Currency markets and parity condition

7/30/2019 Currency markets and parity condition

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Copyright 20 03 T hu nderbird, T he American Graduate School of Internation al M anagem ent. All rights reserved.T his case was prepared b y Professor An ant K. Sun daram, w ith research assistance from O m ar C astro (T hun derbird 03 ),for th e purpose of classroom di scussion on ly, and not to in di cate either effective or in effecti ve m an agem ent.

Currency Market s and Parit y Condit ionsIn this Note, we examine one of the most pervasive and influential features of the international environ-men t in which m ultinational enterprises (MN Es) operate: the m arket for national currencies, i.e., theforeign exchange market. Foreign exchange markets create a qualitatively new set of issues for M N Es tomanage, including the different types of exchange rate exposure for its operations. This is so sincecurrencies, and hence transactions denominated in them, do not have a fixed value across borders.Before a manager can start to grapple with the consequences of this fact, it is necessary to understandsome of the underlying forces in the foreign exchange market and the concepts driving these forces.These concepts underpin much of what happens in both the theory and the practice of internationalfinance.

We begin by defining some of the commonly used and necessary terminology. We will then dis-

cuss the theory of purchasing power parity (PPP), one of the most important ideas underlying thetheory and practice of int ernational finance and foreign exchange markets. T he th eory of PPP enablesus to u nd erstand the d istinction between nom inal and real exchange rates, a distinction whose impor-tance will become clear later in the discussion. These ideas will be integrated with those relating to theinfluence of interest rates, which will lead to two ot her crucial und erpinnin gs of int ernational financetheory, th e covered in terest p arity theorem (CIP ) and the u ncovered interest p arity theorem (U IP).

Using these ideas we will summarize the variables that influence the value of currencies in themedium term and examine t he reasons why th ey are argued t o d o so. After providing brief descriptionsof the key institutional features of currency markets, finally this Note briefly addresses the differenttypes of exchange rate exposure that M N Es facetranslation, transaction, and economic exposure.

Before going further it is imp ortant to keep one thin g in mind : the role of an M N E m anager is notto forecast exchange rates. Rather it is first, to appreciate the fact that the uncertainty induced by this

aspect of the international environm ent is real and ubiquitou s, and second, t o m anage and p lan for theeffects of this uncertainty on the op erations and performan ce of the firm. Th is requires us to un derstandthe d ifferent ways in wh ich M N Es are exposed t o exchange rates. Th at in turn requires us to un derstandthe working of the foreign exchange markets, as well as the basic parity conditions, i.e., PPP, CIP, andUIP.

For the purposes of this discussion, and unless otherwise mentioned, the United States (U.S.) willbe considered th e hom e countr y and t he U .S. dollar ($) th e hom e currency. France will be consideredthe foreign count ry and the euro () th e foreign currency. This discussion is, of course, generalizable toany pair of countries and currencies.

Basic D efinitions

The foreign exchange rate is the nominal price of one nations money in terms of anothers, that is, thenu mb er of U.S. dollars it t akes to b uy each .1 The price of one currency in terms of another can be

1 The nominal price is distinct from the real price, as will be made clear shortly.


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quoted either directly or indirectly. A direct quote expresses the foreign exchange rate in terms of thenu mb er of units of hom e currency it t akes to b uy each u nit of foreign currency (the same concept as,say, the number of dollars it takes to buy one hamburger). From the U.S. perspective, a direct quotewould be written $/. An in direct q uote is th e reverseth e nu mb er of un its of foreign currency it takesto buy each unit of home currency (the number of hamburgers per dollar), which would be written/$. To avoid con fusion it is extrem ely im port ant th at we rem ember which of the two quo tat ion meth -

ods is being used; otherwise, just about everything we do in international finance would become topsy-tu rvy. In o ur d iscussion of these basic ideas, we will use the d irect quote ($/) throu ghout. (T he effectsof using the indirect qu ote on all the formulae we develop are shown in t he Appendix to t his chapter.)

