20 Coping with Exchange Rates

20 Coping with exchange rates

International transactions have to be financed using foreign exchange. This involves exchange rates. This chapter explains how exchange rates affect business and how they are determined. It goes on to analyse one of the chief problems facing an international business: how to cope with exchange rate volatility. Various options for dealing with exchange rate risk are outlined.

At firm level, this volatility can mean the difference between prosperity and closedown for exporting or import-competing firms, depending on the level of exchange rate “pass-through”. Economic theory provides explanations of how exchange rates are determined. Purchasing Power Parity (PPP) theory is the best known but others focus on the balance of payments, money supply growth rates and portfolio asset effects. Each theory has limitations at theoretical and empirical levels.

Exchange rates are difficult to predict because of random and sometimes violent changes in economic ‘fundamentals’ and irrationality in foreign exchange markets. Businesses must identify their exposure to exchange rate risk and apply risk-reducing measures, using the forward market, swaps and options and other hedging instruments. Internal mechanisms include netting, leads and lags, and matching assets and liabilities. These instruments are costly to firms but so is exchange rate volatility, so the benefits of reduced exposure must be balanced against these costs.

Questions for Discussion

Q1. Purchasing power parity states that countries with high inflation rates tend to have depreciating currencies. Can you explain why?

First, PPP should be explained. In this context, relative PPP is being referred to. Second, the consequences of one country having a sustained higher inflation than its trading partner might be explained step-by-step as follows:

exports become less cost competitive
import-competing industries find it harder to compete against foreign rivals
the current account balance of payments position deteriorates
capital may start to flow outwards as markets start talking of a possible weakening of the currency
in the short run these pressures may be resisted by running down reserves or by interest rate hikes.
eventually if the inflation persists the exchange rate will have to be devalued.

Q2. Why should the discovery of a natural resource, say North Sea oil, be expected to lead to a strengthening of a country's currency? Taking the rise in sterling in the early 1980s as an example, what effect would you expect such an appreciation to have had on: a) Britain's manufacturing sector, b) British exporters, c) British consumers?

The discovery of oil will lead to an increase in the supply of foreign currency, and consequently a strengthening of the currency, through the following mechanisms

an initial net capital inflow into the country ( from new investment opportunities etc.).
as the economy becomes self-sufficient in its energy needs, energy related imports will decline.
as the domestic oil industry develops its capacity, it may begin to export oil, further strengthening the currency.

The net effects on the relevant sectors can be summarised as follows:

(a) The manufacturing sector, is exposed to foreign competition and, as the appreciation makes imports cheaper, we should expect the sector to be adversely affected. However, an appreciation could, in certain circumstances, have beneficial long run effects as it forced manufacturers to develop more efficient production techniques and to compete in terms of quality rather than price.

(b) As they become more costly in the world markets as a result of an appreciation, exports will decline and British exporters will lose.

Q3. Why do large differences in interest rates continue to prevail between countries notwithstanding the increasing international mobility of capital which must tend to reduce them?

Differences in interest rates persist between countries for two reasons:

First, if a currency is expected to devalue, its investors will require an additional premium to compensate for the expected depreciation. The covered interest rate parity theorem states that the domestic interest rate less the foreign rate is equal to the expected change in the exchange rate. Expected currency movements are at the root of international interest rate differentials. Many factors can cause an expectation of exchange rate depreciation, such as lax monetary policy ( which leads to inflation and a devalued currency), persistent balance of payments deficits, lack of cost competitiveness, and large and growing amounts of public debt.

Second, risk premia may be required by some investors to invest in some countries. For example, if the country is already highly indebted, and if the risk of default if high, its interest rate is likely to remain higher than its trading partners’.

Q4. Why are exchange rates volatile? What can government do to try and reduce such volatility? Does government action sometimes cause volatility?

There is no easy answer as to why exchange rates are volatile. However it is generally accepted that volatility arises from the following sources;

Macroeconomic shocks to the system: changes in the conduct of monetary and fiscal policy will affect exchange rates. Demand and supply shocks, such as acts of god, war, and changes in tastes, preferences and technology will affect exchange rates.

The interaction of uncoordinated monetary policy and these shocks should also be mentioned as a source of instability .

Price stickiness in other markets: for example if wages are inflexible, labour market shocks could have repercussions in the currency market.

