Exchange rates

Keywords Spot exchange rates • Appreciation/depreciation • Arbitrage (triangular) • Forward rates/hedging • Premium/discount • Law of one price (relative) • Purchasing power parity • Real exchange rate • Flexible/fixed exchange rates • Effective exchange rates (nominal/real) • Interest rates (term structure) • Interest parity (covered/uncovered) Introduction The previous chapters were all concerned with the question why and how firms go abroad and the implications for these firms and the home and host countries. We now turn to the monetary aspects of the interactions between nations, firms, and consumers in the global economy, with a focus on exchange rates in this chapter. Because countries have their own currency, and internationalizing firms are often confronted with changes in exchange rates, international business activity is associated with a risk. This risk is two-fold: there is a transaction risk and a translation risk. International firms are exposed to both types of risk. Economic exposure refers to the exposure of a firm’s value to changes in the exchange rates. If a firm is active in many countries, with associated receipts and payments in different foreign currencies, and the value of the firm is equal to the present value of all future after-tax cash flows in these countries translated to the base country currency, then it is clear that economic exposure is the most comprehensive measure of exposure to foreign exchange risk (and far from easy to calculate). The transaction risk refers to gains and losses that may be incurred when monetary transactions are settled in a foreign currency. For example, a British firm buys cars from a German firm with a contract price of 1 million euros, and payment is due in 60 days. At the time of the contract the pound/euro exchange rate is 1:1, meaning that the British firm expects to pay 1 million pounds. However, 60 days later when payment is due, the exchange rate has changed to 1.1:1, meaning that the pound decreased in value. To get one euro, more pounds are needed. In other words, the British firm will have to pay 1.1 million pounds, implying that the price has gone up by 100.000 pounds. The German car manufacturer still gets its 1 million euros, but the British firm has to pay more in pounds.