B06-03-0010

Copyright 2003 T hunderbird, T he American Graduate School of International Management. All rights reserved.
T his case was prepared by Professor Anant K. Sundaram, with research assistance from Omar Castro (T hunderbird 03),
for the purpose of classroom discussion only, and not to indicate either effective or ineffective management.
Currency Market s and Parit y Condit ions
In this Note, we examine one of the most pervasive and influential features of the international environ-
ment in which multinational enterprises (MNEs) operate: the market for national currencies, i.e., the
foreign exchange market. Foreign exchange markets create a qualitatively new set of issues for MNEs to
manage, including the different types of exchange rate exposure for its operations. This is so since
currencies, 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 understand
some 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 international
finance.
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 the
theory and practice of international finance and foreign exchange markets. The theory of PPP enables
us to understand the distinction between nominal 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 the
influence of interest rates, which will lead to two other crucial underpinnings of international finance
theory, the covered interest parity theorem (CIP) and the uncovered interest parity theorem (UIP).
Using these ideas we will summarize the variables that influence the value of currencies in the
medium term and examine the reasons why they are argued to do so. After providing brief descriptions
of the key institutional features of currency markets, finally this Note briefly addresses the different
types of exchange rate exposure that MNEs facetranslation, transaction, and economic exposure.
Before going further it is important to keep one thing in mind: the role of an MNE manager is not
to forecast exchange rates. Rather it is first, to appreciate the fact that the uncertainty induced by this
aspect of the international environment is real and ubiquitous, and second, to manage and plan for the
effects of this uncertainty on the operations and performance of the firm. This requires us to understand
the different ways in which MNEs are exposed to exchange rates. That in turn requires us to understand
the working of the foreign exchange markets, as well as the basic parity conditions, i.e., PPP, CIP, and
UIP.
For the purposes of this discussion, and unless otherwise mentioned, the United States (U.S.) will
be considered the home country and the U.S. dollar ($) the home currency. France will be considered
the foreign country and the euro () the foreign currency. This discussion is, of course, generalizable to
any 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, the
number of U.S. dollars it takes to buy 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.
2 B06-03-0010
quoted either directly or indirectly. A direct quote expresses the foreign exchange rate in terms of the
number of units of home currency it takes to buy each unit 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 quote
would be written $/ . An indirect quote is the reversethe number of units of foreign currency it takes
to buy each unit of home currency (the number of hamburgers per dollar), which would be written
/ $. To avoid confusion it is extremely important that we remember which of the two quotation meth-
ods is being used; otherwise, just about everything we do in international finance would become topsy-
turvy. In our discussion of these basic ideas, we will use the direct quote ($/) throughout. (The effects
of using the indirect quote on all the formulae we develop are shown in the Appendix to this chapter.)
The two commonly observed foreign exchange rates are the spot rate (which we denote as e
0
or,
when there is no scope for confusion, just e) and the T-period forward rate (which we denote as e
T
). The
spot rate is todays exchange rate, or the number of dollars you have to pay to buy each .
2
In actuality,
this transaction is formally settled two business days after the date on which the spot transaction is
entered into.
The T-period forward rate is the exchange rate available today for transactions that we may wish to
make at time T. That is, we can enter into an agreement today to, say, deliver 100 ninety days hence, at
the 90-day forward rate known to us, or agreed upon today (no money changes hands until the ninetieth
day). Thus, for example, we would pay $(100*e
90
), 90 days from now. Typically, maturities are 30, 90,
180, or 360 days. Forward rates are important for managing a problem that MNEs face known as
transaction 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 the
two are institutional. Therefore, while actual forward rates may differ slightly from actual futures rates
due to these institutional features (and because there are some valuation differences induced by the
effects 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, which
we will express as E(e
0
T
). This rate reflects the expectation the market has about the price of a currency
T days from now. E(e
0
T
) is, of course, only an expectation and is not known with certainty. We will see
later that the forward rate and the expected future spot rate should be (in theory) closely related.
D epreciation, Appreciation, Premium, and D iscount
Using the direct quote, the foreign currency is said to undergo an appreciation relative to the home
currency when there is an increase in e, and the foreign currency is said to undergo a depreciation
relative to the home currency when there is a decrease in e. That is:
e increases foreign currency appreciation
e decreases foreign currency depreciation
Using the example of hamburgers, if the price of hamburgers () goes up (the equivalent of an
increase in e), we would say that the hamburger has become 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/ . The number of dollars we need to buy each has gone up (e has increased), and this means
that has become ten cents more expensive with respect to the dollar, that is, has appreciated.
2
In the real world, there are bid-offer (or bid-ask) spreads in currency quotations, that is, a rate at which the
foreign exchange market will buy (bid) currencies from you and a rate at which it will sell (offer) currencies
to you. Bid-offer spreads are quite small for the heavily traded currencies. In order to keep the development
of ideas conceptually simple, we ignore bid-offer spreads.
B06-03-0010 3
A foreign currency is said to be at a forward premium if
e
T
> e
0
(1)
That is, if its forward rate is higher than the spot rate. If the inequality is reversed, the foreign
currency is at a forward discount. The percentage annualized premium (or discount) is
|
.
|