Lack of perfect rationality in the forex market: the existence of speculative bubbles and bandwagons (whereby the actions of investors cause spiralling upward movements in prices, for no apparent economic reason) reflects the propensity of investors to act according to the dictates of “animal spirits” and the herd instinct rather than perfect rationality. Speculation (holding a risky position in a currency in the hope of earning profits) itself can be a source of instability in the forex market. For example, suppose speculators expect a fall in the value of a currency. This gives rise to anticipatory purchases of foreign currency, propelling the exchange rate downwards and causing an expectation of a future fall.

Related to this point is the use of charts and technical analysis in the forex market. Some traders, rather than basing their strategies on economic fundamentals have developed techniques to predict trends and patterns from currency data. The use of these “charts” may cause distortionary effects in the forex markets. For example, if a large enough group of traders use the same charting method, this creates the potential for volatilty. Such volatility can be exacerbated where chartists and fundamentalists exist in tandem.

Government action to reduce volatility in the foreign exchange markets can take several forms:

interest rate policy, institutional mechanisms such as controls on exchange rates and international capital movements, high capital reserve requirements, and taxes on speculation
the introduction of specific monetary and fiscal policies that are seen to be consistent with the accepted long run value of the currency. In such cases monetary and fiscal policy need to be credible to avoid time inconsistency problems.
sovereign governments may negotiate international agreements seeking exchange rate co-operation and co-ordination of policies. Normally these agreements provide for a system of (semi) fixed exchange rates amongst member countries and detailed institutional mechanisms/arrangements in the event of currency instability and needs for realignments. The European Exchange Rate Mechanism (ERM ) is an example of such an international agreement (essentially where European Monetary Authorities agree upon a system of semi-fixed exchange rates between member countries - see Chapter 21)

Government action can exacerbate volatility in a number of ways:

If open market operations and central bank intervention are seen to be at odds with market sentiment about the value of the currency, such “confused signals” will give rise to volatility. A similar result arises when intervention in the currency market is seen to be inconsistent with prevailing monetary and fiscal policy. For example, the currency crisis of 1992, and sterling’s eventual withdrawal from the ERM was partly due to the market’s perception that the sterling/DM link was unsustainable and that monetary policy was tighter than required for the weak British economy (see chapter 21).

Q5. Since the advent of flexible exchange rates, foreign exchange risk has been a major source of concern for multinationals. Is exchange rate exposure a problem just for multinationals or could a firm with a wholly domestic market orientation also be affected?

A firm with a wholly domestic orientation can be affected by exchange rates. Even if a firm sold 100 per cent of its output on the domestic market, a depreciation of the currency, by making imports more price competitive, could erode its sales. If the firm operated in the non-traded sector, it might still be affected by the exchange rate, through changes in the price of any imported inputs. Finally, exchange rate fluctuations and subsequent exchange rate management affects real variables in the entire economy ...interest rates, inflation, employment etc.

Q6. Explain why firms with highly price-elastic demand for their product (price-takers) are more likely to be affected by currency fluctuations than those with low price-elasticity of demand (price-makers).

Consider the effect of an appreciation of the domestic currency on a price-taking firm. After the appreciation, the foreign currency equivalent of the domestic price increases. But any rise in the foreign price charged results in a severe loss of sales, and, in order to preserve the original profit margin, the firm will have to lower its prices in the foreign market by the extent of the appreciation. By contrast, foreign producers need not change their prices, therefore world prices remain at their original level. As the domestic firm is a price-taker on the world markets, it must either accept original price (by cutting costs and/or reducing profit margins) or go out of business. Note, that a depreciation of the domestic currency would result in windfall profits for the firm.

On the other hand price-makers can adjust their prices to maintain profit margins in the light of currency fluctuations. Given an appreciation, they can charge higher prices in the export market, knowing that foreign demand is relatively inelastic and/or there are few other firms that can undercut their prices.

Q7. It has been said that "good currency risk management and good business management are synonymous". Do you agree? Discuss the main market instruments which a firm can purchase in order to reduce its foreign exchange exposure can be reduced.

In world of uncertain exchange rate movements, currency risk management should be given a high priority by firms that trade in the global economy. However, currency risk is not the only type of risk to which firms are exposed. Other sources of risk include basic price risk (uncertainty as to the future prices of assets and commodities), default risk, inflation risk, term structure risk, general market risk, consumer confidence, political risk... etc. Sometimes these factors may manifest themselves via exchange rates, however this is by no means necessarily true all of the time. (For example the risk that a firm’s employees will strike is unlikely to be caused by or reflected through currency movements.) In order to formulate proper business risk management, managers must identify all risk factors that could affect the business and use the appropriate strategy/instruments to deal with the risk.

