rate, his gain (the interest rate differential) will be offset by his expected loss because
of foreign exchange rate changes.
The Unbiased Forward Rate Theory asserts that the forward exchange rate is the
“best” estimate of the expected future spot rate. While it is consistent with the effi-
cient market theory that asserts that all relevant information is reflected in prices, in-
cluding forwards and futures, market efficiency allows the existence of factors that
can introduce a “bias” in the forward price of foreign exchange. However, in the ab-
sence of such factors, it is difficult to claim that systematic and regular biases exist
that would not be taken advantage of by professional market participants and, thus,
eliminated. Indeed, the best empirical evidence of ex post data demonstrates that risk
premiums exist, but they are time variant, exhibiting a largely random pattern.
For risk management, therefore, there is little choice but to act as if ex ante, the
forward is an unbiased predictor of the expected future spot rate in all those curren-
cies where there are no factors such as exchange controls, excess external indebted-
ness, or other identifiable reasons that would rationalize a reasonably systematic risk
premium. In the absence of such influences, the unbiased forward rate theory can be
stated simply:
Now we can summarize the impact of unexpected exchange rate changes on the
internationally involved firm by drawing on these parity conditions. Given sufficient
time, competitive forces and arbitrage will neutralize the impact of exchange rate
changes on the returns to assets; due to the relationship between rates of devaluation
and inflation differentials, these factors will also neutralize the impact of the changes
on the value of the firm. This is simply the principle of Purchasing Power Parity and
the Law of One Price operating at the level of the firm. On the liability side, the cost
of debt tends to adjust as debt is repriced at the end of the contractual period, re-
flecting (revised) expected exchange rate changes. And returns on equity will also re-
flect required rates of return; in a competitive market, these will be influenced by ex-
pected exchange rate changes. Finally, the unbiased forward rate theory suggests that
locking in the forward exchange rate offers the same expected return as remaining
exposed to the ups and downs of the currency—on average, it can be expected to err
as much above as below the forward rate.
In the long run, it would seem that a firm operating in this setting will not experi-
ence net exchange losses or gains. However, because of contractual or, more impor-
tantly, strategic commitments, these equilibrium conditions rarely hold in the short and
medium term. Moreover, the preceding equilibrium conditions refer to economic rela-
tionships across all markets in the entire economy, which does not necessarily mean
that they hold for the individual firm that operates in a specific segment of the market.
Therefore, the essence of foreign exchange exposure and, significantly, its manage-
ment, are made relevant by these deviations, which may be temporary or structural.
6.4 IDENTIFYING EXPOSURE. The first step in management of corporate foreign
exchange risk is to acknowledge that such risk does exist and that managing it is in
the interest of the firm and its shareholders. The next step, however, is much more
difficult: the identification of the nature and magnitude of foreign exchange exposure.
In other words, identifying what is at risk, and in what way. The focus here is on the
exposure of nonfinancial corporations, or rather the value of their assets. This re-
Expected exchange rateForward exchange rate6 • 8 MANAGEMENT OF CORPORATE FOREIGN EXCHANGE RISK