Keywords

Balance sheet translation; exchange rate forecasting; exchange risk exposure; financial theory; foreign exchange risk; foreign exchange risk premium; market efficiency; risk aversion

Types of Foreign Exchange Risk

One problem we encounter when trying to evaluate the effect of exchange rate changes on a business firm arises in determining the appropriate concept of exposure to foreign exchange risk.

We can identify three principal concepts of exchange risk exposure:

Economic exposure is the most important to the firm. Rather than worry about how accountants will report the value of our international operations (translation exposure), it is far more important to the firm (and to rational investors) to focus on the purchasing power of long-run cash flows insofar as these determine the real value of the firm.

Let us consider an example of a hypothetical firm’s situation to illustrate the differences among the alternative exposure concepts. Suppose we have the balance sheet of XYZ-France, a foreign subsidiary of the parent US firm XYZ, Inc. The balance sheet in Table 8.1 initially shows the position of XYZ-France in terms of euros. A balance sheet is simply a recording of the firm’s assets (listed on the left side) and liabilities (listed on the right side). A balance sheet must balance. In other words the value of assets must equal the value of liabilities so that the sums of the two columns are equal. Equity is the owners’ claims on the firm and is a sort of residual value in that equity will change to keep liabilities equal to assets.

Although the balance sheet at the top of Table 8.1 is stated in terms of euros, the parent company, XYZ Inc., consolidates the financial statements of all foreign subsidiaries into its own statements. Thus the euro-denominated balance sheet items must be translated into dollars to be included in the parent company’s balance sheet. Translation is the process of expressing financial statements measured in one unit of currency in terms of another unit of currency.

Assume that initially the exchange rate equals €1=$1. The balance sheet in the middle of Table 8.1 uses this exchange rate to translate the balance sheet items into dollars. Current US accounting standards, introduced in 1981, require all foreign-denominated assets and liabilities to be translated at current exchange rates. In the United States, accounting standards are set by the Financial Accounting Standards Board (FASB). On December 7, 1981, the FASB issued Financial Accounting Standard No. 52, commonly referred to as FAS 52. FAS 52 essentially requires that balance sheet accounts be translated at the exchange rate prevailing at the date of the balance sheet. The issue in translation exposure is the sensitivity of the equity account of the balance sheet to exchange rate changes. The equity account equals assets minus liabilities and measures the accounting or book value of the firm. As the domestic currency value of the foreign-currency-denominated assets and liabilities of the foreign subsidiary changes, the domestic currency book value of the subsidiary will also change.

The top two balance sheets in Table 8.1 give us the euro and dollar position of the firm on May 31. However, suppose there is a devaluation of the euro on June 1 from $1=€1 to $0.90=€1. The balance sheet in terms of dollars will change as illustrated by the new translation at the bottom of the table. Now the owners’ claim on the firm in terms of dollars, or in terms of the book value measured by equity, has fallen from $6 to $5.4 million. Given the current method of translating exchange rate changes, when the currency used to denominate the foreign subsidiaries’ statements is depreciating relative to the dollar, then the owners’ equity will fall. We must realize that this drop in equity does not necessarily represent any real loss to the firm or real drop in the value of the firm. The euro position of the firm is unchanged; only the dollar value to the US parent is altered by the exchange rate change.

Since the balance sheet translation of foreign assets and liabilities does not by itself indicate anything about the real economic exposure of the firm, we must look beyond the balance sheet and the translation exposure. Transaction exposure can be viewed as a kind of economic exposure, since the profitability of future transactions is susceptible to exchange rate change, and these changes can have a big effect on future cash flows—as well as on the value of the firm. Suppose XYZ-France has contracted to deliver goods to a Japanese firm and allows 30 days’ credit before payment is received. Furthermore suppose that at the time the contract was made, the exchange rate was 100 yen/euro (¥100=€1). Suppose also that the contract called for payment in yen of exactly ¥100,000 in 30 days. At the current exchange rate the value of ¥100,000 is €1,000. But if the exchange rate changes in the next 30 days, the value of ¥100,000 would also change. Should the yen depreciate unexpectedly, then in 30 days XYZ-France will receive ¥100,000; however, this will be worthless than €1,000, so that the transaction is not as profitable as originally planned. This is transaction exposure. XYZ has committed itself to this future transaction, thereby exposing itself to exchange risk. Had the contract been written to specify payment in euros, then the transaction exposure to XYZ-France would have been eliminated; the Japanese importer would now have the transaction exposure. Firms can, of course, hedge against future exchange rate uncertainty in the forward-looking markets discussed in Chapter 4, Forward-Looking Market Instruments. The Japanese firm could buy yen in the forward market to be delivered in 30 days and thus eliminate the transaction exposure.