The two commonly observed foreign exchange rates are the spot rate (which we denote as e0or,

when t here is no scope for confusion, just e) and the T-periodforw ard rate (which we denote as eT). The

spot rat e is tod ays exchange rate, or th e number of do llars you have to p ay to bu y each.2 In actuality,this transaction is formally settled two business days after the date on which the spot transaction isentered into.

T he T-period forward rate is th e exchange rate available tod ay for tr ansactions th at we may wish tomake at time T. Th at is, we can ent er into an agreement tod ay to, say, deliver100 ninety days hence, atthe 90 -day forward rate known to us, or agreed up on t oday (no m oney changes hands unt il the ninetieth

day). Thu s, for example, we would p ay $(100*e90), 90 d ays from now. Typically, m atur ities are 30, 9 0,180, or 360 days. Forward rates are impor tant for man aging a problem that M N Es face known astransaction exposure to exchange rates, which we will address later in the Note.

The forward rate is conceptually similar to the futures rate. Many of the differences between thetwo are institutional. Therefore, while actual forward rates may differ slightly from actual futures ratesdue to these institutional features (and because there are some valuation differences induced by theeffects of interest rate uncertainty), for our purposes, we will use the two concepts interchangeably.

These two types of exchange rate, however, are different from the expected future spot rate, whichwe will express asE(e

0

T). This rate reflects the expectation the market has about the price of a currencyT days from n ow.E(e

0

T) is, of course, only an expectation and is not known with certainty. We will seelater that the forward rate and the expected future spot rate should be (in theory) closely related.

D epreciation, Appreciation , Prem ium , and D iscount

Using the direct quote, the foreign currency is said to undergo an appreciation relative to the homecurrency when there is an increase in e, and the foreign currency is said to undergo a depreciationrelative to the home currency when there is a decrease in e. Th at is:

e increases foreign currency appreciatione decreases foreign currency depreciation

Using the example of hamburgers, if the price of hamburgers () goes up (the equivalent of anincrease in e), we would say that the hamb urger has becom e more expensive, i.e., it has appreciated vis-

-vis the dollar. To be more specific, suppose the initial exchange rate is $1.00/ and this changes to$1.10/. Th e num ber of dollars we need t o bu y each has gone up (e has increased), and this meansthat has become ten cents more expensive with respect to the dollar, that is, has appreciated.

2 In t he real world, th ere are bid-offer (or bid-ask) spreads in currency quotat ions, that is, a rate at which th eforeign exchange market will buy (b id) currencies from you and a rate at which it will sell (offer) currenciesto you. Bid-offer spreads are quite small for the heavily traded currencies. In order to keep the developmentof ideas conceptually simp le, we ignore bid -offer spreads.


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A foreign currency is said to be at a forward premium if

eT> e

0(1)

That is, if its forward rate is higher than the spot rate. If the inequality is reversed, the foreigncurrency is at a forward discount. T he percentage annualized prem ium (or discount) is

= Te

ee

FPT 360

)100(%0

0

(2)where T is the nu mb er of days forward.

Exchange R ates and Prices: Purchasing Pow er Parity

T he th eory of purchasing p ower parity (PPP), perhaps on e of the most in fluential ideas in all of eco-nomics, establishes a formal link between a countrys price level or inflation rates (relative to anothercountrys) and the prevailing exchange rate between the two countries. There are two well-known ver-sions of this theory, the absolute version and the relative version.

