Indonesia

		ConsumerPrice Indexes	Real Exchange Rate
	Rupiah (per dollar)		1995 Rupiah/1995
Year	Exchange Rate	Indonesia CPIU.S. CPI	Dollar

1990	1,901.00	65.00	85.76	2,508.18
1995	2,308.00	100.00	100.00	2,308.00
2000	9,675.00	222.00	112.99	4,924.32

Japan

		ConsumerPrice Indexes	Real Exchange Rate
	Yen		1995 Yen/1995
Year	Exchange Rate	Japan CPIU.S. CPI	Dollar

1990	134.40	93.00	85.76	123.94
1995	102.83	100.00	100.00	102.83
2000	109.50	101.00	112.99	122.50

Spain

		ConsumerPrice Indexes	Real Exchange Rate
	Peseta		1995 Peseta/1995
Year	Exchange Rate	Spain CPIU.S. CPI	Dollar

1990	96.91	78.00	85.76	106.55
1995	121.41	100.00	100.00	121.41
2000	190.16	114.00	112.99	188.47

Thailand

		ConsumerPrice Indexes	Real Exchange Rate
	Baht		1995 Baht/1995
Year	Exchange Rate	Thailand CPIU.S. CPI	Dollar

1990	25.29	79.00	85.76	27.45
1995	25.19	100.00	100.00	25.19
2000	43.20	123.00	112.99	39.69

Turkey

		ConsumerPrice Indexes	Real Exchange Rate
	Lira		1995 Lira/1995
Year	Exchange Rate	Turkey CPIU.S. CPI	Dollar

1990	2,930.00	5.00	85.76	50,256.04
1995	59,650.00	100.00	100.00	59,650.00
2000	684,684.00	1,583.00	112.99	48,871.70

*Based on authors’calculations using data from the International Financial Statistics (IFS) database.

in that country in 1995. For example, the CPI of 123 for Thailand in 2000 means that

prices were 23 percent higher in 2000 than they were in 1995.

The right-hand column summarizes the real exchange rate for each selected

currency, or the equivalent purchasing power that must be exchanged from one

Grinblatt1543Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1543Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

766Part VIRisk Management

currency to another. To determine the purchasing power being exchanged in the spot

market, adjustments must be made for the rate of inflation in each evaluated country

and in the United States. To accomplish this adjustment, the spot exchange rate is

divided by the local CPI and multiplied by the U.S. CPI, resulting in the real

exchange rate. Because all the local consumer price indexes and the U.S. CPI are

stated with a 1995 basis, the real exchange rate reported is also relative to 1995

prices.

In 1990, for example, Turkey’s spot exchange rate was TL2,930 per US$. How-

ever, the 1990 Turkish lira had 20 times the purchasing power of the 1995 lira (100/5.0).

Meanwhile, the 1990 dollar had only 1.17 times the purchasing power of the 1995

dollar. To take into account the disparities in the inflation rates of the two countries,

divide the spot rate of TL2,930 by the local CPI of 5.60 and multiply by the U.S. CPI

of 85.76 to find the real exchange rate. In this case, the real exchange rate for 1990 is

equivalent to TL50,256 per US$. As you can see from Exhibit 21.5, the real exchange

rate between Turkey and the United States dropped between 1990 and 1995. In other

words, the U.S. dollar cost of goods and services in Turkey increased at a higher rate

than the U.S. dollar cost of goods and services in the United States. It should also be

noted that, with the exception of Turkey, between 1995 and 2000, the U.S. dollar

strengthened in real terms, implying that goods and services in foreign countries became

less expensive for U.S. purchasers.

Hedging When Both Inflation Differences and Real Effects Drive Exchange Rate

Changes.Whenever exchange rates can change for purely monetary reasons as well

as for real reasons, it is difficult to implement effective hedges. To understand this, con-

sider again the case where a firm needs to purchase an input that will be priced in

British pounds. By buying the pounds in the forward market, the firm effectively hedges

against changes in the value of the pound that are unrelated to price level changes.

However, if the pound fell 10 percent in value because a monetary shift caused a 10

percent increase in British prices, then the firm’s loss on its foreign exchange contracts

would not be offset by a decrease in the price of the inputs.

