Weeks 5-6

Question 1

what is the law of one price

Answer 1

• Identical goods and services, measured in a common currency should cost the same in all markets.

Question 2

what is purchase power parity theory

Answer 2

• PPP: theory suggesting that exchange rates will
  adjust over time to reflect the differential in
  inflation rates in the two countries; in this way, the
  purchasing power of consumers when purchasing
  domestic goods will be the same as that when they
  purchase foreign goods.

– General inflation level “Basket of goods”
– CPI in practice

Question 3

what is the absolute and relative form of PPP

Answer 3

Absolute Form of PPP: Without international barriers,
consumers shift their demand to wherever prices are
lower. Prices of the same basket of products in two
different countries should be equal when measured in
common currency.
Relative Form of PPP: Due to market imperfections,
prices of the same basket of products in different
countries will not necessarily be the same, but the rate
of change in prices should be similar when measured
in common currency

Question 4

what is relative PPP

Answer 4

Theory stating that the rate of change in the prices of
products should be somewhat similar when measured in a
common currency, as long as transportation costs and
trade barriers are unchanged.

Expected Change in Spot Rate = Expected Inflation Differential

Question 5

using PPP to estimate exchange rate effects

Answer 5

• The relative form of PPP can be used to estimate how an
  exchange rate will change in response to differential
  inflation rates between countries.
• International trade is the mechanism by which the
  inflation differential affects the exchange rate according
  to this theory.
• Using a simplified PPP relationship: The percentage change in the exchange rate should be
  approximately equal to the difference in inflation rates between
  the two countries.

Question 6

empirical evidence of PPP

Answer 6

* Absolute PPP
– Commodity Index
* Relative PPP
– Graphically
* Choose two countries (such as the United States and a foreign
country) and compare the differential in their inflation rates to
the percentage change in the foreign currency’s value during
several time periods.
– Correlations / Regression
* Apply regression analysis to historical exchange rates and
inflation differentials.
– Real Value of the Currency
– Do we see mean-reversion?

Question 7

what is purchasing power disparity

Answer 7

▪ Any points off of the PPP
line represent purchasing
power disparity.
▪ If the exchange rate does not
move as PPP theory suggests,
there is a disparity in the
purchasing power of the two
countries.
▪ Point C represents a
situation where home
inflation (ph) exceeds
foreign inflation (pf ) by
4%.
▪ Yet, the foreign currency
appreciated by only 1% in
response to this inflation
differential. Consequently,
purchasing power disparity
exists.

Question 8

what are limitations to PPP tests

Answer 8

Results vary with the base period used. The base period chosen
should reflect an equilibrium position since subsequent periods are
evaluated in comparison to it. If a base period is used when the
foreign currency was relatively weak for reasons other than high
inflation, most subsequent periods could show higher appreciation
of that currency than what would be predicted by PPP.

Question 9

use of PPP and limitations

Answer 9

Deviations from PPP are not as pronounced for longer time
periods, but they still exist. Thus, reliance on PPP to derive
a forecast of the exchange rate is subject to significant
error, even when applied to long-term forecasts.
– Transportation costs
– No substitutes for traded goods
– Product differentiation
– Sticky prices
– Non-traded goods and services
– Inflation index construction
– Productivity bias
– Shipping times
– Confounding effects

Question 10

what are confounding effects

Answer 10

• A change in a country’s spot rate is driven by more than the
  inflation differential between two countries.
• Since the exchange rate movement is not driven solely by
  ΔINF, the relationship between the inflation differential and
  exchange rate movement cannot be as simple as the PPP
  theory suggests.
• Potential influences on the change in the spot rate include:
  – Δ Inflation differentials
  – Δ Interest differentials
  – Δ Income differentials
  – Δ Government controls
  – Δ Expectations

Question 11

what is unbiased expectations hypothesis?

Answer 11

Efficiency:
– Information incorporated into prices
– Spot and forward rates will move in tandem, in light
of news and expectations.

