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About this book

Since I first published Management of Foreign Exchange Risk (Lexington Books, 1978), financial innovation-spurred, in part, by exploding volatility in currency prices-has revolutionized the theory and praxis of foreign exchange risk management. Old-fashioned forward contracts have surrendered market share to currency swaps and options as well as to their perpetually multiplying derivatives. Interestingly, forex derivatives now provide a low cost and highly efficient method of transferring risk from the firms that are exposed to risk but which would rather not be (i. e. , risk-hedgers) to those which are not exposed but which-in exchange for a fee-would assume some exposure to risk (i. e. , risk­ bearers). Perhaps more importantly, foreign exchange risk management, which was once a fairly mechanical task confmed to the international treasury function, is now permeating global strategic management. Indeed, since the demise of the Bretton Woods system of pegged exchange rates, the cost of forex hedging instruments has fallen so dramatically that firms can readily avail themselves of hedging products which can reduce unwanted risk, thereby potentially gaining a competitive advantage over rivals that do not. Management and Control of Foreign Exchange Risk has grown out of a fundamental revision of my earlier work published almost 20 years ago. In the process, my thinking about risk and its mathematics has greatly benefitted from my association with John Cozzolino and Charles Tapiero.

Table of Contents

Frontmatter

1. Determination of Spot Exchange Rates

Abstract
Of all the winds of change that have buffeted multinational corporations in recent years, none has had a more pervasive impact upon their risk-return profile than the breakdown of the international monetary system of fixed exchange rates that had prevailed until March 1973 under the Bretton Woods agreement (1944–1971) and, later, under the short-lived Smithsonian accord (1971–1973).
Laurent L. Jacque

2. Determination of Forward Exchange Rates

Abstract
The forward exchange market provides firms exposed to foreign exchange risks with a versatile hedging tool, namely, the forward exchange contract. In recent years, the dramatic increase in exchange rate volatility has led to the creation of new hedging instruments such as currency futures, currency options, and currency swaps, which are increasingly used as adjuncts to old-fashioned forward contracts: they are analyzed in chapter 3. This chapter offers a conceptual model of the forward exchange market, with special attention given to understanding how various transacting parties interact and, in so doing, determine the forward exchange rate.
Laurent L. Jacque

3. Currency Futures, Options, Derivatives, and Swaps

Abstract
Forward exchange contracts had been available for decades, but it was not until the breakdown of the Bretton Woods system of fixed exchange rates and the resulting heightened volatility in currency prices that new foreign exchange risk management products started to appear. Futures contracts on foreign exchange were first introduced in May 1972 when the International Money Market of the Chicago Mercantile Exchange began trading contracts on the British pound, Canadian dollar, Deutsche mark, Japanese yen, and Swiss franc.
Laurent L. Jacque

4. Forecasting Floating Exchange Rates

Abstract
It is hardly necessary to emphasize the frequency and magnitude of changes of pegged exchange rates or the continuous gyrations of floating exchange rates to understand the hazards of successful decision-making in international business.
Laurent L. Jacque

5. Forecasting Pegged Yet Adjustable Exchange Rates

Abstract
Since the breakdown of the Bretton Woods system of fixed exchange rates in late 1971, currency prices are commonly believed to be determined by a floating exchange rate system. However, only a handful of key currencies float independently. All other currencies are either tied to one of the key currencies or possibly to an artificial currency unit such as the Special Drawing Right. Thus the current international monetary system is best described as a system in which currencies within major trading blocs maintain quasi-pegged yet adjustable relationships with each other, but fluctuate continuously—or float in unison—against the currencies of the other major blocs.1
Laurent L. Jacque

6. Accounting Exposure to Foreign Exchange Risk

Abstract
What is currency exposure to foreign exchange risk? How can such exposure be measured? How should internal reporting systems be designed to keep track of it? Should such currency exposures be centrally consolidated by the multinational corporation? Many of the answers to these various questions depend on the nature of the corporation’s involvement in foreign markets.
Laurent L. Jacque

7. Economic Exposure to Foreign Exchange Risk

Abstract
In this chapter, the accounting concept of exposure to foreign exchange risk (developed at great length in the previous chapter) is found to be lacking from the standpoint of a modern theory of finance because it is rooted in the historical valuation of the firm. Specifically, it ignores the future, longer-term implications of exchange rate changes for the competitive posture and hence, the profitability or valuation of the multinational corporation. As Dufey comments about the impact of the French franc devaluation on the French subsidiary of a U.S. multinational corporation:
Local currency revenue and cost streams will not follow the pattern projected before the devaluation. In fact, after the devaluation, the local currency flows will exhibit differences that are systematic and predictable as to direction. Therefore, a uniform, indiscriminate application of the devaluation percentage to the projected pre-devaluation flows gives an inaccurate picture.1
Laurent L. Jacque

8. Exchange Risks in International Trade

Abstract
Firms still in the early phases of internationalization are primarily exposed to foreign exchange risks of a transaction nature that result from the practice of denominating accounts receivable (in the case of exports) or accounts payable (in the case of imports) in a foreign currency.
Laurent L. Jacque

9. Optimal Currency Denomination in Long-Term Debt Financing

Abstract
As state-owned and corporate entities gain a more global outlook, foreign currency-denominated debt instruments become an integral part of their financing options. In a world of efficient currency markets and integrated capital markets, optimal currency-denomination for long-term debt sourcing decisions become a matter of indifference since nominal interest rates reflect inflation rate expectations, which, in turn, determine the future spot exchange-rate adjustment path. In such an idealized world, the effective cost of debt across currency “habitats” should be equal. In reality, most financial markets are segmented from one another—at least to some degree—and the resulting international cost of debt discrepancies are what keep corporate treasurers busily employed. Indeed, in a world of “mildly” segmented capital markets (see box 9.1), where “overshooting” exchange rates, credit rationing with interest-rate ceilings, and “crowding out” by public borrowers are generally the norm rather than the exception, the issue of optimal currency denomination assumes real operational significance.
Laurent L. Jacque

10. Hedging Translation Exposure

Abstract
Exchange rates used in translating the financial statements of foreign subsidiaries may depreciate or appreciate substantially over a given accounting period. Short of net zero exposures on a currency-by-currency basis, such fluctuations in exchange rates will generally result in considerable exchange losses (gains) that will clearly play havoc with what might otherwise be a smooth income stream from foreign operations. Translation losses will also reduce shareholders’ equity and therefore impact the debt-equity ratio of the firm. As the leverage ratio deteriorates, the firm will find its cost of debt financing increasing and/or its access to financial markets restricted.
Laurent L. Jacque

11. Exchange Rates and the International Control Conundrum

Abstract
The design of an effective management control system for domestic companies is burdened with the problem of information asymmetry and goal incongruence between parent and subsidiaries. In an international setting, the problems are further compounded by exchange rate fluctuations between the foreign subsidiary’s local currency and the parent company’s reference currency.1 To be reliable, management control systems for multinational corporations (MNCs) must somehow incorporate a multiplicity of complicating factors such as exchange rates, differential rates of inflation, and byzantine national price and exchange controls.
Laurent L. Jacque

Backmatter

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