The main instruments available to reduce foreign currency exposure include:

Forward currency contracts - These contracts commit the user to buying or selling a particular currency at a specific date in the future. They are mainly used for trade between two private parties and are tailor-made to suit the needs of both parties. Given that they are tailor-made, forward contracts can be engineered to totally eliminate a firm’s exposure to exchange rate risk.

Futures contracts, in general do not eliminate total risk. Futures contracts relate to standard quantities (this quantity may undershoot or overshoot in the cover it provides on the firm’s position in foreign currency). Furthermore the maturity date of the future contract may not correspond to the dates of the firms “spot” activities. Therefore a perfect hedge is not usually available with regards futures (the type of risk referred to above is known as basis risk). However as futures trading occurs on an organised exchange, and one deals with a clearing house rather than another private party, the risk of default (risk that one of the contractees will renege on the contract) is significantly lower than that of a forward contract.

Option contracts can also be used to manage foreign currency risk exposure. This is a contract that gives the buyer the right, but not the obligation to buy or sell a specific amount of currency at a particular rate on or before a specified date. Whilst futures and forwards involve binding commitments, an option is best thought of as a form of insurance. It eliminates “downside” risk, but leaves the opportunity to benefit from positive “upward” exchange rate volatility. However the holder of an option must pay a premium to the seller of the option.

These are the three classic forms of derivatives used in currency management. Recent years have seen enormous growth in “exotics” or complex derivatives. These derivatives usually have some special features that differentiate them from regular (“plain vanilla”) instruments. The appearance of such derivatives is primarily due to the increased volatility in the currency markets.

Q8. A company can also deal with the exposure problem through internal exposure management. What does this entail?

Internal exposure management is often used by small firms (where the costs of using traded instruments is higher than any potential gains) and in emerging economies where the market for traded instruments is undeveloped or indeed does not exist.

Internal exposure management, involves the use of “natural hedges”, i.e. process where a firm can offset its risk exposure without recourse to traded instruments.

A good example of a natural hedge is that of an exporting firm relocating its production facilities to the export market so as to match its costs and revenues in one currency. In recent years, due to the appreciation of the DM German firms are increasingly moving their production out of Germany in favour of their main export markets.

Other forms of natural hedges include netting agreements (whereby groups of companies trading with one another in different countries calculate their positions with respect to each other and pay the difference between what they owe and what they are owed), diversification of sales and purchases (reduce volatility of net foreign currency position by diversifying trade into many geographical regions). The reasoning behind diversification is that not all currencies can simultaneously move in the same direction. If one currency appreciates then necessarily another currency or group of currencies must depreciate. If a firm’s exports are diversified into many markets, there would be a tendency for currency movements to cancel one another out.

Exercises

Q1. Suppose the one-year interest rate on British pound deposits is 10 percent, the dollar interest rate is 6 percent, and the current $/£ spot rate is $1.50.

a)What do you expect the spot rate to be in 1 year?

b)Suppose both the United States and United Kingdom implement new policies that lead to an expected future spot rate of $2. Suppose further that the dollar

interest rate rises to 7%. What spot rate would be consistent with these two

changes?

(a) The interest rate parity theorem states (approximately):

Rd - Rf=- %S

where Rd refers to the domestic interest rate, Rf the foreign interest rate, and %S to the expected percentage change in the exchange rate. Assume that sterling is the domestic currency and the dollar is the foreign currency. A simple application of the theorem leads us to expect that sterling will have depreciated by about 4% (10% - 6%) over the year.

A 4% sterling depreciation will raise the cost of a dollar from 0.6667p to 0.693p. This is equivalent to a change in the $/£ spot rate from $1.50 to $1.44.

As a check on result consider the following transactions;

1) Invest $1.50 @ 6% for 1 year, yielding 9 cents at the end of the year (payoff of $1.59)

2) Invest £1 @ 10% for 1 year, yielding 10 pence at the end of the year (payoff of £1.10)

At the initial date, both these transactions cost the same amount. Given absence of arbitrage opportunities in the financial markets we would expect both of them to yield the same net return, i.e. that $1.59 = £1.10. A $/£ exchange rate of $1.445 will guarantee such an outcome, i.e. an exchange rate that has depreciated by about 4%.