Exchange Risk and Corporate International Finance

The major sources of financial uncertainty for firms engaged in international business arise from changes in exchange rates and changes in exchange controls — events which are not readily predictable. The risks of changes in exchange rates — both of changes in parities under a pegged rate system and fluctuations under a floating rate system — are inherent in a system of national currencies, just as the risks of changes in exchange controls and of expropriation are inherent in a system of multiple sovereigns.

Changes in exchange rates are uncertain events. Most changes in exchange rates are associated with differential movements in national price levels — the price levels in the countries whose currencies are devalued or depreciate have risen more rapidly than the U.S. price level and, to a lesser extent, the countries whose currencies were revalued or appreciated have had less rapid inflation. Even then, the timing of such changes cannot be foretold with accuracy. Moreover, not all changes in exchange rates, especially on a month-to-month or quarter-to-quarter basis, reflect changes in relative prices. Since most industrial countries ceased pegging their currencies in early 1973, the exchange rate between the mark price of the U.S. dollar has fluctuated sharply, even though the U.S. and German price levels have increased at almost the same rate.

Changes in exchange rates are inevitable in a world of more than one hundred national currencies. Investors may be able to advance their economic welfare by acquiring assets denominated in currencies they expect to appreciate and selling assets and issuing liabilities denominated in currencies they expect to depreciate. As investors revise their holdings of assets denominated in different currencies, exchange rates should change. At any moment individual investors must determine whether the anticipated changes in the exchange rates have been fully discounted in other economic variables, or whether there remains an unexploited profit opportunity.

Political risk involves the uncertainty that investors have about changes in laws and regulations that national authorities apply to the transfer of funds across national borders and the ownership of assets within their jurisdictions by foreign firms and residents. Each national government can control the movement of securities across national borders, thus hindering foreign loans and investments, and the repatriation of profits, dividends and capital. Each government can use its legal powers to acquire the property of private parties — of foreign residents as well as of domestic residents — located within its jurisdiction. And each also can refuse to pay its debts to foreigners with minimal fear of being sued.

Three proportionality concepts — the Purchasing Power Parity Theory, Fisher Open and the Interest Rate Parity Theorem — involve the relationships between changes in exchange rates and levels and rates of change of national commodity price levels, interest agios and exchange agios. If these propositions are continuously valid in the short run as well as in the long run, exchange risk disappears; the firm’s net worth, income and market value would not be affected by changes in exchange rates, regardless of the currencies in which its assets and liabilities are denominated.¹ To the extent that there are deviations from these propositions, either in the short run or the long run, changes in exchange rates may affect the firm’s income and perhaps its market value.

Whether investors find it attractive to alter the currency mix of financial assets and liabilities in anticipation of changes in the exchange rates depends on how fully interest rate differentials and forward exchange rates reflect such anticipations. If Fisher Open holds continuously, changes in the currency mix of portfolios would not affect the firm’s income, net worth or market value; neither would changes in exchange rates. Thus a central question is whether the deviations from Fisher Open are so large that the concept has little empirical usefulness, or whether, if it is useful, deviations are systematic and predictable or random.

Political risk is customarily associated with the expropriation of local branches of foreign firms by the host-country governments, usually with inadequate compensation, mostly within developing countries. Consequently, many firms prefer to borrow locally to finance their foreign subsidiaries to minimise their exposure to losses from expropriation; they anticipate that if a subsidiary is expropriated, its new owners would be obliged to repay its debts, and the parent firm would be free of any remaining financial obligation. A second, less dramatic concern with political risk involves changes in exchange controls — firms are concerned about host-country constraints on the payment of dividends and the repayment of capital;¹ they want to ‘get their money out’ as soon as possible.

Risk neutralisation involves structuring the currency mix of the firm’s assets and liabilities so that changes in exchange rates will have minimal impacts on its income, net worth, and market value.¹ The firm with a long position in the pengo can reduce its exposure by acquiring additional pengo liabilities; the firm might borrow pengos and use the loan proceeds to buy dollars or it might sell the pengo forward.² As a first step, the firm should estimate the impact of anticipated changes in exchange rates on its income and market value with the current mix of assets and liabilities denominated in various currencies, and then with alternative mixes of assets and liabilities denominated in these currencies. ³ This chapter describes the techniques that can be used to alter the firm’s exposure to exchange risk and the costs or returns associated with such changes.⁴

The measurement of the firm’s exposure to exchange risk involves estimating how various benchmarks of its economic performance — income, net worth and market value — would be affected by changes in exchange rates. Many firms indicate that they prefer not to be exposed. But there is less than complete agreement on the currency mix of assets and liabilities that is consistent with a non-exposed position.

The structure of corporate income taxes may affect the willingness of the firm to maintain an exposed position in various foreign currencies and bear the uncertainty of variations in income from changes in exchange rates. Moreover, the tax structure also affects the techniques used to alter exposure, and the countries in which firms realise their exchange gains and their exchange losses.

The statements of corporate managers and financial executives suggest a variety of strategies towards exchange risk. A strategy is a systematic approach indicating when an exposure in a foreign currency should be maintained, and when it should be increased or reduced. The elements in a strategy include the anticipated costs of altering exposure by transactions effected currently and at various future dates, and the firm’s attitudes towards the uncertainty about impacts of changes in exchange rates and changes in exchange controls on its income, net worth, and market value.

The firm involved in international business encounters a unique set of risks. The timing of changes in both exchange rates and in exchange controls is unknown. Governments announce that they will not change their parities, or that they will rely on floating exchange rates for the indefinite future, or that they will not adopt or alter their exchange controls, or that the property rights of foreign firms will be respected. Such commitments may be maintained — for a time. But national monetary policies and national politics are in more or less continuous flux; governments come and go, and successor regimes may not feel bound by the commitments of their predecessors — and even by their own commitments.