The forward rate should be an unbiased estimate of
the future spot rate.
– If the forward rate is biased, excess profit could be achieved.

Question 12

what happens when there is a bias in the estimate

Answer 12

• Assume f0 is a biased estimate of st.
  e.g. Assume st is, on average, greater than f0.
• The trading rule:
  1. Buy the currency forward
  2. Sell the currency when the contract matures
  e.g., f0 = .8740 but st = .88
• When contract matures,*
  Buy @ forward .8740
  Sell @ spot .8800
  Gain 60 points

Question 13

what are the problems with unbiased expectations hypothesis

Answer 13

• Relies on the certainty assumption
• The previous example is not an arbitrage
  The investor is not receiving a risk premium
• What if investors are risk averse?
  f0- s*0 = p p=/ 0
  p may be either positive or negative
  i.e. paid by some investors and received by others

Question 14

what is the fisher effect

Answer 14

Fisher’s Equation:
i ≈ r + p
(1 + nominal) = (1 + real rate) (1 + inflation rate)

1. The Fisher effect suggests that the nominal interest
   rate contains two components:
   a. Expected inflation rate
   b. Real interest rate
2. The real rate of interest represents the return on the
   investment to savers after accounting for expected
   inflation

Question 15

how to apply the fisher effect?

Answer 15

Use the Fisher Effect to Derive Expected Inflation per
Country
▪ The first step is to derive the expected inflation rates of the
two countries based on the Fisher effect. The Fisher effect
suggests that nominal interest rates of two countries differ
because of the difference in expected inflation between the
two countries.

Rely on PPP to Estimate the Exchange Rate Movement
▪ The second step is to apply the theory of PPP to determine
how the exchange rate would change in response to those
expected inflation rates of the two countries.

Question 16

what are IFE derivation/implications

Answer 16

What if IFE holds?
Equating the average yield from domestic and international
investments.

Two cautions:
* known rates vs. unexpected interest rate movements
* present vs. expected future movements in exchange rates

Question 17

what are implications of international fisher effect

Answer 17

The international Fisher effect (IFE) theory suggests that currencies with
high interest rates will have high expected inflation (due to the Fisher
effect) and the relatively high inflation will cause the currencies to
depreciate (due to the PPP effect).

Question 18

illustration of IFE line - when ER changes perfectly offset interest rate differentials

Answer 18

▪ All the points along the IFE
line reflect exchange rate
adjustments to offset the
differential in interest rates.
This means investors will end
up achieving the same yield
(adjusted for exchange rate
fluctuations) whether they
invest at home or in a foreign
country.
▪ Points below the IFE line
generally reflect the higher
returns from investing in
foreign deposits.
▪ Points above the IFE line
generally reflect returns from
foreign deposits that are
lower than the returns
possible domestically.

Question 19

what are the tests of the IFE

Answer 19

Plot: If the actual points (one for each period) of interest rates
and exchange rate changes were plotted over time on a graph,
we could determine whether:
* the points are systematically below the IFE line (suggesting
higher returns from foreign investing)
* above the line (suggesting lower returns from foreign investing)
* evenly scattered on both sides (suggesting a balance of higher
returns from foreign investing in some periods and lower foreign
returns in other periods)
Statistical Test of the IFE
* Apply regression analysis to historical exchange rates and the
nominal interest rate differential.

Question 20

what are the limitations of the IFE

Answer 20

The IFE theory relies on the Fisher effect and PPP
Limitation of the Fisher Effect
* The difference between the nominal interest rate and actual
inflation rate is not consistent. Thus, while the Fisher effect can
effectively use nominal interest rates to estimate the market’s
expected inflation over a particular period, the market may be
wrong.
Limitation of PPP
* Other country characteristics besides inflation (income levels,
government controls) can affect exchange rate movements.
Even if the expected inflation derived from the Fisher effect
properly reflects the actual inflation rate over the period, relying
solely on inflation to forecast the future exchange rate is subject
to error.

