Chapter 27 Managing International Risks 717
bre44380_ch27_707-731.indd 717 10/08/15 10:48 AM
interest in all countries? Does the difference in money interest rates equal the difference in the
expected inflation rates?
This is not an easy question to answer since we cannot observe expected inflation. How-
ever, in Figure 27.4 we have plotted the average interest rate in each of 60 countries against
the average inflation rate. Switzerland is tucked into the bottom-left corner of the chart,
while Venezuela is represented by the dot in the top-right corner. You can see that, in gen-
eral, the countries with the highest interest rates also had the highest inflation rates. There
were much smaller differences between the real rates of interest than between the nominal
(or money) rates.
This may be a good point at which to offer a warning: Do not naively borrow in curren-
cies with the lowest interest rates. Those low interest rates may reflect the fact that investors
expect inflation to be low and the currency to appreciate. In this case, the gain that you realize
from “cheap” borrowing is liable to be offset by the high cost of the currency that is needed
to service the loan. Many have learned this lesson the hard way. For example, in recent years
over 500,000 Poles were lured by low Swiss interest rates into taking out mortgages in Swiss
francs. When the Swiss franc jumped by 23% against the Polish zloty in January 2015, many
of those borrowers found themselves in big trouble.
Professional foreign exchange traders may, from time to time, enter into carry trades in
which they take on currency risk by borrowing in countries with low interest rates and then
use the cash to buy bonds in countries with high interest rates. But wise corporate managers
do not speculate in this way; they use foreign currency loans to offset the effect that exchange
rate fluctuations have on the company’s business.
–10 –5 015 01520253035
Annual inflation rate, %, 2010−201440024681012141618
VenezuelaSwitzerland
Average short-term interest rate, %, 2010-2014◗ FIGURE 27.4
Countries with the
highest interest
rates generally have
the highest inflation.
In this diagram each
of the 60 points rep-
resents the experi-
ence of a different
country.
Source: IMF, International
Financial Statistics.27-3 Hedging Currency Risk
Sharp exchange rate movements can make a large dent in corporate profits. To illustrate how
companies cope with this problem, we look at a typical company in the United States, Outland
Steel, and walk through its foreign exchange operations.