenos Aires 72.4 Shanghai 85.5

Hong Kong 95.2 Sydney 79.2

Source: Union Bank of Switzerland, 1997.

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-6

The real exchange rateThe real exchange rate

The real exchange rate adjusts the nominal exchange rate for differential inflation since an arbitrarily defined base period.

Change in the real exchange rate is defined by:

1+xtd/f = (St

d/f / St-1d/f) [(1+pt

f)/(1+ptd)]

where

xtd/f = % change in the real exchange rate

Std/f = the nominal spot rate at time t

ptc = inflation in currency c during period t

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-7

Percentage changes in real exchange ratesPercentage changes in real exchange rates

Xtd/f= level of the real exchange rate

xtd/f = (St

d/f / St-1d/f) [(1+pt

f)/(1+ptd)]1

= [(¥110/$)/(¥100/$)][(1.10)/(1.00)] = 1.21, or a 21% increase

130%

120%

110%

100%

90%

80%

t=0 t=1

Real value of the dollar has appreciated by 21 percent.

Xt¥/$

X1¥/$ = X0

¥/$ (1+ x1¥/$) = 1.21 = 121%

Base: X0¥/$ = 1.00 = 100%

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-8

Real value of the dollarReal value of the dollar(1970-1998)(1970-1998)

Mean level = 100 for each series

0%

50%

100%

150%

200%

Jan 1970 Jan 1975 Jan 1980 Jan 1985 Jan 1990 Jan 1995

U.K.

Japan Germany

Kirt C. Butler, Multinational Finance, South-Western College Publishing, 2e 5-9

The empirical behaviorThe empirical behaviorof exchange ratesof 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 ratesThe behavior of nominal exchange rates

Exchange rate changes are approximately

normally distributed at each point in time.

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 ratesThe behavior of real exchange rates

Deviations from purchasing power parity can be substantial in the short run.

Real exchange rates can take several years to return to equilibrium.

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 forecastingExchange rate forecasting

Market-Based Exchange Rate Forecasts

» E[Std/f] = Ft

d/f

» E[Std/f] = S0

d/f [(1+id)/(1+if)]t

» E[Std/f] = S0

d/f [(1+pd)/(1+pf)]t

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 financeContinuous time finance(advanced)(advanced)

Recall that

std/f = ln(1+st

d/f) = ln(Std/f/St-1

d/f) = ln(Std/f)ln(St-1

d/f)

and ptd = ln(1+ pt

d) and ptf = ln(1+ pt

f)

Continuously compounded change in the real exchange rate is

xtd/f = ln(1+xt

d/f)

= ln[(Std/f / St-1

d/f ) (1+ ptf )/(1+ pt

d)]

= ln(Std/f) - ln(St-1

d/f) + ln(1+ ptf) - ln(1+ pt

d)