Question 21

IFE versus reality

Answer 21

• The IFE theory contradicts how a country with a high interest
  rate can attract more capital flows and therefore cause the local
  currency’s value to strengthen (Ch. 4).
• IFE theory also contradicts how central banks may purposely try
  to raise interest rates in order to attract funds and strengthen the
  value of their local currencies (Ch. 6).
• Whether the IFE holds in reality is dependent on the countries
  involved and the period assessed.
• The IFE theory may be especially meaningful to situations in
  which the MNCs and large investors consider investing in
  countries where the prevailing interest rates are very high.

Question 22

comparison of IRP, PPP and IFE

Answer 22

Although all three theories relate to the determination of
exchange rates, they have different implications.
* IRP focuses on why the forward rate differs from the spot rate
and on the degree of difference that should exist. It relates to a
specific point in time.
* PPP and IFE focus on how a currency’s spot rate will change
over time.
* Whereas PPP suggests that the spot rate will change in
accordance with inflation differentials, IFE suggests that it will
change in accordance with interest rate differentials.
* PPP is related to IFE because expected inflation differentials
influence the nominal interest rate differentials between two
countries

Question 23

types of multinational forecasting

Answer 23

▪ Hedging decisions
▪ Selective hedging
▪ Short-term investment decisions
▪ Investment of excess cash
▪ Capital budgeting decisions
▪ Earnings assessment
▪ Timing of earnings remittances
▪ Long-term financing decisions
▪ Denomination of securities

Question 24

what is forecasting under market efficiency

Answer 24

▪ Weak-form efficiency: historical and current
exchange rate information is already reflected in
today’s exchange rate and is not useful for
forecasting.
▪ Semi-strong-form efficiency: all relevant public
information is already reflected in today’s
exchange rate.
▪ Strong-form efficiency: all relevant public and
private information is already reflected in today’s
exchange rate.

Question 25

forecasting to be consistent with EMH

Answer 25

▪ the spot rate should incorporate information /
expectations
▪ forecasts should also incorporate information /
expectations

Question 26

what is technical forecasting

Answer 26

The use of historical exchange rate data to predict
future values.
Limitations of technical forecasting:
* Focuses on the near future
* Rarely provides point estimates or range of
possible future values
* Technical forecasting model that worked well in
one period may not work well in another

Question 27

what is fundamental forecasting

Answer 27

Based on fundamental relationships between economic variables and
exchange rates
Use of sensitivity analysis for fundamental forecasting
* Considers more than one possible outcome for the factors exhibiting
uncertainty
Use of PPP for fundamental forecasting
* While the inflation differential by itself is not sufficient to accurately
forecast exchange rate movements, it should be included in any
fundamental forecasting model

Question 28

what are limitations of fundamental forecasting

Answer 28

• Unknown timing of the impact of some factors
• Forecasts of some factors may be difficult to obtain
• Some factors are not easily quantified
• Regression coefficients may not remain constant
  Market-Based Forecasti

Question 29

what is market based forecasting

Answer 29

Using the spot rate
* Today’s spot rate may be used as a forecast of the spot
rate that will exist on a future date.

Using the forward rate to forecast the future spot rate
* Does unbiased expectations hold? Expected change in
Spot = Forward premium/discount
* Rationale for using the forward rate should serve as a
reasonable forecast for the future spot rate because
otherwise speculators would trade forward contracts (or
futures contracts) to capitalise on the difference between
the forward rate and the expected future spot rate

Question 30

what is long term forecasting with forward rates

Answer 30

• Long-term exchange rate forecasts can be derived from
  long-term forward rates. Like any method of forecasting
  exchange rates, the forward rate is typically more accurate
  when forecasting exchange rates for short-term horizons
  than for long-term horizons.

