Exchange rate risk and international investment
Firms operating internationally face currency risk. They manage it with hedging and by structuring operations wisely.
Types of currency exposure
Transaction exposure is the risk that exchange rates change between agreeing a deal and paying or being paid. Translation (accounting) exposure arises when foreign subsidiaries' statements are converted into the parent's currency. Economic (operating) exposure is the long-term effect of exchange rates on a firm's competitiveness and cash flows.
Hedging with derivatives
Firms hedge transaction exposure using forward contracts (customised agreements to exchange at a set rate), futures (standardised exchange-traded contracts), currency options (the right, but not obligation, to exchange at a set rate, for a premium), and currency swaps (exchanging cash flows in different currencies over time).
Natural hedging
Operational strategies reduce exposure without derivatives: matching revenues and costs in the same currency (for example, building factories in countries where products are sold), borrowing in the currencies of foreign revenues, and diversifying across markets. Many car makers produce in their major sales markets partly for this reason.
International capital budgeting
When evaluating foreign projects, firms forecast cash flows in the foreign currency, convert them using expected exchange rates, and discount them at a rate reflecting the project's risk, including country risk. Alternatively, foreign cash flows can be discounted at a foreign-currency discount rate and converted at the spot rate.
Country and political risk
International investments face country risk: expropriation, sudden tax or regulatory changes, capital controls that block moving money out, political instability, and war. Firms assess these risks, buy political risk insurance from agencies such as the World Bank's MIGA, and structure deals to limit exposure.
International portfolio investment
Investors diversify internationally because foreign markets do not move perfectly with domestic ones. Returns depend on both foreign asset returns and currency changes: if a foreign stock rises 10% but its currency falls 5% against yours, your return is roughly 4.5%. Correlations between markets have risen with globalisation and tend to rise during crises.
Multinational financing
Multinationals can raise funds in global markets: Eurobonds (bonds issued outside the country of their currency), foreign bonds, global syndicated loans, and listings on foreign stock exchanges through American Depositary Receipts (ADRs). Access to multiple markets can lower the cost of capital.
Worked example
A US investor buys a Japanese stock for 1,000,000 yen when 1 dollar = 150 yen (6,667 dollars). A year later the stock is worth 1,100,000 yen (+10%), but the yen has weakened to 160 per dollar. The investment is now worth 6,875 dollars: a dollar return of only about 3.1%, because the currency move offset most of the stock's gain.
Key takeaways
Currency exposure can be transaction, translation, or economic. Firms hedge with forwards, futures, options, and swaps. Natural hedges match currencies of revenues and costs. International projects need currency forecasts and country risk adjustments. Political risk includes expropriation and capital controls, partly insurable through agencies such as MIGA. International investing diversifies but adds currency risk. Multinationals raise funds through Eurobonds, global loans, and ADRs.
Flashcard
Risk between agreement and payment
Check your understanding
A US investor's foreign stock rises 10% in local currency, but the foreign currency falls 6% against the dollar. Approximately what is the investor's dollar return?