The example of transaction exposure, just analyzed, illustrates how exchange rate uncertainty can affect the future profitability of the firm. The possibility that exchange rate changes can affect future profitability, and therefore the current value of the firm, is indicative of economic exposure. Managing foreign exchange risks involves the sorts of operations considered in Chapter 4, Forward-Looking Market Instruments. There we covered the use of forward markets, swaps, options, futures, and borrowing and lending in international currencies, and so will not review that information here. Note, however, that firms should manage cash flows carefully, with an eye toward expected exchange rate changes, and should not always try to avoid all risks since risk taking can be profitable. Firms practice risk minimization subject to cost constraints and eliminate foreign exchange risk only when the expected benefits from it exceed the costs.

Although forward exchange contracts may be an important part of any corporate hedging strategy, there exist other alternatives that are frequently used. For example, suppose a firm has assets and liabilities denominated both in a weak currency X, which is expected to depreciate, and in a strong currency Y, which is expected to appreciate. The firm’s treasurer would try to minimize the value of accounts receivable denominated in X, which could mean tougher credit terms for customers paying in currency X. The firm may also delay the payment of any accounts payable denominated in X, because it expects to be able to buy X for repayment at a cheaper rate in the future. Insofar as is possible, the firm will try to reinforce these practices on payables and receivables by invoicing its sales in currency Y and its purchases in X. Although institutional constraints may exist on the ability of the firm to specify the invoicing currency, it would certainly be desirable to implement such policies.

We see, then, that corporate hedging strategies involve more than simply minimizing holdings of currency X and currency-X-denominated bank deposits. Managing cash flows, receivables, and payables will be the daily activity of the financial officers of a multinational firm. In instances when it is not possible for the firm successfully to hedge a foreign currency position internally, there is always the forward or futures market. If the firm has a currency-Y-denominated debt and it wishes to avoid the foreign exchange risk associated with the debt, it can always buy Y currency in the forward market and thereby eliminate the risk.

In summary foreign exchange risk may be hedged or eliminated by the following strategies:

The Foreign Exchange Risk Premium

Let us now consider the effects of foreign exchange risk on the determination of forward exchange rates. As mentioned previously the forward exchange rate may serve as a predictor of future spot exchange rates. We may question whether the forward rate should be equal to the expected future spot rate, or whether there is a risk premium incorporated in the forward rate that serves as an insurance premium inducing others to take the risk, in which case the forward rate would differ from the expected future spot rate by this premium. The empirical work in this area has dealt with the issue of whether the forward rate is an unbiased predictor of future spot rates. An unbiased predictor is one that is correct on average, so that over the long run the forward rate is just as likely to overpredict the future spot rate as it is to underpredict. The property of unbiasedness does not imply that the forward rate is a good predictor. For example, there is the story of an old lawyer who says, “When I was a young man I lost many cases that I should have won; when I was older I won many that I should have lost. Therefore, on average, justice was done.” Is it comforting to know that on average the correct verdict is reached when we are concerned with the verdict in a particular case? Likewise the forward rate could be unbiased and “on average” correctly predict the spot rate without ever actually predicting the future realized spot rate. All we need for unbiasedness is that the forward rate is just as likely to guess too high as it is to guess too low.

