3.5. CFO’S SUMMARY 115
for instance, in the BigMac data set). Also, there is a lot of variability over time,
making countries more attractive or unattractive as production centers or markets.
Most of that variability comes from the nominal exchange rate: inflation contributes
little, except for hyper-inflation episodes (with inflation rates measured in 100s or
1000s per month). Thus, currency risk affects contractual cash flows fixed infcbut
also the operations of a firm. It even messes up thecapmbecause real exchange
risk means that investors from different countries no longer perceive asset returns
and risks in the same way.
What are the implications for theCFO? You should remember, first, that varia-
tions in the real exchange rate are long-memory events and can be vast. So they
can have a big impact on how and where you should produce, and may even force
you to change your fundamental strategy. All this comes on top of a shorter-run
effect, of course: variations in exchange rates cause capital gains and losses onfc-
denominated contractual claims and liabilities.
Your instinctive reaction may be that the firm should try to reduce the impact
of these changes. This may be too fast, though: we first need to determine whether
any such “hedging” policy really adds value. To be able to answer this question,
we need to understand how the hedge instruments work: forwards, futures, swaps,
and options. A good knowledge of these derivatives is, of course, also required to
make an informed choice among the available hedge instruments. This is what the
remainder of Part II is about. We begin with forward markets.
References
Grabbe, O., 1995. International Financial Markets, 3rd Edition, New York: Else-
vierDeardorff , a. V., 1979. One-Way Arbitrage and Its Implications for the Foreign
Exchange Markets. The Journal of Political Economy, Vol. 87 Issue 2, p351-65