T he absolute PPP relationship says that

P = eP* (3)

where P is the domestic price level, P* is the foreign price level, and e is the spot exchange rate (directquot e). If we think abou t it for a mom ent, all that PPP is about is the absence of arbitrage oppor tun itiesin a frictionless (and u nd ifferentiated) goods market th at is, it says that th e exchange rate will adjust toeliminate discrepancies in p rice levels, or price levels will adjust to eliminate discrepancies in exchangerates, for similar commodities between two countries. Consider an example. Suppose a ton of widgetscosts $1 in the Un ited States and0.90 in France, and t he exchange rate is $1.00/. For a U.S. buyer ofwidgets, the price at the current exchange rate is only $0.90 per ton and thus cheaper. This willincrease the demand for French widgets and decrease the demand for U.S. widgets, raising their price(P*) and lowering th eir U.S. price (P). Furth er in t he process of buying the French widgets, U .S. buyerswill be supplying dollars and d emand ing euros, leading to appreciation of t he euro an d d epreciation ofth e dollar (an increase in e). In equilibrium t hen, t he th eory says that U .S. and French widget prices and

the $/ exchange rate will adjust, resulting in PPP .

A more commonly used definition of PPP is relative PPP (RPPP), which expresses this arbitragerelationship in terms of prices and exchange rates today (time 0) relative to our expectation for somefuture poin t in time (say, time 1). R PPP says that:

=

*

0

*

1

0

1

0

1

P

P

e

e

P

P(4)

where P, P*, and e are as above, and the subscripts 1 an d 0 refer to tom orrow and tod ay, respectively.Equation (4) can be rewritten as

1 + P = (1 + e)(1 + P*) (5)or as,

1*1

1

+

+=

P

Pe (6)

where P is the expected percentage chan ge in d om estic prices, i.e., the dom estic inflation rate, e is the

expected percentage change in exchange rates and P* is the expected percentage change in foreignprices, i.e., the foreign inflation rate.


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What we have just seen is also a simple model for predicting future exchange rates. RPPP tells us

that if the dom estic inflation rate is expected to be higher th an t he foreign inflation rate, then e must

be greater than zero, i.e., the foreign currency is expected to app reciate against the home currency by epercentage poin ts. Specifically, if th e inflation rate in the U .S. durin g the next year is expected to be 3% ,

and t he inflation rate in t he Euro-zone is expected to be 1% , RPPP predicts that e = (1.03/1.01) 1 =0.0198 = 1.98%, or an approximately 2% appreciation of the against the U S$.3

Now we are ready to define real exchange rates, and more importantly changes in real exchangerates. Based on absolute P PP, th e real exchange rate is defined as:

=

P

ePS

*(7)

N ote th at if absolute P PP always holds, then S would be equal to 1. When S is different from 1,there has been a change in the real exchange rate. For instance if the nominal exchange rate, e, rises invalue, i.e., the foreign currency appreciates and neither P nor P* changes, then Swould be greater than1, im plying th at th e foreign currency has appreciated (and the h ome currency has depreciated) in realterms. The intuition is as follows. If PPP held, an increase in e should have been the result of (oraccompanied by) a decrease in foreign prices P* or an increase in domestic prices P. The fact that theyboth stayed the same as before indicates that foreign goods have become more expensive in real termsand/ or do mestic goods have become cheaper in real terms. (T hink about, and convince yourself that, inthis situation, domestic exporters have become better off, and domestic importers have become worseoff than before.)

T he change in the real exchange rate is the nominal, i.e., actual exchange rate change minus thechange in exchange rates predicted by RPPP:

S = [Actual change] [RPPP-predicted change]

= eActual

eRPPP

(8)

where S refers to the percentage change in the real exchange rate, eActual

refers to the percentagechange in the actual exchange rate, i.e., the new exchange rate minus the old change rate divided by the

old exchange rate, and eRPPP the R PPP-p redicted chan ge is as derived from equation (6 ) above.

There is also an effective exchange rate, which is a multilateral rate that measures the overallnominal value of the currency in the foreign exchange market. For example, the effective U.S. dollarexchange rate combin es many bilateral exchange rates using a weightin g scheme that reflects the imp or-tance of each countrys trade with the United States. Several institutions (for example, the InternationalMonetary Fund, the Federal Reserve Board) regularly calculate and report the effective exchange rates.There is also a real effective exchange rate, adjusting for multilateral PPP relationships.