\
|
|
|
.
|

\
|
=
T e
e e
FP
T
360
) 100 ( %
0
0
(2)
where T is the number of days forward.
Exchange Rates and Prices: Purchasing Power Parity
The theory of purchasing power parity (PPP), perhaps one of the most influential ideas in all of eco-
nomics, establishes a formal link between a countrys price level or inflation rates (relative to another
countrys) 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.
The 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 (direct
quote). If we think about it for a moment, all that PPP is about is the absence of arbitrage opportunities
in a frictionless (and undifferentiated) goods marketthat is, it says that the exchange rate will adjust to
eliminate discrepancies in price levels, or price levels will adjust to eliminate discrepancies in exchange
rates, for similar commodities between two countries. Consider an example. Suppose a ton of widgets
costs $1 in the United States and 0.90 in France, and the exchange rate is $1.00/ . For a U.S. buyer of
widgets, the price at the current exchange rate is only $0.90 per ton and thus cheaper. This will
increase the demand for French widgets and decrease the demand for U.S. widgets, raising their price
(P*) and lowering their U.S. price (P). Further in the process of buying the French widgets, U.S. buyers
will be supplying dollars and demanding euros, leading to appreciation of the euro and depreciation of
the dollar (an increase in e). In equilibrium then, the theory 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 arbitrage
relationship in terms of prices and exchange rates today (time 0) relative to our expectation for some
future point in time (say, time 1). RPPP 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 and 0 refer to tomorrow and today, respectively.
Equation (4) can be rewritten as
1 + P = (1 + e)(1 + P*) (5)
or as,
1
* 1
1
|
.
|

\
|
+
+
=
P
P
e
(6)
where P is the expected percentage change in domestic prices, i.e., the domestic inflation rate, e is the
expected percentage change in exchange rates and P* is the expected percentage change in foreign
prices, i.e., the foreign inflation rate.
4 B06-03-0010
What we have just seen is also a simple model for predicting future exchange rates. RPPP tells us
that if the domestic inflation rate is expected to be higher than the foreign inflation rate, then e must
be greater than zero, i.e., the foreign currency is expected to appreciate against the home currency by e
percentage points. Specifically, if the inflation rate in the U.S. during the next year is expected to be 3%,
and the inflation rate in the 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 US$.
3
Now we are ready to define real exchange rates, and more importantly changes in real exchange
rates. Based on absolute PPP, the real exchange rate is defined as:
|
.
|