The effective return differential between two countries’ assets should be dependent on the perceived risk of each asset and the risk aversion of the investors. Now let us clarify what we mean by risk and risk aversion. The risk associated with an asset is the contribution of that particular asset to the overall portfolio. Modern financial theory has commonly associated the riskiness of a portfolio with the variability of the returns from that portfolio. This is reasonable in that investors are concerned with the future value of any investment, and the more variable the return from an investment is, the less certain we can be about its value at any particular future date. Thus we are concerned with the variability of any individual asset insofar as it contributes to the variability of our portfolio return (our portfolio return is simply the total return from all our investments).

Risk aversion implies that an investor who is faced with two assets with equal return will prefer the asset with the lowest risk. In terms of investments two individuals may agree on the degree of risk associated with two assets, but the more risk-averse individual would require a higher interest rate on the riskier asset to induce him or her to hold it than would the less risk-averse individual. Risk aversion implies that people must be paid to take risk. Individuals with bad credit must pay a higher interest rate than those with good credit, otherwise lenders would only lend to the good credit individuals.

It was already stated that the effective return differential between assets of two countries is a function of risk and risk aversion. The effective return differential between a US security and a security in the United Kingdom is

$i_{\text{US}}-(E_{t+1}^{*}-E_t)/E_t-i_{\text{UK}}=f(\text{risk}\text{aversion},\text{risk})$ (8.1)

(8.1)

The left-hand side of the equation is the effective return differential measured as the difference between the domestic US return, i_US, and the foreign asset return, (E*_t+1−E_t)/E_t−i_UK. We must remember that the effective return on the foreign asset is equal to the interest rate in terms of foreign currency plus the expected change in the exchange rate, where E*_t+1 is the expected dollar price of pounds next period. The right-hand side of Eq. (8.1) indicates that changes in risk and risk aversion will cause changes in the return differential.

We can view the effective return differential shown in Eq. (8.1) as a risk premium. Let us begin with the approximate interest parity relation:

$i_{\text{US}}-i_{\text{UK}}=(F-E_t)/E_t$ (8.2)

(8.2)

To convert the left-hand side to an effective return differential, we must subtract the expected change in the exchange rate (but since this is an equation, whatever is done to the left-hand side must also be done to the right-hand side):

$i_{\text{US}}-(E_{t+1}^{*}-E_t)/E_t-i_{\text{UK}}=(F-E_t)/E_t-(E_{t+1}^{*}-E_t)/E_t$ (8.3)

(8.3)

or

$i_{\text{US}}-(E_{t+1}^{*}-E_t)/E_t-i_{\text{UK}}=(F-E_{t+1}^{*})/E_t$

Thus we find that the effective return differential is equal to the percentage difference between the forward and expected future spot exchange rate. The right-hand side of Eq. (8.3) may be considered a measure of the risk premium in the forward exchange market. Therefore if the effective return differential is zero, then there would appear to be no risk premium. If the effective return differential is positive, then there is a positive risk premium on the domestic currency (the currency in the numerator of E_t, in this case the dollar) since the expected future spot price of dollars is higher than the prevailing forward rate. In other words, traders offering to buy dollars for pounds in the future will receive a premium using the forward market, in that dollars are expected to appreciate (relative to pounds) by an amount greater than the current forward rate. Thus the trader can buy cheaper dollars using the forward market. Conversely, traders wishing to sell dollars for delivery next period will pay a premium to be able to use the forward market to ensure a set future price.

For example, suppose E_t=$2.10, E*_t+1=$2.00, and F=$2.05. The foreign exchange risk premium is

$(F-E_{t+1}^{*})/E_t=(\$2.05-\$2.00)/\$2.10=0.024$

and the expected change in the exchange rate is equal to

$(E_{t+1}^{*}-E_t)/E_t=(\$2.00-\$2.10)/\$2.10=-0.048$

The forward discount on the pound is

$(F-E_t)/E_t=(\$2.05-\$2.10)/\$2.10=-0.024$

Thus the dollar is expected to appreciate against the pound by approximately 4.8%, but the forward premium indicates an appreciation of only 2.4% if we use the forward rate as a predictor of the future spot rate. The discrepancy results from the presence of a risk premium that makes the forward rate a biased predictor of the future spot rate. Specifically the forward rate overpredicts the future dollar price of pounds in order to allow the risk premium.