Exchange Rates and Interest Rates

The relationship between exchange rates and nominal interest rates is captured in two simple proposi-

tions: (1) the covered interest parity theorem (CIP) which deals with a no-arbitrage equilibrium ininternational financial markets, and (2) the speculative efficiency hypothesis and the resulting uncov-ered parity theorem (UIP ) which d eals with a speculative equilibrium in in ternational financial mar-kets. Each of th ese is described below.

3 The RPPP relationship is also sometimes expressed in its approximate form, as eP P*, where means approximately equal to. While this approximate form is a useful simplification when expectedann ual inflation rates are low (say, less than 5% ), applying it in th is way can lead to fairly large errors wheninflation rates are high. In general, it is advisable to use the exact formula as given in (6) above, rather thanthe app roximate formu la.


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Covered Interest Parity Theorem

Covered interest parity is the mechanism through which an equilibrium relationship is establishedbetween spot and forward exchange rates, and risk-equivalent domestic and foreign nominal interestrates. This relationship is also sometimes referred to as the interest rate parity theorem or the coveredinterest arbitrage cond ition.

In add ition to the n otation d eveloped th us far, suppose rstands for th e dom estic (U .S.) T-periodnom inal interest rate, and r* stands for the risk-equivalent foreign (French) T-period nominal interestrate. At any given point in time, we can observe e

0, e

T, r, and r*. Is th ere an equilibrium relationship

among these four variables? And if this equilibrium relationship is not met, is there an arbitrage oppor-tunity? The answer to both questions is yes.

Let us illustrate this issue with a simple example. Suppose that the $/ spot exchange rate (e0) is

$1.00/ and the 180-day forward rate (e180

) is $0.98/ (that is, the is at a forward discount vis--visthe dollar). Let us also suppose that the relevant annual interest rate in the U.S., r, is 4% and that thecorresponding French interest rate, r*, is 10% (that is, the 180-day interest rates are 2% and %,respectively).4

Suppose we did the following:

Borrow

02.1$

Xin t he U .S. markets for 18 0 d ays (so that we repay $X in 18 0 d ays);

Convert it into

00.102.1

X;

Invest this in t he markets to get

00.102.1

05.1Xat th e end of 180 days;

Sell Forw ard this amou nt today to guarantee ourselves

00.102.1

98.005.1$

Xin th e future, i.e.,

180 days from now; and finally,

Repay the $X we owe the U .S. bank t hat we originally borrowed from .

T he profit from th is transaction is:

X(1.00882) X =X(0.00882)

For example, if we started with a borrowin g of $10 m illion , we would h ave nett ed a riskless profitof $88,2 00 not bad for a d ays work!

The profit relationship above can also be expressed in terms of our symbols as:

Xre

reX T

+

+

)1(

*)1()(

0

(9)

4 Note that the half-yearly rates are just one-half of the annualized quotesthis is, indeed, the correct wayto calculate part-year rates, since that is the convention in foreign exchange markets. This convention arisesfrom t he interest rate/t ime-measure conventions used in t he bon d m arkets that foreign exchange markets usefor their interest rate benchm arks, nam ely the eurobon d m arkets. Th us the qu arterly interest rate would beone-fourth of the annual rate, the m ont hly interest rate would be one-twelfth of the annual rate, etc.


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H owever, if everybody else in the market start ed doin g exactly the same thin g, such arb itrageprofits would be driven to zero. Why this would happen is easy to see. If everyone goes through thesame set of transactions:

rwill increase because of increased demand for U.S. funds;r* will decrease because of increased supply of euro fun ds,

e0 will rise, i.e., the foreign curren cy will appreciate because of the spot conversion dem and for (and supply of dollars) ande

Twill fall because of the in creased sup ply of forward (and demand for forward d ollars),

thereby driving the profit in expression (9) to zero.