For the most part, short-term exchange rate changes are generated by real changes,

indicating that short-term hedges should be effective. This follows from the fact that,

over short intervals, exchange rates fluctuate more than inflation rates. Over long peri-

ods, however, inflation accounts for a large part of exchange rate movements. Perhaps

this explains why firms tend to actively hedge short-term currency fluctuations, but tend

to ignore the effect of long-term fluctuations.

Why Most Firms Do Not Hedge Economic Risk

Most major multinational firms hedge transaction and translation currency risk, at least

partially. However, most firms do not hedge long-term economic risk. Hedging the

long-term economic consequences of an exchange rate change is substantially more

complicated than hedging either transaction or translation risk. The largest obstacle here

is that it requires estimation of both the current and the long-term effects of exchange

rate changes on the firm’s cash flows.

Consider, for example, the case of a U.S. firm like IBM, which manufactures com-

puters in the United States for sale in Europe. What is the effect of a change in the U.S.

dollar/Euro exchange rate on IBM’s long-term profitability? To answer this question, one

must first ascertain whether the change in the Euro can be attributed to a general change

in price levels, so that the inflation-adjusted or real exchange rate remains constant. As

Grinblatt1545Titman: Financial	VI. Risk Management	21. Risk Management and	© The McGraw1545Hill
Markets and Corporate		Corporate Strategy	Companies, 2002
Strategy, Second Edition

Chapter 21

Risk Management and Corporate Strategy

767

mentioned above, if the real exchange rate remains constant, then a nominal exchange

rate change is likely to have only a minor effect on IBM’s cash flows. However, changes

in real exchange rates can have a significant effect on these cash flows.

Consider what happens when the U.S. dollar strengthens against the Euro, mak-

ing the computers more expensive in Euros. If the Euro weakened because of gen-

eral inflation in Europe, so that the real exchange rate remained constant, then the

price of computers in Europe, relative to other prices, would not have changed. In

this case, demand for IBM computers would not be affected by the change in

exchange rates. Contrast this case with one in which the real exchange rate does

change, raising the relative price of IBM computers in Europe and lowering the

demand for them. IBM’s cash flows in Europe (calculated in U.S. dollars) would

probably decrease in this case since it would either sell fewer computers at the same

U.S. dollar price or, alternatively, be forced by competitors to cut its U.S. dollar price

for computers.

As these arguments suggest, one of the major difficulties in assessing the effect of

exchange rate changes on cash flows has to do with predicting the cause of the

exchange rate movement. If we cannot predict whether future exchange rate fluctua-

tions are associated with relative price changes, then forward and futures contracts pro-

vide imperfect hedges. This point is further illustrated in Example 21.7.

Example 21.7:Hedging Real Changes in the Yen

Suppose that American Lumber sells a significant quantity of prefabricated housing units in

Japan.These units sell for ¥10,000 per square foot, with the market price increasing at the

Japanese inflation rate.The exchange rate is currently ¥100 per US$.Analysts predict that

it will trade in the range of ¥90 per US$ to ¥110 per US$ over the next 12 months, depend-

ing on the differences in the Japanese and U.S.inflation rates as well as productivity changes

that can be reflected in trade imbalances.Forward prices are also at ¥100 per US$.Is it

possible for American Lumber to create a hedge to guarantee a price of US$100 per square

foot for the prefab units?

Answer:It is not possible to create such a hedge.To illustrate why it may not be possi-

ble to perfectly hedge, suppose that Japan experiences 5 percent deflation, causing hous-

ing unit prices to fall to ¥9,500.Although this would normally cause the yen to depreciate,

suppose that a simultaneous increase in Japanese productivity, which tends to strengthen

the yen, offset the effect of inflation on exchange rates exactly, so that the exchange rate

stayed at ¥100 per US$.In this case, American Lumber will sell prefab units at $95 per

square foot and will break even on its hedging activities regardless of its forward positions.

Result 21.14

When exchange rate changes can be generated by both real and nominal changes, it maybe impossible for firms to effectively hedge their long-term economic exposures.

When it is difficult to hedge in the derivatives markets, firms sometimes undertake

what is known as operational hedging, which involves changing the structure of the

firm’s operations. [See Chowdhry and Howe (1999) for details.]