Given the positive risk premium on the dollar, the expected effective return from holding a UK bond will be less than the domestic return to US residents holding US bonds. To continue with the previous example, let us suppose that the UK interest rate is 0.124, whereas the US rate is 0.100. Then the interest rate differential is

$i_{US}-i_{UK}=-0.024$

The expected return from holding a UK bond is

$i_{UK}+(E_{t+1}^{*}-E_t)/E_t=0.124-0.048=0.076$

The return from the US bond is 0.10, which exceeds the expected effective return on the foreign bond; yet this can be an equilibrium solution given the risk premium. Investors are willing to hold UK investments yielding a lower expected return than comparable US investments because there is a positive risk premium on the dollar. Thus the higher dollar return is necessary to induce investors to hold the riskier dollar-denominated investments.

Market Efficiency

Although the previous example had a nonzero effective return differential, it might still be an efficient market. A market is said to be efficient if prices reflect all available information. In the foreign exchange market, this means that spot and forward exchange rates will quickly adjust to any new information. For instance, an unexpected change in US economic policy that informed observers feel will be inflationary (like an unexpected increase in money supply growth) will lead to an immediate depreciation of the dollar. If markets were inefficient, then prices would not adjust quickly to the new information, and it would be possible for a well-informed investor to make profits consistently from foreign exchange trading that would otherwise be excessive relative to the risk undertaken.

With efficient markets, the forward rate would differ from the expected future spot rate only by a risk premium. If this were not the case, and the forward rate exceeded the expected future spot rate plus a risk premium, an investor could realize certain profits by selling forward currency now, because she or he would be able to buy the currency at a lower price in the future than the forward rate at which the currency will be sold. Although profits can most certainly be earned from foreign exchange speculation in the real world, it is also true that there are no sure profits. The real world is characterized by uncertainty regarding the future spot rate, since the future cannot be foreseen. Yet forward exchange rates adjust to the changing economic picture according to revisions of what the future spot rate is likely to be (as well as to changes in the risk attached to the currencies involved). It is this ongoing process of price adjustments in response to new information in the efficient market that rules out any certain profits from speculation. Of course, the fact that the future will bring unexpected events ensures that profits and losses will result from foreign exchange speculation. If an astute investor possessed an ability to forecast exchange rates better than the rest of the market, the profits resulting would be enormous. Foreign exchange forecasting will be discussed in the next section.

Many studies have tested the efficiency of the foreign exchange market. The fact that they have often reached different conclusions regarding the efficiency of the market emphasizes the difficulty involved in using statistics in the social sciences. Such studies have usually investigated whether the forward rate contains all the relevant information regarding the expected future spot rate. They test whether the forward rate alone predicts the future spot rate well or whether additional data will aid in the prediction. If further information adds nothing beyond that already embodied in the forward rate, the market is said to be efficient. On the other hand, if some data are found that would permit a speculator consistently to predict the future spot rate better than can be done using the forward rate (including a risk premium), then this speculator would earn a consistent profit from foreign exchange speculation, and one could conclude that the market is not efficient.

It must be recognized that such tests have their weaknesses. Although a statistical analysis must make use of past data, speculators must actually predict the future. The fact that a researcher could find a forecasting rule that would beat the forward rate in predicting past spot rates is not particularly useful for current speculation and does not rule out market efficiency. The key point is that such a rule was not known during the time the data were actually being generated. So if a researcher in 2017 claims to have found a way to predict the spot rates observed in 2015 better than the 2015 forward rates, this does not mean that the foreign exchange market in 2015 was necessarily inefficient. Speculators in 2015 did not have the forecasting rule developed in 2017, and thus could not have used such information to outguess the 2015 forward rates consistently.

Foreign Exchange Forecasting

Since future exchange rates are uncertain, participants in international financial markets can never know for sure what the spot rate will be 1 month or 1 year ahead. As a result forecasts must be made. If we could forecast more accurately than the rest of the market, the potential profits would be enormous. An immediate question is: What makes a good forecast? In other words how should we judge a forecast of the future spot rate?