T hu s, in a n o-arbitrage equilibrium , we can equate expression (9) to zero. Can celing out X andrewriting the expression in (9), we have the covered interest parity condition:

+

+=

*1

1

0r

r

e

eT(10)

Empirical studies generally show that the covered interest parity relationship holds quite well,

particularly when measured using eurobond interest rates. With increased global capital market integra-tion, the relationship is becoming more true of pairs of domestic interest rates as well, at least in theindu strialized coun tries. Ind eed, b ankers often u se the CIP mod el to quot e forward rates, a som ewhatrare example of a model driving reality, rather than the other way around!

Speculativ e Efficiency Hypot hesis

In this discussion of the theory of speculation in foreign exchange markets, we will assume risk-neutralspeculators, by which we mean speculators who care only about expected returns and not about thestandard deviation (risk) in returns. This theory could also be applied to risk averse cases, but with nosignificant gain in insights for our present purposes.

The idea behind all speculation is quite simple. If you expect a currency (or anything else) to

appreciate in value, you want to b uy int o it (be long in it); if you expect it to depreciate, you want to getout of it (be short in it). Recall that E(e

0

T) is the future spot rate you think will be realized at time T.Recall that this is an unknown variable. All we have today is an expectation of what the value of thecurrency is going to b e when date T comes aroun d.

The concept of speculation stated above translates more formally into the following:

IfeT>E(e

0

T), get out of (the foreign currency).

IfeT


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N ow if others in the m arket also form the same expectation (th ere is no reason to assum e that theyarent equ ally smart), th ey will start buying forward and pushing u p th e forward price of the euro. Infact an d even if no on e else in t he m arket shares our expectation, our going int o an equilibrated m arketwith a sudden and sizeable demand for forward will have a similar effect. In the process, e

Twill rise

until there is a speculative equilibrium:

eT=E(e

0

T) (11)

Likewise, when the forward rate overpredicts the expected future spot rate, we will demand for-ward $ (and supply forward), so that e

Tis driven down until the equality in expression (11) is again

attained. Th is relationship that t he forward rate is the best un biased predictor of the future spot ratein a speculative equ ilibrium is called t he speculative efficiency hypoth esis (SEH ).

Uncovered Interest Parity Theorem

If (11) is true, we can conceptually substituteE(e0

T) in place ofeT

in the covered interest parity condi-tion, with the interesting imp lication th at

*)1(

)1()(

0

0

r

r

e

eE T

+

+=

or that

*)1(

)1(1

r

re

+

+=+

or that

1*)1(

)1(

+

+=

r

re

(12)

This relationship is called the uncovered interest parity theorem (UIP). Note that this formula, likeRPP P, gives us an alternat e means to p redict exchan ge rates. It says that wh en dom estic nomin al interestrates are higher than the foreign nominal interest rates, the foreign currency is expected to appreciate,i.e., the domestic currency is expected to depreciate.

Em pirical tests generally show that t he forward rate is nota very good p redictor of the level of thefutu re spot rate (it explains about 10% of the change in th e actu al future exchange rates). However,evidence is strong that t he forward rate does a better job of predictin g at least the d irection of changes tofuture spot rates than do about two-thirds of the better known foreign exchange forecasting services,making it on e of the better predictors around.

An Im pli cation: T he International Fisher Effect

If we combine the insights from RPPP (equation (6)) and UIP (equation (12)), we obtain anotherinteresting implication, known as the international Fisher effect. It says that:

1*1

11

*)1(

)1(

+

+=

+

+=

r

r

P

Pe

or that

*)1(

*)1(

)1(

)1(

P

r

P

r

+

+=

+

+(13)

or tran slated, that real interest rates, i.e., the nominal interest rates adjusted for inflation expectations,must be the same both at home and abroad. In other words, it implies the following: when goodsmarkets are in equilibrium resulting from RPPP and capital markets are in equilibrium resulting from


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U IP, real produ ctivity of capital, i.e., the N PV of a similar project, mu st be the same across all coun trieswhere these two parity conditions hold!

