BAB 6

 Exchange rate systems can be classified as fixed rate, freely floating, managed float, and pegged. In a fixed
exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very
narrow boundaries.In a freely floating exchange rate system, exchange rate values are determined by
market forces without intervention. In a managed float system, exchange rates are not restricted by
boundaries but are subject to government intervention. In a pegged exchange rate system, a currency’s
value is pegged to a foreign currency or a unit of account and moves in line with that currency (or unit of
account) against other currencies.
 Numerous European countries use the euro as their home currency. The single currency allows
international trade by firms within the eurozone without foreign exchange expenses and without concerns
about future exchange rate movements. However, countries that participate in the euro do not have
complete control of their monetary policy because one monetary policy is applied to all countries in the
eurozone. In addition, some countries might be more susceptible to a crisis in another country in the
eurozone as a result of being in the eurozone.
 Governments can use direct intervention by purchasing or selling currencies in the foreign exchange
market, thereby affecting demand and supply conditions and, in turn, affecting the equilibrium values of
the currencies. When a government purchases a currency in the foreign exchange market, it puts upward
pressure on the currency’s equilibrium value. When a government sells a currency in the foreign exchange
market, it puts downward pressure on the currency’s equilibrium value.
Governments can use indirect intervention by influencing the economic factors that affect equilibrium
exchange rates. A common form of indirect intervention is to increase interest rates in order to attract more
international capital flows, which may cause the local currency to appreciate. However, indirect
intervention is not always effective.
 When government intervention is used to weaken the U.S. dollar, the weak dollar can stimulate the U.S.
economy by reducing the U.S. demand for imports and increasing the foreign demand for U.S. exports.
Thus, the weak dollar tends to reduce U.S. unemployment, but it can increase U.S. inflation.
When government intervention is used to strengthen the U.S. dollar, the strong dollar can increase the
U.S. demand for imports, thereby intensifying foreign competition. The strong dollar can reduce U.S.
inflation but may cause a higher level of U.S. unemployment.

BAB 7

 Locational arbitrage may occur if foreign exchange quotations differ among banks. The act of locational
arbitrage should force the foreign exchange quotations of banks to become realigned, and locational
arbitrage will no longer be possible.
 Triangular arbitrage is related to cross exchange rates. A cross exchange rate between two currencies is
determined by the values of these two currencies with respect to a third currency. If the actual cross
exchange rate of these two currencies differs from the rate that should exist, triangular arbitrage is possible.
 The act of triangular arbitrage should force cross exchange rates to become realigned, at which time
triangular arbitrage will no longer be possible.
 Covered interest arbitrage is based on the relationship between the forward rate premium and the interest
rate differential. The size of the premium or discount exhibited by the forward rate of a currency should be
about the same as the differential between the interest rates of the two countries of concern. In general
terms, the forward rate of the foreign currency will contain a discount (premium) if its interest rate is
higher (lower) than the U.S. interest rate.
 If the forward premium deviates substantially from the interest rate differential, covered interest arbitrage
is possible. In this type of arbitrage, a foreign shortterm investment in a foreign currency is covered by a
forward sale of that foreign currency in the future. In this manner, the investor is not exposed to fluctuation
in the foreign currency’s value.
 Interest rate parity (IRP) is a theory that states that the size of the forward premium (or discount) should be
equal to the interest rate differential between the two countries of concern. When IRP exists, covered
interest arbitrage is not feasible because any interest rate advantage in the foreign country will be offset by
the discount on the forward rate. Thus, the act of covered interest arbitrage would generate a return that is
no higher than what would be generated by a domestic investment.
 Because the forward premium of a currency from a U.S. perspective is influenced by the interest rate of
that currency and the U.S. interest rate and because those interest rates change over time, the forward
premium changes over time. Thus the forward premium may be large and positive in one period when the
interest rate of that currency is relatively low, but it could become negative (reflecting a discount) if that
interest rate rises above the U.S. interest rate.

