718 Part Eight Risk Management
bre44380_ch27_707-731.indd 718 09/30/15 12:10 PM
Outland Steel has a small but profitable export business. Contracts involve substantial delays
in payment, but since the company has a policy of always invoicing in dollars, it is fully pro-
tected against changes in exchange rates. Recently the export department has become unhappy
with this practice and believes that it is causing the company to lose valuable export orders to
firms that are willing to quote in the customer’s own currency.
You sympathize with these arguments, but you are worried about how the firm should
price long-term export contracts when payment is to be made in foreign currency. If the value
of that currency declines before payment is made, the company may suffer a large loss. You
want to take the currency risk into account, but you also want to give the sales force as much
freedom of action as possible.
Notice that Outland can insure against its currency risk by selling the foreign currency
forward. This means that it can separate the problem of negotiating sales contracts from that
of managing the company’s foreign exchange exposure. The sales force can allow for currency
risk by pricing on the basis of the forward exchange rate. And you, as financial manager, can
decide whether the company ought to hedge.
What is the cost of hedging? You sometimes hear managers say that it is equal to the difference
between the forward rate and today’s spot rate. That is wrong. If Outland does not hedge, it will
receive the spot rate at the time that the customer pays for the steel. Therefore, the cost of insurance
is the difference between the forward rate and the expected spot rate when payment is received.
Insure or speculate? We generally vote for insurance. First, it makes life simpler for the
firm and allows it to concentrate on its main business. Second, it does not cost much. (In fact,
the cost is zero on average if the forward rate equals the expected spot rate, as the expecta-
tions theory of forward rates implies.) Third, the foreign currency market seems reasonably
efficient, at least for the major currencies. Speculation should be a zero-NPV game, unless
financial managers have information that is not available to the pros who make the market.
Is there any other way that Outland can protect itself against exchange loss? Of course. It
can borrow foreign currency against its foreign receivables, sell the currency spot, and invest
the proceeds in the United States. Interest rate parity theory tells us that in free markets the
difference between selling forward and selling spot should be equal to the difference between
the interest that you have to pay overseas and the interest that you can earn at home.
Our discussion of Outland’s export business illustrates four practical implications of our
simple theories about forward exchange rates. First, you can use forward rates to adjust for
exchange risk in contract pricing. Second, the expectations theory suggests that protection
against exchange risk is usually worth having. Third, interest rate parity theory reminds us that
you can hedge either by selling forward or by borrowing foreign currency and selling spot.
Fourth, the cost of forward cover is not the difference between the forward rate and today’s
spot rate; it is the difference between the forward rate and the expected spot rate when the
forward contract matures.
Perhaps we should add a fifth implication. You don’t make money simply by buying cur-
rencies that go up in value and selling those that go down. For example, suppose that you
buy Narnian leos and sell them after a year for 2% more than you paid for them. Should you
give yourself a pat on the back? That depends on the interest that you have earned on your
leos. If the interest rate on leos is 2 percentage points less than the interest rate on dollars, the
profit on the currency is exactly canceled out by the reduction in interest income. Thus you
make money from currency speculation only if you can predict whether the exchange rate will
change by more or less than the interest rate differential. In other words, you must be able
to predict whether the exchange rate will change by more or less than the forward premium
or discount.EXAMPLE 27.1^ ●^ Outland Steel
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