The Foreign Exchange Market

T he m arket for foreign exchange is the largest m arket in the world. Transaction s in the foreign exchan ge

market well exceed $1 trillion daily. The market operates almost twenty-four hours a day, so that some-where in the world, at any given time, there is a market open in which you can trade foreign exchange.For example, tradin g start s in Sydney; before Sydney closes, trad ing open s in Tokyo, H ong Kong, andSingapore; before Singapore closes, trading opens in Bahrain; and so on.

Nearly nine-tenths of the trades across the world involve the U.S. dollar. The reasons for this arethree-fold. One, the U.S. dollar is still the most heavily traded currency worldwide and is the referencecurrency for denominating the prices of a number of globally traded products such as oil, aircraft, gold,and so forth. Two, triangular arbitrage opportunities are rarely present in the foreign exchange marketsfor the heavily traded currencies. In other words, if the price of currency A is known with respect to Band C, the price of B in terms of C is automatically determined, otherwise there would be a costlessarbitrage opport un itytraders quote p rices as thou gh such arbitrage opportu nities are not present andthus, the arbitrage opportunity is non-existent in the first place. Three, the dollar-based quotation

dram atically reduces informat ion com plexity. It is far easier for a trader to remem ber, say, eight curren cyquotes against the U.S. dollar and derive the rest by assuming absence of triangular arbitrage opportu-nities, rather than remember the 9*8/2 = 36 pairwise currency quotes (including those for the U.S.dollar) that actually prevail.

Both direct and indirect quotes (against the U.S. dollar) are simultaneously used in foreign ex-change markets, dependin g on t he currency involved. For instance, the Euro and the British p oun d arequot ed in direct t erms (num ber of dollars per currency unit), while the Japanese yen is quot ed ind irectly(the n um ber of yen per do llar).

The most important participants in the market are banks. Traders in the major money centerbanks are constan tly buying from and selling to each oth er; in fact, deals between banks, so-called directdeals, account for nearly 85% of the activity in foreign exchange markets. Foreign exchange is tradedover-the-counter via telephone and computer communications among banks, and not in organizedexchanges such as stock exchanges.

T he th ree comm on types of transactions in foreign exchange markets are spot, out right forward,and swap transactions. Spot transactions involve buying or selling at todays exchange rate (the actualdeposit transfer between the bu yers bank an d t he sellers bank occurs two bu siness days later). O ut rightforward transactions involve agreement on a price today for settlement at some date in the future. Swaptransactionswhich are really forward transactions in disguise, and the markets method to derive thequot ation for forward ratesinvolve an agreemen t t o bu y (or sell) in the spot market, with a simu lta-neous agreement to reverse the t rade in th e outright forward m arket. Approximately 65% of trades takeplace in th e spot m arkets, 33% in swap m arkets, and abou t 2% in th e outright forward markets.

D eterm ining the Value of Exchange RatesThere is a large volume of research on the underlying fundamentals that determine currency values. Inthe short ru n (h our to hou r, or even over days), such fundam entals do n ot seem t o m atter mu ch, sincecurrency trading and speculation are driven almost entirely by technical considerations. This is consis-tent with the fact that direct deals account for a large proportion of foreign exchange transactions.

In the medium- to long-term (one to five years), however, there is general agreement that thefollowing factors are determin ants of the direction in wh ich if not th e level to which currency valuesmove: a countrys level of economic activity (G N P or G D P), its mon ey supply and demand (Ms andMd),


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its nominal and real interest rates (rn and rr), its econom ic produ ctivity (), its inflation rate (P), andits trade or current account balances (the value of exports minus the value of imports, or X M). Ingeneral, the effects of these variables on th e future value of a cur rency (everythin g else remainin g equal)and the reasons for these effects are hypoth esized t o be as follows:

GN P or GDP increase: Increases a currencys value, since there is likely to be greater transaction

demand for that countrys currency.

Ms increase: D ecreases a curren cys value, since th ere is greater supply of th e curren cy; also,increased money supply could signal higher inflation.

Md increase: O pposite effect ofMs increase.

rn increase: D ecreases a currencys value th rough un covered int erest parity and PPP ; intu itivelyit signals an increase in the inflation rate.

rr increase: O pposite effect ofrn increase, since it increases the inflation-adjusted yield fromsecurities denominated in that currency.

increase: Increases a currencys value because it signals GN P increase and rr increase.

