Circumventing Foreign Currency Risk
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 4.3 percent against the dollar, as implied by the ratio between the U.S. and United Kingdom inflation rates (1.10/1.15 = 0.957). 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 [next page]