Short- and Long-Run Exchange Rate Risk Exercise

Worksheet (v1.2)

In this exercise you are asked to choose a currency in which it is assumed you have foreign exchange exposure both in trade (short-run) and investment (long-run). In this exercise you are asked to find both spot and forward exchange rates for a chosen currency and also inflation rates associated with that currency. You are encouraged to read through the exercise first before choosing your currency to ensure the requested data is accessible via the links provided.

1.Short-Run Exchange Rate Risk

Assume you have a trade receivable denominated in a foreign currency of your choice that is payable to you by your customer in 6 months. At the current spot rate the trade receivable is worth the equivalent of US$5,000,000.To find the current spot rate for the chosen currency pair go to http://www.hsbcnet.com/gbm/fxcalc-disp.[1] Enter 5,000,000 in the "Convert" box, United States dollar in the "From:" box, and your chosen currency in the "To:" box. Click on "Go" for the spot rate, which will be expressed in European terms, that is, units of foreign currency per one US dollar. Enter the name of the chosen currency, the date the site is accessed, and the spot rate in European terms in the table below.

To find a 180 day forward rate for the currency pair, go to http://www.hsbcnet.com/gbm/fwcalc-disp#. For "Amount" you can just enter 1 and enter US dollars in the "Buy" box and the foreign currency in the "Sell" box. For "Value Date" enter "6 Months" and click "Go" for the forward rate. (Clicking on the Inverse box will switch the rate from European to American terms.) Enter the one-year forward rate in the table below.Make sure the forward rate is expressed in the same way as the forward rate, that is, in European terms.

Foreign Currency

Date

Current Spot Rate in European terms: FX per1 US dollar

Six -Month Forward Rate in European terms: FX per 1 US dollar

Based on the data above, answer the following questions:

a)At the current spot rate how much in the foreign currency are you owed in 6 months?

b)Assuming you fully hedge your FX exposure in the forward market, how many US dollars will you receive in 6 months?

c)Is the foreign currency selling in the forward market at a premium, i.e. it appreciates relative to the spot rate, or a discount, i.e., it depreciates relative to the spot rate? Provide numbers to support your answer.

2.Long-Run Exchange Rate Risk

Assume you have undertaken a 3-year investment abroad with expected cash flows denominated in your chosen currency. At the current spot rate those cash flows are expected to provide a positive net present value (NPV) in US dollar terms. Based on relative purchasing power parity you are asked to estimate future spot rates over the next three years based on comparative inflation data.[2] With that data complete the table below.

S₀ = Current Spot Rate in European Terms (Foreign currency per US dollar)

E(S_t) =ExpectedExchange Rate Spot Rate in t Years in European Terms (Foreign currency per US dollar)

h_US=Annual Inflation Rate in the United States

h_FC =Annual Foreign Country Inflation Rate

Using the data above and textbook equation (18.3) E(S_t) = S₀ [1 + (h_FC - h_US)]^t and assuming the estimated inflation rate in Year 1 also holds for Years 2 and 3, please respond to the following:

a)Based on relative purchasing power parity, estimate S_1.

b)Based on relative purchasing power parity, estimate S_2.

c)Based on relative purchasing power parity, estimate S_3.

d)Based on relative purchasing power parity, has the foreign currency appreciated or depreciated against the US dollar?Explain.

e)Based on relative purchasing power parity, has the NPV of the investment project increased or decreased in US dollar terms? Explain.

[1] Please note currencies are grouped according to their region: Americas (where the United States dollar may be found), Asia-Pacific, Europe, and MENA. Please advise your instructor should this or any other link in the assignment be broken.

[2] Sources of Inflation data include http://stats.oecd.org/for OECD countries and http://data.worldbank.org/indicator/FP.CPI.TOTL.ZGat the World Bank site. It is viewed important to be consistent in the definition and source of inflation numbers for the US and the other currency that you use for the relative PPP equation. The most basic definitions of inflation are consumer price index (CPI), producer price index (PPI), and GDP deflator. Estimates of the next year's inflation are preferred but it is also common to use the past year's inflation as the best estimate of next year's and subsequent years' inflation. You are encouraged to share any useful websites for this data you find with the class.