P increase: D ecreases a curren cys value th rou gh PPP.

X Mincrease: Increases a currencys value, since it in creases the deman d for that cur rency (topay for its exports) and decreases the demand for the other countrys currency (because ofreduced imports).

O f course, it is importan t t o keep in m ind that non e of these variable changes occurs in isolation,and so the effect of an individual variable may be difficult to discern. In addition, actual changes inthese variables are often not necessary for currency values to changea credible expectation by themarket that these changes will occur is sufficient (and it is difficult to pin down exactly when the

expectations of market participants actually change). Finally, there may be significant currency move-ments even when expectations regarding a particular countrys fundamentals do not change; all that isnecessary is for expectations regarding a fundamental in the other country to change.

It is for these reasons that cu rrency forecasting is an exercise that is, at best, tenu ous and , at worst,somewhat po int less. T herefore, the list of variables and th e effects ind icated above shou ld be used witha fair amou nt of caution. Th e role of an M N E m anager is not to forecast exchange rates; rather, it is (a)to app reciate the fact t hat t he un certainty ind uced by this aspect of the int ernational environm ent is realand ubiquitous, and (b) to manage and plan for the effects of this uncertainty on the operations andperformance of the firm. T his in t urn requires us to und erstand the different ways in which M N Es areexposed t o exchange rates.

Types of M N E Exchange Rate Exposure5

T here are three types of impact of exchange rates on the op erations and performance of M N Es: trans-lation, transaction, and economic exposure (also sometimes called operating or real exposure) to ex-change rates. A stylized graphical description of the three types of exchange rate exposure is shown inFigure 1.

5 For a thorough discussion of the different types of exchange rate exposure defined in this section, and howmanagers of cross-border enterprises can and should deal with them, see the Thunderbird Case Series NoteA Global Managers Gu ide to C urrency Risk M anagement .


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Translation exposure deals with the ex post impact of n omin al exchange rate changes on th e con-solidated financial statements of MNEs. There are well-known accounting rules, e.g., the FinancialAccounting Standards Board Rule 52, or FAS 52 in the U.S., to deal with currency translation issues.In the most commonly used method in U.S. firms, translation effects are typically dealt with as follows:Income Statement items such as revenues and expenses are booked at the actual exchange rate at whichtransactions occur or some average exchange rate during the relevant period; Balance Sheet items are

translated using the exchange rate that prevails on the date when the books are consolidated; currencytran slation gains and losses do n ot have any Incom e Statem ent im pact, rath er, they are simply entered asa plug item in the equity accounts in the Balance Sheet.6

The second type of exposure, transaction exposure, results from the fact that firms enter intotransactions of kn own ex ante value (in domestic currency terms) prior to an exchange rate change, butare required to settle these transactions after an exchange rate change. These are exchange rate effectsresulting from outstanding obligations across borders that have to be managed during the life of theseobligations, rather than just recorded using accoun ting m ethods. The two comm on types of transactionexposure incurred by firms are (1) those relating to payables and receivables outstanding and (2) thoserelating to borrowing (debt issuance) or lendin g (debt in vestment) abroad. For instance, if a companyhas sold its products abroad and invoiced them in the foreign currency, it incurs a foreign currencyreceivable. During the life of the receivable, if the foreign currency were to depreciate, it would lower

the home currency value of the sale. Similarly, for importers with foreign currency payables, an appre-ciation of the foreign currency will increase the amount of home currency required to pay for thepurchase. This in turn raises the question of whether and how such transaction exposures should behedged. Many commonly available financial instruments such as currency forwards, currency futures,and currency options contracts are used to manage this type of exposure. 7

