3.6 International Finance

Types of Exchange-Rate Exposure

Operating across currencies creates three distinct exposures, ordered roughly from narrowest to broadest in scope.

Transaction exposure: the risk that an exchange-rate change between the date a transaction is booked and the date it settles alters the home-currency value of a committed cash flow. Example: a U.S. firm that will collect 1 million euros in 90 days loses value if the euro weakens.

Translation (accounting) exposure: the effect of restating a foreign subsidiary's financial statements into the parent's reporting currency for consolidation. It is an accounting, not a cash, effect and flows through other comprehensive income.

Economic (operating) exposure: the long-run effect of currency movements on the firm's competitive position, future cash flows, and market value, even for purely domestic firms whose competitors import. It is the broadest and hardest to hedge.

Trap: transaction exposure concerns specific committed cash flows; economic exposure concerns the entire future cash-flow stream and competitiveness.

Hedging Foreign-Exchange Risk

Firms reduce currency risk with derivatives and financing techniques, choosing the tool that fits whether the future cash flow is certain or contingent.

Forward contract: a customized agreement to exchange currency at a fixed rate on a future date; locks in the rate with no upfront premium. The standard tool for hedging a known future cash flow.

Currency futures: standardized, exchange-traded forwards; liquid but less customizable, marked to market daily.

Currency options: give the right, not the obligation, to exchange at a set strike rate for a premium. They cap downside while preserving upside, ideal when the cash flow is uncertain (e.g., a contingent bid).

Money-market hedge: borrow in one currency now, convert at today's spot rate, and invest, so the future exchange rate is effectively locked using the spot rate and interest rates rather than a forward contract.

Hedging reduces the variability of outcomes, not the expected value; it buys certainty, sometimes at the cost of forgone favorable moves.

Parity Conditions

Two equilibrium relationships connect rates, prices, and exchange rates.

Interest-Rate Parity (IRP)

IRP states that the difference between the forward and spot exchange rate equals the interest-rate differential between the two currencies. A currency with a higher interest rate trades at a forward discount; the lower-rate currency trades at a forward premium. Arbitrage (covered interest arbitrage) forces this to hold: if it did not, traders could borrow cheap, lend dear, and lock a riskless profit via the forward market.

Purchasing-Power Parity (PPP)

PPP holds that, absent trade frictions, identical goods should cost the same everywhere when priced in a common currency (the law of one price). The implication: a country with higher inflation sees its currency depreciate so prices realign. PPP explains long-run exchange-rate trends better than short-run moves.

Financing International Operations

Multinationals can borrow in local-currency debt to create a natural hedge (foreign revenue services foreign debt), tap the Eurobond and eurocurrency markets, or issue in the parent's currency. Matching the currency of financing to the currency of cash flows reduces transaction exposure without explicit derivatives.

Country and Political Risk

Country (political) risk is the risk that government action or instability in a host country impairs an investment. Key forms:

Mitigation includes structuring local financing, buying political-risk insurance, forming joint ventures with local partners, and adding a country-risk premium to the project's discount rate.

Spot vs. Forward Rates and Quoting

The spot rate is the exchange rate for immediate delivery; the forward rate is locked today for future delivery. A currency trades at a forward premium when its forward rate exceeds its spot rate, and at a forward discount when it is lower. Watch the quote direction: a rate stated as dollars-per-euro moves opposite to one stated as euros-per-dollar, a frequent source of sign errors on the exam.

Natural and Operating Hedges

Not all hedging uses derivatives. A natural hedge offsets a foreign-currency inflow with a foreign-currency outflow, such as sourcing materials in the same currency as sales. Firms also diversify production across countries so a currency shock that hurts one location's costs benefits another's, smoothing economic exposure that financial contracts cannot easily cover.

Translation Methods

Under the current-rate method, a foreign subsidiary's assets and liabilities are translated at the period-end rate and the adjustment goes to a cumulative translation account in equity. The temporal method translates monetary items at the current rate and non-monetary items at historical rates, with gains and losses hitting income. The method depends on the subsidiary's functional currency.

Evaluating Foreign Investments

To value a foreign project, forecast cash flows in the local currency, discount at a rate reflecting that market's risk, and convert to the home currency, or convert each year's cash flow at expected future exchange rates and discount at the home-currency rate. Add a premium for country and political risk where warranted, and remember that blocked-funds restrictions can reduce the cash actually available to the parent.