\
|
=
P
eP
S
*
(7)
Note that if absolute PPP 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 in
value, i.e., the foreign currency appreciates and neither P nor P* changes, then S would be greater than
1, implying that the foreign currency has appreciated (and the home currency has depreciated) in real
terms. The intuition is as follows. If PPP held, an increase in e should have been the result of (or
accompanied by) a decrease in foreign prices P* or an increase in domestic prices P. The fact that they
both stayed the same as before indicates that foreign goods have become more expensive in real terms
and/ or domestic goods have become cheaper in real terms. (Think about, and convince yourself that, in
this situation, domestic exporters have become better off, and domestic importers have become worse
off than before.)
The change in the real exchange rate is the nominal, i.e., actual exchange rate change minus the
change in exchange rates predicted by RPPP:
S = [Actual change] [RPPP-predicted change]
= e
Actual
e
RPPP
(8)
where S refers to the percentage change in the real exchange rate, e
Actual
refers to the percentage
change in the actual exchange rate, i.e., the new exchange rate minus the old change rate divided by the
old exchange rate, and e
RPPP
the RPPP-predicted change is as derived from equation (6) above.
There is also an effective exchange rate, which is a multilateral rate that measures the overall
nominal value of the currency in the foreign exchange market. For example, the effective U.S. dollar
exchange rate combines many bilateral exchange rates using a weighting scheme that reflects the impor-
tance of each countrys trade with the United States. Several institutions (for example, the International
Monetary 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 in
international financial markets, and (2) the speculative efficiency hypothesis and the resulting uncov-
ered parity theorem (UIP) which deals with a speculative equilibrium in international financial mar-
kets. Each of these is described below.
3
The RPPP relationship is also sometimes expressed in its approximate form, as e P P*, where
means approximately equal to. While this approximate form is a useful simplification when expected
annual inflation rates are low (say, less than 5%), applying it in this way can lead to fairly large errors when
inflation rates are high. In general, it is advisable to use the exact formula as given in (6) above, rather than
the approximate formula.
B06-03-0010 5
Covered Int erest Parit y Theorem
Covered interest parity is the mechanism through which an equilibrium relationship is established
between spot and forward exchange rates, and risk-equivalent domestic and foreign nominal interest
rates. This relationship is also sometimes referred to as the interest rate parity theorem or the covered
interest arbitrage condition.
In addition to the notation developed thus far, suppose r stands for the domestic (U.S.) T-period
nominal interest rate, and r* stands for the risk-equivalent foreign (French) T-period nominal interest
rate. At any given point in time, we can observe e
0
, e
T
, r, and r*. Is there 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 (e
0
) is
$1.00/ and the 180-day forward rate (e
180
) is $0.98/ (that is, the is at a forward discount vis--vis
the dollar). Let us also suppose that the relevant annual interest rate in the U.S., r, is 4% and that the
corresponding 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
$
X
in the U.S. markets for 180 days (so that we repay $X in 180 days);
Convert it into
(

00 . 1 02 . 1
X
;
Invest this in the markets to get
(

00 . 1 02 . 1
05 . 1 X
at the end of 180 days;
Sell Forward this amount today to guarantee ourselves
(

00 . 1 02 . 1
98 . 0 05 . 1
$
X
in the future, i.e.,
180 days from now; and finally,
Repay the $X we owe the U.S. bank that we originally borrowed from.
The profit from this transaction is:
X(1.00882) X = X(0.00882)
For example, if we started with a borrowing of $10 million, we would have netted a riskless profit
of $88,200not bad for a days work!
The profit relationship above can also be expressed in terms of our symbols as:
X
r e
r e
X
T

+
+
) 1 (
*) 1 (
) (
0
(9)
4
Note that the half-yearly rates are just one-half of the annualized quotesthis is, indeed, the correct way
to calculate part-year rates, since that is the convention in foreign exchange markets. This convention arises
from the interest rate/ time-measure conventions used in the bond markets that foreign exchange markets use
for their interest rate benchmarks, namely the eurobond markets. Thus the quarterly interest rate would be
one-fourth of the annual rate, the monthly interest rate would be one-twelfth of the annual rate, etc.
6 B06-03-0010
However, if everybody else in the market started doing exactly the same thing, such arbitrage
profits would be driven to zero. Why this would happen is easy to see. If everyone goes through the
same set of transactions:
r will increase because of increased demand for U.S. funds;
r* will decrease because of increased supply of euro funds,
e
0
will rise, i.e., the foreign currency will appreciate because of the spot conversion demand for
(and supply of dollars) and
e
T
will fall because of the increased supply of forward (and demand for forward dollars),
thereby driving the profit in expression (9) to zero.
Thus, in a no-arbitrage equilibrium, we can equate expression (9) to zero. Canceling out X and
rewriting the expression in (9), we have the covered interest parity condition:
(