We can certainly raise objections to rating forecasts on the basis of simple forecast errors. Even though, other things being equal, we should prefer a smaller forecast error to a larger one, in practice other things are not equal. To be successful, a forecast should be on the “correct side” of the forward rate. The “correct side” means that the forecast makes the market participant choose correctly whether to use the forward market or not. For instance consider the following example:

A Japanese firm has a $1 million receipt due in 12 months and uses the forecasts to help decide whether to cover the dollar receivable with a forward contract or wait and sell the dollars in the spot market in 12 months. In terms of forecast errors, Mr. A’s prediction of ¥106=$1 yields an error of −6.2% ((106−113)/113) against a realized future spot rate of ¥113. Ms. B’s prediction of ¥116=$1 is much closer to the realized spot rate, with an error of only 2.6% ((116−113)/113). While Ms. B’s forecast is closer to the rate eventually realized, this is not the important feature of a good forecast, in this case. Ms. B forecasts a future spot rate in excess of the forward rate, so if it followed her prediction, the Japanese firm would wait and sell the dollars in the spot market in 12 months (or would take a long position in dollars). Unfortunately since the future spot rate ¥113=$1 is less than the current forward rate at which the dollars could be sold (¥115=$1), the firm would receive ¥113 million rather than ¥115 million for the $1 million.

Following Mr. A’s forecast of a future spot rate below the forward rate, the Japanese firm would sell dollars in the forward market (or take a short position in dollars). The firm would then sell dollars at the current forward rate of ¥115 per dollar rather than wait and receive only ¥113 per dollar in the spot market in the future. The forward contract yields ¥2 million more than the uncovered position. The important lesson is that a forecast should be on the correct side of the forward rate; otherwise, a small forecasting error is not useful. Corporate treasurers or individual speculators want a forecast that will give them the direction the future spot rate will take relative to the forward rate.

If the foreign exchange market is efficient so that prices reflect all available information, then we may wonder why anyone would pay for forecasts. There is some evidence that advisory services have been able to “beat the forward rate” at certain times. If such services could consistently offer forecasts that are better than the forward rate, what can we conclude about market efficiency? Evidence that some advisory services can consistently beat the forward rate is not necessarily evidence of a lack of market efficiency. If the difference between the forward rate and the forecast represents transaction costs, then there is no abnormal return from using the forecast. Moreover, if the difference is the result of a risk premium, then any returns earned from the forecasts would be a normal compensation for risk bearing. Finally we must realize that the services are rarely free. Although the economics departments of larger banks sometimes provide free forecasts to corporate customers, professional advisory services charge anywhere from several hundred to many thousands of dollars per year for advice. If the potential profits from speculation are reflected in the price of the service, then once again we cannot earn abnormal profits from the forecasts.

Fundamental Versus Technical Trading Models

Exchange rate forecasters typically use two types of models: technical or fundamental. A fundamental model forecasts exchange rates based on variables that are believed to be important determinants of exchange rates. As we shall learn later in the text, fundamentals-based models of exchange rates view as important things like government monetary and fiscal policy, international trade flows, and political uncertainty. An expected change in some fundamental variable leads to a current change in the forecast. A technical trading model uses the past history of exchange rates to predict future movements. Technical traders are sometimes called chartists because they use charts or diagrams depicting the time path of an exchange rate to infer changing trends. Finance scholars typically have taken a dim view of technical analysis, since the ability to predict future price movements by looking only at the past would bring the concept of efficient markets into question. However, recent research has led to a more supportive view of technical analysis by some scholars and the method is widely popular among foreign exchange market participants. Surveys indicate that nearly 90% of foreign exchange dealers use some sort of technical analysis to form their expectations of exchange rates. However, the same surveys suggest that technical models are seen as particularly useful for short-term forecasting, while fundamentals are seen as more important for predicting long-run changes.

Although the returns to a superior forecaster would be considerable, there is no evidence to suggest that abnormally large profits have been produced by following the advice of professional advisory services. But then if you ever developed a method that consistently outperformed other speculators, would you tell anyone else?

Summary

Exercises