The third category, economic exposure, results from the fact that the firms expected cash flowsexperience unexpected changes in the real exchange rate. More precisely, if we define a firms cash flowas , where is the sum of domestic and foreign cash flows (and hence a function of the real exchangerate), then a firm is said to have economic exposure to exchange rates if/e, that is the sensitivity ofcash flows to real exchange rate changes is not equal to zero. While translation and transaction expo-sures often d o not (an d n eed not ) affect real cash flows (since th e ex ant e domestic currency value of theexposure is known and hence can be hedged), economic exposure has to be dealt with typically through

variables such as pricing, sourcing from different locations, diversifying the manufacturing base geo-graphically, and so forth, rather than through financial hedging techniques. That is, these are exchangerate exposures that h ave to be plann ed for, rather t han just man aged or recorded. (Again, see Footnot e6 for reference to material that contains a detailed discussion of this issue.)

6 The exception is when a foreign asset is liquidated. In that event, the actual loss or gain from the sale goesinto the Income Statement . See the N ote referred to in Foot not e 6 for more details.7 It is beyond the scope of this Not e to add ress the details of such h edging (but see Footn ote 6). H owever, hereis a sum mary of how forwards, futu res, and option s would be used. W hen a firm is attemp ting to hedge itsexpected foreign currency receipts, it is worried about putting a floor on the home currency value of suchreceipts, i.e., it is interested in protecting itself against a depreciation of the foreign currency. This in turnrequires it to sell forward the foreign currency (if using forwards), or go short a foreign currency futurescontract (if using futu res), or to bu y a foreign currency put option (if using options). O n t he other hand, whena firm is attempting to hedge its expected foreign currency paym ents, it is worried about put ting a ceiling onthe home currency value of such payments, i.e., it is interested in protecting itself against an appreciation ofthe foreign currency. This requires it to buy forward the foreign currency (if using forwards), or go long ona foreign currency futures contract (if using futures), or to buy a foreign currency call option (if usingoptions).


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Figure 1 Types of Exchange Rate Exposure Faced by M NEs

Adapted from M ulti nat ion al Bu siness Fin an ce, by D avid Eiteman, Arthu r Stonehill, and M ichael Moffett,10 th Edition , Addison Wesley, 200 4.

Moment in Time

When Exchange Rate

Changes

Translation

Exposure(Record)

Economic

Exposure(Plan Ahead)

Transaction

Exposure

(Manage)

Time

Moment in Time

When Exchange Rate

Changes

Translation

Exposure(Record)

Economic

Exposure(Plan Ahead)

Transaction

Exposure

(Manage)

Time


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APPENDIX

A Restatement of Some of the Key Relationships Using the Indirect Quote

It m ight be u seful to see comparisons of some of the import ant formulae with d irect versus indirectquotes. In the real world, you should have the ability to deal with both perspectives, since some

currencies are quoted one way, e.g., and oth ers the op posite way, e.g., th e Japanese Yen. Further, youwill be confronted with these differences from one article to another, one text book to another, etc.

T he best strategy, th erefore, is not t o try t o m emorize any of th e formulae, but t o develop t heability to d erive them from first p rinciples, given the p articular currency quotation. O f course, th esimp lest approach is to just use one perspective direct q uotesand if the situation requires you toswitch perspectives, to pretend that the home currency is the foreign currency (and vice versa) for thepurp ose of applying the form ulae!

D irect Q uote ($/) Ind irect Q uote (/$ )

Ap preciati on of FX : eincreases edecreases

D epreciat ion of FX: e decreases e increases

Ab solut e PPP: P = eP* P* = eP

Relati ve P PP:

=

*

0

*

1

0

1

0

1

P

P

e

e

P

P

=

0

1

0

1

*

0

*

1

P

P

e

e

P

P

Forward Prem ium : eT> e

0e

T< e

0

CIP: *)1(

)1(

0 r

r

e

eT

+

+=

)1(

*)1(

0 r

r

e

eT

+

+=

UIP: *)1(

)1()(

0

0

r

r

e

eE T

+

+=)1(

*)1()(

0

0

r

r

e

eE T

+

+=

Currency markets and parity condition

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