Using Interest Rates

Forward rates provide a direct and convenient forecast of future spot currency exchange rates. Unfortunately, forward quotes normally are not readily available beyond one year. Hence, if a manager needs a longer-term currency exchange rate forecast, forward rates are of little help. Fortunately, one can use observed interest rate differentials between two countries, and the general international Fisher effect (IFE) relationship lo make longer-term exchange rate forecasts. Recall from Equation 3.9 that the IFE relationship is given as

This relationship can be modified to cover more than one period into the future as follows:

(3.10)

For example, assume that the annual nominal interest rate on five-year U.S. Treasury bonds is 6 percent, and the annual nominal interest rate on five-year Swiss government bonds is 4.5 percent. Also, assume that the current spot exchange rate between dollars and Swiss francs (SFr) is $0.6955/SFr. What is the expected future spot rate in five years? It can be calculated using Equation 3.10 as follows:

S₅/$0.6955 = (1 + 0.06)⁵ / (1+0.045)⁵

S₅ = $0.7469

The IFE relationship predicts that the dollar will lose value relative to the SFr. The expected spot exchange rate in five years is $0.7469/SFr.

One could also use the PPP relationship to forecast future exchange rates. However, the advantage of the IFE relationship is that interest rates between two countries are readily observable for almost any maturity, whereas differential levels of future inflation are not. In order to use PPP to make exchange rate forecasts, one would first have to forecast the inflation rates in both countries. Hence it is normally desirable to use the IFE relationship when making longer-term exchange rate forecasts, such as might be needed when evaluating foreign long-term invest­ment projects with cash flows extending several years into the future.

Foreign exchange risk

Foreign exchange risk is said to exist when a portion of the cash flows expected to be received by a firm are denominated in foreign currencies. As exchange rates change, there is uncertainty about the amount of domestic currency that will be received from a transaction denominated in a foreign currency. There are three primary categories of foreign exchange risk that multinational firms must consider.

1. Transaction exposure (short-term)

2. Economic (operating) exposure (long-term)

3. Translation (accounting) exposure

Transaction Exposure

Most firms have contracts to buy and sell goods and services, with delivery and payment to occur at some time in the future. If payments under the contract involve the use of foreign currency, additional risk is involved.

For example, General Electric is major producer of locomotives. Suppose that General Electric contracts with the Mexican government to sell 100 locomotives for delivery one year from now. General Electric wants to realize $400 million from this sale. The Mexican government has indicated that it will only enter into the contract if the price is stated in Mexican pesos (Ps). The one-year forward rate is Ps3.11/$. Hence General Electric quotes a price of Psl,244,000,000. Once the contract has been signed, General Electric faces a significant transaction exposure. Unless General Electric takes actions to guarantee its future dollar proceeds from the sale—that is, unless it hedges its position, for example, by selling Psl,244,000,000 in the one-year forward market—it stands to lose on the transaction if the value of the peso weakens. Suppose that over the coming year the inflation rate in Mexico rises significantly beyond what was expected at the time the deal was signed. According to relative PPP, the value of the peso can be expected to decline, say to Ps4/$. If this happens, General Electric will receive only $311 million (Psl,244,000,0007 Ps4/$) rather than the $400 million it was expecting.

One well-documented example of the potential consequences of transaction exposure is the case of Laker Airlines. In the late 1970s, in the face of growing demand from British tourists traveling to the United States, Laker purchased several DC-10 aircraft and financed them in U.S. dollars. This transaction ultimately led to Laker's bankruptcy because Laker's primary source of revenue was pounds sterling, whereas its debt costs were denominated in dollars. Over the period from the late 1970s to 1982, when Laker failed, the dollar strength­ened relative to the pound sterling. This had a devastating effect because (1) the strong dollar discouraged British travel to the United States, and (2) the pound sterling cost of principal and interest payments on the dollar-denominated debt increased.

Managing Transaction Exposure. A number of alternatives are available to a firm faced with transaction exposure. First, the firm may choose to do nothing, and simply accept the risk associated with the transaction. Doing nothing works well for firms with extensive international transactions that may tend to cancel each other out. For example, if General Electric has purchased goods or services from Mexican firms that require the payment in approximately the same number of pesos as it expects to receive from the sale of the locomotives, then it is not necessary to do anything to counter the risk arising from a loss in value of the peso relative to the dollar.

A second alternative is to invoice all transactions in dollars (for a U.S.-based firm). This avoids any transaction risk for the U.S. firm, but shifts this risk to the other party.