+
+
=
(

* 1
1
0
r
r
e
e
T
(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 the
industrialized countries. Indeed, bankers often use the CIP model to quote forward rates, a somewhat
rare example of a model driving reality, rather than the other way around!
Speculat ive Efficiency Hypot hesis
In this discussion of the theory of speculation in foreign exchange markets, we will assume risk-neutral
speculators, by which we mean speculators who care only about expected returns and not about the
standard deviation (risk) in returns. This theory could also be applied to risk averse cases, but with no
significant 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 buy into it (be long in it); if you expect it to depreciate, you want to get
out 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 the
currency is going to be when date T comes around.
The concept of speculation stated above translates more formally into the following:
If e
T
> E(e
0
T
), get out of (the foreign currency).
If e
T
< E(e
0
T
), get out of $ (the domestic currency).
In the first case, our expectation is that the forward rate overpredicts the future spot rate for and
underpredicts the future spot rate for $. Thus, we want to buy into $ (and sell ).
An example will perhaps make this clearer. We know that the 180-day forward rate on is $0.98/
. Suppose that we think that the actual future spot rate is going to be $0.99/ (that is, we think that the
forward rate known to us today underpredicts the expected future spot rate). Using the decision rule
above, we want to get out of $ and into . We buy forward at $0.98/ ; when the 180
th
day comes
around, if our expectations are realized, we can sell these for $0.99/ cents. We would have made a
profit of 1 cent on every we bought. (As an exercise, work out what would happen if, instead, e
T
= 0.99
and E(e
0
T
) = 0.98.)
B06-03-0010 7
Now if others in the market also form the same expectation (there is no reason to assume that they
arent equally smart), they will start buying forward and pushing up the forward price of the euro. In
fact and even if no one else in the market shares our expectation, our going into an equilibrated market
with a sudden and sizeable demand for forward will have a similar effect. In the process, e
T
will rise
until there is a speculative equilibrium:
e
T
= 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
T
is driven down until the equality in expression (11) is again
attained. This relationshipthat the forward rate is the best unbiased predictor of the future spot rate
in a speculative equilibriumis called the speculative efficiency hypothesis (SEH).
Uncovered Int erest Parit y Theorem
If (11) is true, we can conceptually substitute E(e
0
T
) in place of e
T
in the covered interest parity condi-
tion, with the interesting implication that
*) 1 (
) 1 ( ) (
0
0
r
r
e
e E
T
+
+
=
or that
*) 1 (
) 1 (
1
r
r
e
+
+
= +
or that
1
*) 1 (
) 1 (

+
+
=
r
r
e
(12)
This relationship is called the uncovered interest parity theorem (UIP). Note that this formula, like
RPPP, gives us an alternate means to predict exchange rates. It says that when domestic nominal interest
rates are higher than the foreign nominal interest rates, the foreign currency is expected to appreciate,
i.e., the domestic currency is expected to depreciate.
Empirical tests generally show that the forward rate is not a very good predictor of the level of the
future spot rate (it explains about 10% of the change in the actual future exchange rates). However,
evidence is strong that the forward rate does a better job of predicting at least the direction of changes to
future spot rates than do about two-thirds of the better known foreign exchange forecasting services,
making it one of the better predictors around.
An Implicat ion: The Int ernat ional Fisher Effect
If we combine the insights from RPPP (equation (6)) and UIP (equation (12)), we obtain another
interesting implication, known as the international Fisher effect. It says that:
1
* 1
1
1
*) 1 (
) 1 (
|
.
|

