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Contemporary Financial Management
Chapter 18:
Managing International Risk
© 2004 by Nelson, a division of Thomson Canada Limited
Introduction
 This chapter explores the factors that determine
exchange rates, ways to forecast future
exchange rates, aspects of foreign exchange
risk, and ways of managing that risk.
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© 2004 by Nelson, a division of Thomson Canada Limited
Factors Affecting Exchange Rates
 Supply and Demand
 Economic Conditions
 Inflation
 Interest rates
 Government trade policies
 Political stability
 Risk of expropriation
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© 2004 by Nelson, a division of Thomson Canada Limited
Why Exchange Rates Fluctuate
Theories of
Currency Fluctuation
Interest
Rate
Parity
Purchasing
Power
Parity
Expectations
Theory
(Hypothesis)
Absolute
Relative
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© 2004 by Nelson, a division of Thomson Canada Limited
International
Fisher
Effect
Interest Rate Parity
 Forward rate will differ from spot rate to offset
interest rate differences
 If not covered, interest arbitrage will move rates
back to parity
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Absolute PPP: The Law of One Price
 Prices for a good will be the same after currency
conversion
 It holds loosely for commodities
 Trade restrictions and taxes keep prices different
between countries
 Consider the “Big Mac” index
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© 2004 by Nelson, a division of Thomson Canada Limited
Relative Purchasing Power Parity
 Different rates of inflation will be offset by equal
but opposite changes in expected future spot
exchange rates
 Less restrictive than absolute PPP
 If inflation is higher in Germany than in Canada,
then the Euro weakens relative to the Canadian
dollar
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© 2004 by Nelson, a division of Thomson Canada Limited
Expectations Theory
 The forward rate reflects the market expectation
of the future spot rate
 Provides an unbiased estimate of the future spot
rate
 Implication for managers
 Exchange rate forecasts are provided free
from the marketplace
 Hedging is cost effective
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International Fisher Effect
 Nominal (quoted) interest rates consist of a real
interest rate plus the expected inflation rate
 IFE holds that in equilibrium real interest rates
will be equal in different countries
 If not, then capital will flow to the country with
the higher real interest rate until it reaches
equilibrium
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© 2004 by Nelson, a division of Thomson Canada Limited
Example
CDN Rate = 6%
Japanese Rate = 0.5%
Time Horizon = 1 year
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IFE
Inflation rates differ by 5½%.
One-year future spot rate is 5½%
The dollar weakens against yen.
IRP
Dollar will sell at a 5½% discount.
RPPP
Higher Canadian inflation rates will
cause a lower Canadian dollar.
© 2004 by Nelson, a division of Thomson Canada Limited
Exchange Rates
 Exchange rates fluctuate over time in response
to changing supply and demand
 In the case of the Peso
 Demand for Pesos decreased
 Supply of Pesos increased
 Value of Pesos decreased in relation to other
currencies
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© 2004 by Nelson, a division of Thomson Canada Limited
Foreign Exchange Risk
 Transaction
 The potential for a change in value of a
foreign-currency denominated transaction
before the transaction is finalized
 Economic
 Changes to a firm’s cash flow due to changes
in real exchange rates
 Translation
 Changes in the book value of assets and
liabilities recorded on the Balance sheet due
to changes in exchange rates
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© 2004 by Nelson, a division of Thomson Canada Limited
Managing Transaction Exposure
 Do nothing
 Works for multinationals with many different
foreign exchange exposures
 Invoice in currency of home country
 Shift the risk to another party
 Hedge
 Forward Contracts
 Money market
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Managing Economic Exposure
 Shift production
 Increase productivity
 Outsource
 Reduce price sensitivity
 Change to markets with strong currencies
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Translation Risk
 SECTION 1650 OF THE CICA HANDBOOK
 Balance Sheet
• Assets & liabilities converted at date of
Balance Sheet
• Equity accounts converted at historic rates
 Income Statement
• Converted on date of transaction or a
weighted average of exchange rates
• Gains/losses not recognized on Income
Statement until subsidiary is sold (or
liquidated).
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© 2004 by Nelson, a division of Thomson Canada Limited
Major Points
 Supply and demand, economic conditions,
government policy and political stability affect
exchange rates.
 Under interest rate parity, forward rate will differ
from spot rate to offset interest rate differences
 Absolute purchasing power parity suggests that
rices for a good will be the same after currency
conversion.
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© 2004 by Nelson, a division of Thomson Canada Limited
Major Points
 Relative purchase power parity suggests that
different rates of inflation will be offset by equal
but opposite changes in expected future spot
exchange rates.
 Expecations theory suggests that the forward
rate reflects the market expectation of the
future spot rate.
 Under the international Fisher effect, nominal
(quoted) interest rates consist of a real interest
rate plus the expected inflation rate.
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© 2004 by Nelson, a division of Thomson Canada Limited