Question 31

what are implications of the IFE for forecasts

Answer 31

• Since the forward rate captures the interest rate differential
  (and therefore the expected inflation rate differential)
  between two countries, it should provide more accurate
  forecasts for currencies in high inflation-differential
  countries.

Question 32

mixed forecasting and implementation

Answer 32

Use a combination of forecasting techniques
* A mixed forecast is a weighted average of the various
forecasts developed.
Guidelines for Implementing a Forecast:
* Apply forecasts consistently within the MNC
* Measure impact of alternative forecasts
* Consider other sources of forecasts

Question 33

methods of forecasting exchange rate volatility

Answer 33

Using recent levels of volatility
* The volatility of historical exchange rate movements over
a recent period can be used to enhance forecasting.
Using historical patterns of volatilities
* If there is a pattern to the changes in exchange rate
volatility over time, a series of time periods may be used
to forecast volatility in the next period.
Using implied standard deviation
* Derive the exchange rate’s implied standard deviation
from the currency option pricing model.

Question 34

what is risk management

Answer 34

Many MNCs attempt to stabilise their earnings with
hedging strategies because they believe exchange
rate risk is relevant.
* Identify the risks (sensitivity)
* Measure the risks (sensitivity & forecasts)
* Can we manage these risks?
* What are the costs of managing these risks?
* Does managing risk add value?
* Does the value of corporate hedging outweigh
the costs?

Question 35

what is corporate hedging

Answer 35

* Should we hedge (relevance)?
* Arguments against corporate hedging
* Hedging goals / corporate objectives
* Arguments for corporate hedging
* Types of exposures
* Transaction / Competitive / Translation
* Significance & measurement
* Exposure management
* Managing competitive exposure
* Managing translation exposure
* Managing transaction exposure

Question 36

what are arguments against corporate heding

Answer 36

1. The investor hedge argument
* Exchange rate risk is irrelevant because investors
can hedge exchange rate risk on their own
2. Currency diversification argument
* The value of currency diversified MNC’s will not
be less affected by exchange rate risk
3. Stakeholder diversification argument
* If stakeholders are well diversified, they will be
somewhat insulated against losses due to MNC
exchange rate risk
4. Purchase Power Parity
* Real currency value mean reversion
5. Implications of the CAPM
* Unsystematic => ignore
* Systematic => implications of the SML
➢ No benefits + costs
6. Risk Exposure
* Investors seek to diversify exposures

Question 37

evidence of hedging goals/use

Answer 37

Study of 350 non-financial US Firms
Most important objective of hedging:
49% Managing volatility in cashflows
42% Managing volatility in accounting earnings
8% Managing the market value of the firm
1% Managing balance sheet accounts & ratios
Proportion that frequently hedge
-contractual commitments : 50%
-competitive / economic exposures : 8%
Proportion that frequently hedge foreign currency risks more than one
year off : 11%

Question 38

what are arguments for corporate hedging

Answer 38

• Avoid financial distress
• Investors versus companies
• Information
• Company is more than just shareholders
• Pursuing the desired strategy
• Stabilisation

Question 39

hedging foreign exchange risk

Answer 39

Adding value through financial management
–Economic exposure
»Transaction exposure
»Competitive exposure
–Translation exposure
“Hedging…creates value by protecting the
company’s supply of funds and thus guarantees
the resources necessary to carry out its
strategic plan”

Question 40

what is economic exposure

Answer 40

* Definition:
– The sensitivity of the firm’s cash flows to exchange rate
movements; sometimes referred to as operational
exposure.

– Transaction exposure
* The sensitivity of the firm’s contractual transactions in foreign
currencies to exchange rate movements.
– Competitive exposure
* “economic exposure encompasses all of the ways that an
MNC’s cash flows can be affected by exchange rate
movements.”