\
|
+
+
=
+
+
=
r
r
P
P
e
or that
*) 1 (
*) 1 (
) 1 (
) 1 (
P
r
P
r
+
+
=
+
+
(13)
or translated, 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 goods
markets are in equilibrium resulting from RPPP and capital markets are in equilibrium resulting from
8 B06-03-0010
UIP, real productivity of capital, i.e., the NPV of a similar project, must be the same across all countries
where these two parity conditions hold!
The Foreign Exchange Market
The market for foreign exchange is the largest market in the world. Transactions in the foreign exchange
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, trading starts in Sydney; before Sydney closes, trading opens in Tokyo, Hong Kong, and
Singapore; 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 are
three-fold. One, the U.S. dollar is still the most heavily traded currency worldwide and is the reference
currency 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 markets
for the heavily traded currencies. In other words, if the price of currency A is known with respect to B
and C, the price of B in terms of C is automatically determined, otherwise there would be a costless
arbitrage opportunitytraders quote prices as though such arbitrage opportunities are not present and
thus, the arbitrage opportunity is non-existent in the first place. Three, the dollar-based quotation
dramatically reduces information complexity. It is far easier for a trader to remember, say, eight currency
quotes 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, depending on the currency involved. For instance, the Euro and the British pound are
quoted in direct terms (number of dollars per currency unit), while the Japanese yen is quoted indirectly
(the number of yen per dollar).
The most important participants in the market are banks. Traders in the major money center
banks are constantly buying from and selling to each other; in fact, deals between banks, so-called direct
deals, account for nearly 85% of the activity in foreign exchange markets. Foreign exchange is traded
over-the-counter via telephone and computer communications among banks, and not in organized
exchanges such as stock exchanges.
The three common types of transactions in foreign exchange markets are spot, outright forward,
and swap transactions. Spot transactions involve buying or selling at todays exchange rate (the actual
deposit transfer between the buyers bank and the sellers bank occurs two business days later). Outright
forward transactions involve agreement on a price today for settlement at some date in the future. Swap
transactionswhich are really forward transactions in disguise, and the markets method to derive the
quotation for forward ratesinvolve an agreement to buy (or sell) in the spot market, with a simulta-
neous agreement to reverse the trade in the outright forward market. Approximately 65% of trades take
place in the spot markets, 33% in swap markets, and about 2% in the outright forward markets.
D etermining the Value of Exchange Rates
There is a large volume of research on the underlying fundamentals that determine currency values. In
the short run (hour to hour, or even over days), such fundamentals do not seem to matter much, since
currency 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 the
following factors are determinants of the direction in whichif not the level to whichcurrency values
move: a countrys level of economic activity (GN P or GDP), its money supply and demand (M
s
and M
d
),
B06-03-0010 9
its nominal and real interest rates (r
n
and r
r
), its economic productivity (), its inflation rate (P), and
its trade or current account balances (the value of exports minus the value of imports, or X M). In
general, the effects of these variables on the future value of a currency (everything else remaining equal)
and the reasons for these effects are hypothesized to 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.
M
s
increase: Decreases a currencys value, since there is greater supply of the currency; also,
increased money supply could signal higher inflation.
M
d
increase: Opposite effect of M
s
increase.
r
n
increase: Decreases a currencys value through uncovered interest parity and PPP; intuitively
it signals an increase in the inflation rate.
r
r
increase: Opposite effect of r
n
increase, since it increases the inflation-adjusted yield from
securities denominated in that currency.
increase: Increases a currencys value because it signals GNP increase and r
r
increase.
P increase: Decreases a currencys value through PPP.
X M increase: Increases a currencys value, since it increases the demand for that currency (to
pay for its exports) and decreases the demand for the other countrys currency (because of
reduced imports).
Of course, it is important to keep in mind that none of these variable changes occurs in isolation,
and so the effect of an individual variable may be difficult to discern. In addition, actual changes in
these variables are often not necessary for currency values to changea credible expectation by the
market 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 is
necessary is for expectations regarding a fundamental in the other country to change.
It is for these reasons that currency forecasting is an exercise that is, at best, tenuous and, at worst,
somewhat pointless. Therefore, the list of variables and the effects indicated above should be used with
a fair amount of caution. The role of an MNE manager is not to forecast exchange rates; rather, it is (a)
to appreciate the fact that the uncertainty induced by this aspect of the international environment is real
and ubiquitous, and (b) to manage and plan for the effects of this uncertainty on the operations and
