Circumventing Foreign Currency Risk
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 [next page]