Question 41

MNCs transaction portfolio

Answer 41

Measurement of currency volatility
* The standard deviation statistic measures the degree of
movement for each currency. In any given period, some
currencies clearly fluctuate much more than others.
Currency volatility over time
* The volatility of a currency may not remain consistent from
one time period to another. An MNC can identify
currencies whose values are most likely to be stable or
highly volatile in the future.
Measurement of currency correlations
* The correlations coefficients indicate the degree to which
two currencies move in relation to each other.
Applying currency correlations to net cash flows
* If an MNC has positive net cash flows in various
currencies that are highly correlated, it may be exposed to
exchange rate risk. However, many MNCs have some
negative net cash flow positions in some currencies to
complement their positive net cash flows in other
currencies.
Currency correlations over time
* Because currency correlations change over time, an MNC
cannot use previous correlations to predict future
correlations with perfect accuracy.

Question 42

transaction exposure based on value at risk

Answer 42

Measures the potential maximum 1-day loss on the value of
positions of an MNC that is exposed to exchange rate
movements.
Factors that affect the maximum 1-day loss:
* Expected percentage change in the currency rate for the
next day
* Confidence level used
* Standard deviation of the daily percentage changes in
the currency

Question 43

issues with value at risk

Answer 43

• Asset distributions
• Shocks to the system (volatility stability)
• Long holding periods
• Portfolios of risk => correlations
• Statistical adjustment
• Using historical portfolio returns
• Monte Carlo analysis
• Non liquid assets
• Lack of data

Question 44

what is transaction exposure vs competitive exposure

Answer 44

• Transaction exposure
  – Already contracted for -> FC Quantity unaffected
  – Domestic Currency value affected by:
• change in FX rate (conversion)
• Competitive exposure
  – Domestic Currency value affected by:
• change in FX rate (conversion)
• Actual Quantity of FC received

Question 45

what are general causes of competitive exposure

Answer 45

Exchange rate movements
– Unexpected
– Real
KEY: Relative price levels between countries
is a function of both nominal FX rates &
inflation (see parity condition lectures).

Question 46

the individual firms level of competitive exposure

Answer 46

Ability to maintain home-currency
margins
▪ Domestic margins on sales & exports
▪ Price elasticity of demand
▪ Competitive environment
- Product differentiation
- Production locations

Question 47

what is translation exposure

Answer 47

Determinants of translation exposure:
* Proportion of business by foreign subsidiaries: The
greater the percentage of an MNC’s business conducted
by its foreign subsidiaries, the larger the percentage of a
given financial statement item that is susceptible to
translation exposure.
* Locations of foreign subsidiaries: Location can also
influence the degree of translation exposure because the
financial statement items of each subsidiary are typically
measured by the respective subsidiary’s home currency

Question 48

accounting methodology of mnc translation exposre

Answer 48

• The functional currency of an entity is the currency of the
  economic environment in which the entity operates.
• The current exchange rate of the reporting date is used to
  translate the assets and liabilities of a foreign entity from its
  functional currency into the reporting currency.
• The weighted average exchange rate over the relevant period is
  used to translate revenue, expenses, and gains and losses of a
  foreign entity from its functional currency into the reporting
  currency.
• Translated income gains or losses due to changes in foreign
  currency values are not recognized in current net income but
  are reported as a second component of stockholder’s equity;
  (exceptions)
• Realised income gains or losses due to foreign currency
  transactions are recorded in current net income, (exceptions)

Question 49

what are impacts of translation exposure

Answer 49

Exposure of an MNC’s Stock Price to Translation
Effects
* Because an MNC’s translation exposure affects its
consolidated earnings, it can affect the MNC’s valuation.
* Signals that complement translation effects: Exchange
rate conditions that cause a translation effect can also
signal changes in expected cash flows in future years.
Such changes could also influence the stock price.
* Exposure of managerial compensation to translation
effects: Since an MNC’s stock may be subject to
translation effects and since managerial compensation is
often tied to the MNC’s stock price, it follows that
managerial compensation is affected by translation
effects.