performance of the firm. This in turn requires us to understand the different ways in which MNEs are
exposed to exchange rates.
Types of MN E Exchange Rate Exposure
5
There are three types of impact of exchange rates on the operations and performance of MNEs: 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 in
Figure 1.
5
For a thorough discussion of the different types of exchange rate exposure defined in this section, and how
managers of cross-border enterprises can and should deal with them, see the Thunderbird Case Series Note
A Global Managers Guide to Currency Risk Management.
10 B06-03-0010
Translation exposure deals with the ex post impact of nominal exchange rate changes on the con-
solidated financial statements of MNEs. There are well-known accounting rules, e.g., the Financial
Accounting 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 which
transactions 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; currency
translation gains and losses do not have any Income Statement impact, rather, they are simply entered as
a 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 into
transactions of known ex ante value (in domestic currency terms) prior to an exchange rate change, but
are required to settle these transactions after an exchange rate change. These are exchange rate effects
resulting from outstanding obligations across borders that have to be managed during the life of these
obligations, rather than just recorded using accounting methods. The two common types of transaction
exposure incurred by firms are (1) those relating to payables and receivables outstanding and (2) those
relating to borrowing (debt issuance) or lending (debt investment) abroad. For instance, if a company
has sold its products abroad and invoiced them in the foreign currency, it incurs a foreign currency
receivable. 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 the
purchase. This in turn raises the question of whether and how such transaction exposures should be
hedged. 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 flows
experience unexpected changes in the real exchange rate. More precisely, if we define a firms cash flow
as , where is the sum of domestic and foreign cash flows (and hence a function of the real exchange
rate), then a firm is said to have economic exposure to exchange rates if /e, that is the sensitivity of
cash flows to real exchange rate changes is not equal to zero. While translation and transaction expo-
sures often do not (and need not) affect real cash flows (since the ex ante domestic currency value of the
exposure 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 exchange
rate exposures that have to be planned for, rather than just managed or recorded. (Again, see Footnote
6 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 goes
into the Income Statement. See the Note referred to in Footnote 6 for more details.
7
It is beyond the scope of this Note to address the details of such hedging (but see Footnote 6). However, here
is a summary of how forwards, futures, and options would be used. When a firm is attempting to hedge its
expected foreign currency receipts, it is worried about putting a floor on the home currency value of such
receipts, i.e., it is interested in protecting itself against a depreciation of the foreign currency. This in turn
requires it to sell forward the foreign currency (if using forwards), or go short a foreign currency futures
contract (if using futures), or to buy a foreign currency put option (if using options). On the other hand, when
a firm is attempting to hedge its expected foreign currency payments, it is worried about putting a ceiling on
the home currency value of such payments, i.e., it is interested in protecting itself against an appreciation of
the foreign currency. This requires it to buy forward the foreign currency (if using forwards), or go long on
a foreign currency futures contract (if using futures), or to buy a foreign currency call option (if using
options).
B06-03-0010 11
Figure 1 Types of Ex change Rat e Ex posure Faced by M NEs
Adapted from Multinational Business Finance, by David Eiteman, Arthur Stonehill, and Michael Moffett,
10
th
Edition, Addison Wesley, 2004.
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
12 B06-03-0010
APPENDI X
A Rest at ement of Some of t he Key Relat ionships Using t he I ndirect Quot e
It might be useful to see comparisons of some of the important formulae with direct versus indirect
quotes. In the real world, you should have the ability to deal with both perspectives, since some
currencies are quoted one way, e.g., and others the opposite way, e.g., the Japanese Yen. Further, you
will be confronted with these differences from one article to another, one text book to another, etc.
The best strategy, therefore, is not to try to memorize any of the formulae, but to develop the
ability to derive them from first principles, given the particular currency quotation. Of course, the
simplest approach is to just use one perspectivedirect quotesand if the situation requires you to
switch perspectives, to pretend that the home currency is the foreign currency (and vice versa) for the
purpose of applying the formulae!
Direct Quot e ($/) Indirect Quot e (/$)
Appreciation of FX: e increases e decreases
Depreciation of FX: e decreases e increases
Absolute PPP: P = eP* P* = eP
Relative PPP:
|
|
.
|

\
|
|
|
.
|

\
|
=
*
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 Premium: e
T
> e
0
e
T
< e
0
CIP:
*) 1 (
) 1 (
0
r
r
e
e
T
+
+
=

) 1 (
*) 1 (
0
r
r
e
e
T
+
+
=
UIP:
*) 1 (
) 1 ( ) (
0
0
r
r
e
e E
T
+
+
=
) 1 (
*) 1 ( ) (
0
0
r
r
e
e E
T
+
+
=