search in the foreign exchange markets has come a long way since the days when in-
ternational trade was thought to be the dominant factor determining the level of the
exchange rate. Monetary variables, capital flows, rational expectations, and portfolio
balance are all now understood to factor into the determination of currency values in
a floating exchange rate system. Many models have been developed to explain and to
forecast exchange rates. No model has yet proved to be the definitive one, probably
because the worlds’ economies and financial markets are undergoing constant rapid
evolution.
Corporations nevertheless avidly seek ways to predict currencies, in order to de-
cide when to hedge and when not to hedge. The models typically fall into one of the
following categories: political event analysis, fundamental, or technical analysis.
Academic studies in international finance, in contrast, find strong empirical sup-
port for the role of arbitrage in global financial markets, and for the view that ex-
change rates exhibit behavior that is characteristic of other speculative asset markets:
They react to news. Rates are far more volatile than changes in underlying economic
variables; they are moved by changing expectations, and hence are difficult to fore-
cast. In a broad sense they are “efficient” but tests of efficiency face inherent obsta-
cles in testing the precise nature of this efficiency directly.
The simplistic “efficient market” model is the unbiased forward rate theory intro-
duced earlier. It says that the forward rate equals the expected future level of the spot
rate. Because the forward rate is a contractual price, it offers opportunities for spec-
ulative profits for those who correctly assess the future spot price relative to the cur-
rent forward rate. Specifically, risk neutral players will seek to make a profit if their
forecast differs from the forward rate, so if there are enough such participants, the
forward rate will always be bid up and down until it equals the expected future spot.
Because expectations of future spot rates are found on the basis of presently avail-
able information (historical data) and an interpretation of its implication for the fu-
ture, they tend to be subject to frequent and rapid revision. The actual future spot rate
6 • 20 MANAGEMENT OF CORPORATE FOREIGN EXCHANGE RISKSTEPS IN MANAGING ECONOMIC EXPOSURE
- Estimation of planning horizon as determined by reaction period (time dependence of ex-
posure). - Determination of expected future spot rate (depending on state of FX market, usually for-
ward rate). - Estimation of expected revenue and cost streams, given the expected spot rate.
- Estimation of effect on revenue and expense streams for unexpected exchange rate
changes (exposure estimation). - Choice between hedging and positioning (depending on state of FX market)
- Choice of appropriate type of hedging instrument/strategy (cash market, derivatives, arbi-
trage considerations). - Determination of specific characteristics of hedging instrument (duration, denomination,
options) - Estimation of amount of hedging instrument required.
- Decision about “residual” risk: consider adjusting business strategy/operations.
Exhibit 6.7. Steps in Managing Economic Exposure.