BAB 8

 Purchasing power parity (PPP) theory specifies a precise relationship between relative inflation rates of
two countries and their exchange rate. In inexact terms, PPP theory suggests that the equilibrium exchange
rate will adjust by the same magnitude as the differential in inflation rates between two countries. Though
PPP continues to be a valuable concept, there is evidence of sizable deviations from the theory in the real
world.
 The international Fisher effect (IFE) specifies a precise relationship between relative interest rates of two
countries and their exchange rates. It suggests that an investor who periodically invests in foreign interest-
bearing securities will, on average, achieve a return similar to what is possible domestically. This implies
that the exchange rate of the country with high interest rates will depreciate to offset the interest rate
advantage achieved by foreign investments. However, there is evidence that during some periods the IFE
does not hold. Thus, investment in foreign short-term securities may achieve a higher return than what is
possible domestically. If a firm attempts to achieve this higher return, however, it does incur the risk that
the currency denominating the foreign security might depreciate against the investor’s home currency
during the investment period. In this case, the foreign security could generate a lower return than a
domestic security, even though it exhibits a higher interest rate.
 The PPP theory focuses on the relationship between the inflation rate differential and future exchange rate
movements. The IFE focuses on the interest rate differential and future exchange rate movements. The
theory of interest rate parity (IRP) focuses on the relationship between the interest rate differential and the
forward rate premium (or discount) at a given point in time.

BAB 9

 Multinational corporations need exchange rate forecasts to make decisions on hedging payables and
receivables, short-term financing and investment, capital budgeting, and long-term financing.
 The most common forecasting techniques can be classified as (1) technical, (2) fundamental, (3) market
based, and (4) mixed. Each technique has limitations, and the quality of the forecasts produced varies. Yet
due to the high variability in exchange rates, each technique has limited accuracy.
 Forecasting methods can be evaluated by comparingthe actual values of currencies to the values predicted
by the forecasting method. To be meaningful, this comparison should be conducted over several periods.
Two criteria used to evaluate performance of a forecast method are bias and accuracy. When comparing
the accuracy of forecasts for two currencies, the absolute forecast error should be divided by the realized
value of the currency to control for differences in the relative values of currencies.
Because it is nearly impossible to predict future exchange rates with perfect accuracy, MNCs specify
an interval around their point estimate forecast. An interval around the point estimate can be derived from
the recent exchange rate volatility, the historical time series of volatilities, or the implied standard
deviation from currency option prices.

BAB 10

 MNCs with less risk can obtain funds at lower financing costs. Since they may experience more volatile
cash flows because of exchange rate movements, exchange rate risk can affect their financing costs. Thus,
MNCs recognize the relevance of exchange rate risk, and may benefit from hedging their exposure.
 Transaction exposure is the exposure of an MNC’s contractual transactions to exchange rate movements.
MNCs can measure their transaction exposure by determining their future payables and receivables
positions in various currencies, along with the volatility levels and correlations of these currencies. From
this information, they can assess how their revenue and costs may change in response to various exchange
rate scenarios.
 Economic exposure is any exposure of an MNC’s cash flows (direct or indirect) to exchange rate
movements. MNCs can attempt to measure their economic exposure by determining the extent to which
their cash flows will be affected by their exposure to each foreign currency.
 Translation exposure is the exposure of an MNC’s consolidated financial statements to exchange rate
movements. To measure translation exposure, MNCs can forecast their earnings in each foreign currency
and then determine how their earnings could be affected by the potential exchange rate movements of each
currency.
 BAB 11

 An MNC may choose to hedge most of its transaction exposure or to selectively hedge. Some MNCs hedge
most of their transaction exposure so that they can more accurately predict their future cash inflows or
outflows and make better decisions regarding the amount of financing they will need. Many MNCs use
selective hedging, in which they consider each type of transaction separately.
 To hedge payables, a futures or forward contract on the foreign currency can be purchased. Alternatively, a
money market hedge strategy can be used; in this case, the MNC borrows its home currency and converts
the proceeds into the foreign currency that will be needed in the future. Finally, call options on the foreign
currency can be purchased.
 To hedge receivables, a futures or forward contract on the foreign currency can be sold. Alternatively, a
money market hedge strategy can be used. In this case, the MNC borrows the foreign currency to be
received and converts the funds into its home currency; the loan is to be repaid by the receivables. Finally,
put options on the foreign currency can be purchased.
 The currency options hedge has an advantage over the other hedging techniques in that the options do not
have to be exercised if the MNC would be better off unhedged. A premium must be paid to purchase the
currency options, however, so there is a cost for the flexibility they provide. One limitation of hedging is
that if the actual payment on a transaction is less than the expected payment, the MNC overhedged and is
partially exposed to exchange rate movements. Alternatively, if an MNC hedges only the minimum
possible payment in the transaction, it will be partially exposed to exchange rate movements if the
transaction involves a payment that exceeds the minimum.
Another limitation of hedging is that a short-term hedge is only effective for the period in which it was
applied. One potential solution to this limitation is for an MNC to use long-term hedging rather than
repeated short-term hedging. This choice is more effective if the MNC can be sure that its transaction
exposure will persist into the distant future.
 When hedging techniques are not available, there are still some methods of reducing transaction exposure,
such as leading and lagging, cross-hedging, and currency diversification.