Short- and Long-Run Exchange Rate Risk Exercise

Worksheet (v2.3)

Fall 2020 Revision

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.

Note: Please advise your instructor immediately should any of the links provided not work.

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 of the foreign currency relative to the US dollar go to

https://www.investing.com/currencies/streaming-forex-rates-majors

Enter the pair, today's date, and the spot rate labeled "Last" in the table below.

Please note that data is not available for every currency listed.

You may need to convert these rates to European terms, that is, Foreign currency per one US dollar.[1] Should these rates not be in European terms, you can convert them to European terms with the following calculation:

Spot rate in European terms = 1 / Spot Rate in American Terms

Example:Spot rate of EUR and USD in European terms = 1 / Spot Rate in American Terms

= 1/1.1316 = EUR 0.8837 per USD

At https://www.investing.com/currencies/streaming-forex-rates-majorsclick on the chosen pair, and then the Forward Rates tab on the page that opens.

Find the 180 day forward rate for the currency pair in the column labelled "6M FWD " and complete the table below in European terms. Please note site you are not given one price for a 6-month/180 day forward but rather bid-ask points and it is customary to average the two to get one price.

Here is a discussion of forward points from https://www.investopedia.com/terms/f/forwardpoints.asp

"Forward rates offset interest rate differentials so for currencies whose interest rates are lower than those for the USD you would add (subtract) the forward points to the spot rate in American terms: USD per one unit ofFX(in European terms:FXper one USD) so that you are indifferent between investing in USD orFXover the period of the forward."

Foreign Currency

Pair

Spot Date

Current Spot Rate in European Terms (FX per One USD)

Six -Month Forward Rate in European Terms (FX per One USD)

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)

h_US=Annual Inflation Rate in the United States

h_FC =Annual Foreign Country Inflation Rate

Source: https://www.investing.com/currencies/streaming-forex-rates-majors

Source:

Source:

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] To see a spot rate of the quotation in European terms you can go to https://www.oanda.com/currency/converter/ and retain U.S. dollar as "Currency I Have," choose your other currency as "Currency I Want," and with 1 for the amount of US dollars you should then see the value of the foreign exchange per one US dollar.

[2] Sources of Inflation data include http://stats.oecd.org/under "Prices and Purchasing Power Parities" for OECD countries and http://data.worldbank.org/indicator/FP.CPI.TOTL.ZGat the World Bank site. It important to be consistent in the definition and source of inflation numbers for the US and the other country 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.