Wednesday, August 8, 2012

Circumventing Foreign Currency Risk

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Foreign currency exchange (FX) rates express the relational value between any two currencies at any point in time. The value of one currency over the other is determined by simple supply and demand. Fluctuations, and appreciation or devaluation of currencies effect trade globally. When it comes to government, Purchasing Power Parity (PPP), and Balance of Payments (BOP) are two methods of evaluating the effects of FX deviations; in the case of foreign companies, domestic companies with foreign interests, and investors of the same, there are mechanisms available to effectively circumventing FX rate risks. Monitoring FX rate changes and relationships daily, and responding accordingly, is paramount in ensuring the well-being of countries, the profitability of companies, and positive yields for investors of foreign companies.

FX rates represent the price of one currency denominated in units of another currency. While it is meaningless to talk of the price of one currency against itself, it is nevertheless possible to measure the changes in the real value of a currency. In essence, inflation and deflation--that is, the change in the price of a fixed basket of goods and services in terms of a single currency—is the measure of change in the real value of a currency. A currency’s real value is often referred to as its �purchasing power.” �Purchasing power parity” (PPP) is said to exist between two currencies when both command the same basket of real goods and services at the prevailing exchange rate. The PPP theorem basically states that, in the long run, the changes in FX rates will equal the relative changes in the purchasing power of the underlying currencies. To illustrate, let’s consider the dollar/pound sterling exchange rate. To simplify the example, it is assumed that at a certain point in time, called the �base period,” the market exchange rate reflected the �true” exchange rate. In other words, the exchange rate was such that both currencies commanded the �same” basket of goods. Assume that in the following period, the average price of that basket of goods increased 10 percent in dollar terms (i.e. the United States experienced an inflation rate of 10 percent, or equivalently, the U.S. dollar lost 10 percent of its purchasing power), and 15 percent in pound sterling terms. In the absence of restrictions on free trading, the theory suggests that the pound should decline 4. percent against the dollar, as implied by the ratio between the U.S. and United Kingdom inflation rates (1.10/1.15 = 0.57). Although, over the long run, actual exchange rates tend to roughly to track the exchange rates implied by the PPP theorem, at times, these rates can diverge substantially. Such deviations can be due either to institutional constraints, which can temporarily prevent the fundamentals from asserting themselves, or simply to the fact that it can sometimes take a long time, even years, for these fundamental forces to influence the behavior of market participants. �A government that inflates is therefore led to try to manipulate the foreign exchange rate. When it fails, it blames internal inflation on the decline in the exchange rate, instead of acknowledging that cause and effect run the other way.”

In order to understand the forces that create deviations between actual and PPP-implied rates, it is helpful to analyze the supply and demand for a currency using the balance of payments format (BOP). The BOP is a statistical presentation of economic transactions, during a given period, between the residents of one country and those of the rest of the world. By international convention, the BOP is broken down into three accounts current, capital and official settlements. Although, in an accounting sense, the BOP is always in balance, the terms �surplus” and �deficit” are used to refer to the net balance of the current and capital accounts portion of the BOP. Other things being equal, the forecast for a BOP deficit implies a declining currency, because it means that during the given period the supply of that currency will exceed the demand. As with any commodity, when supply exceeds demand, the imbalance will create pressures, which force the price to decline until the supply/demand balance is restored. However, if the imbalance is short-lived, such a price adjustment may not necessarily materialize. If the monetary authorities in a given country do not want their currency to decline, because such a development would imply more expensive imports and as a result, higher inflation, they can simply absorb excess supply of that currency through purchases in the FX markets; the purchase or sale of a county’s currency by its central bank is called �intervention.” Of course, such purchases must be financed through a draw down of reserves. However, unless the BOP deficits are reversed, the exchange rate cannot be protected indefinitely, since reserves will eventually decline to unacceptably low levels, forcing depreciation in the currency. In fact, a sustained decline in reserves is often a red flag, foreshadowing depreciation. Companies and investors, however, do have safeguards that will protect their companies and investments indefinitely.

Whenever a company manufactures in one country and sells its product in another country, the company is susceptible to FX rate risks. To ensure profitability, companies, like governments, must stay informed of intra-day FX changes. This information is not only utilized to make sale price adjustments, but also used in setting foreign costs of production. Unlike government, however, these companies can eliminate FX rate risks, in the same fashion as managers of foreign investment pools. Investing in foreign companies, as well as American companies with foreign interests have the same inherent risks to common stock holders of these companies. Stock portfolios of foreign companies and American companies with foreign interests, most commonly held by mutual or closed end funds, are categorized as �world,” �global,” or �international” funds, and are managed by investment managers that must not only generate profits, but must also minimize losses for its investors. In addition to the obvious losses due to the fall in share values of stocks held by the fund, losses can also be incurred by changes in FX rates. A prudent money manager can avoid FX losses by hedging via currency future contracts and options of the same. Hedging is similar to, what we commonly call, an insurance policy, in that it protects assets; in this case, the assets are foreign stocks and domestic stocks with foreign interests. For example, if a fund holds $1,000,000 of stock in a German company, denominated in Deuche Marks (DM), the fund would sell ten $100,000 DM commodity futures contracts on the Chicago Board of Trade (CBOT); if DMs remained stable by the time the fund sold the stock, the fund would neither lose nor gain on the futures transaction; if DMs, were to lose value versus the U.S. dollar during the stock holding period, the fund would profit on the futures contract and this would offset the currency losses incurred from the sale of the stock; if, on the other hand, DMs rose in value versus the U.S. dollar, the fund would experience a loss on the futures contract, which would, consequently, offset any profits due to currency inflation from the stock sale. Aggressive and knowledgeable fund managers utilize commodity futures markets, not only for hedging, but also as another profit center for the fund. For example, if the fund had sold twenty $100,000 DM contracts, instead of ten, in the above example, the fund would basically have two times the insurance it really needs; the additional $1,000,000 of coverage could be highly profitable to the fund. Profits from futures transactions could far surpass the profits from the actual stock transaction, and are often responsible for elevating the fund’s year-end yield standing well above those funds with the similar investment objectives that are not maximizing on FX opportunities.

Monitoring FX changes and relationships are paramount in ensuring the well-being of countries, profitability of companies, and positive yields for investors of foreign companies. Although governments have two effective methods (PPP & BOP) of evaluating and predicting the effect of changes in FX rates, governments do not have an effective way to protect their currency from appreciating or devaluating, but are at the mercy of large investors and fund managers that are constantly searching the globe for higher yields. Foreign companies, domestic companies with foreign interests, and investors, however, do not share the same fate. With today’s computers, Internet, access to information, and the ability to move capital globally, even the small investor can, not only, capitalize on foreign investment opportunities, but eliminate currency risks as well. Think global for higher yields!

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