Overview

 

This chapter presents the uses of forward foreign exchange rates andthe returns and risks of international financial investments, both covered anduncovered. It begins by noting that in many situations people or organizationsare exposed to exchange rate risk, because the value of the individual'sincome, wealth, or net worth changes when exchange rates change unexpectedly inthe future. A net asset position in the foreign currency is called a longposition; a net liability position is called a short position. Some individualswant to reduce their risk exposure by hedging—an action to reduce a net assetor net liability position in a foreign currency. Other individuals may actuallywant to take on risk exposure in order to profit from exchange rate changes, byspeculating—an action to take on a net asset or net liability position in aforeign currency.

 

A forward foreign exchange contract is an agreement to exchange acertain amount of one currency for a certain amount of another currency on somedate in the future, with the amounts based on the price (forward exchange rate)set when the contract is entered. A forward foreign exchange contract is a kindof derivative contract based on exchange rates. A box in the text discussesother foreign-exchange derivative contracts—currency futures, options, andswaps.

 

Because the forward exchange contract establishes a position inforeign currency, it can be used to hedge or to speculate. A key hypothesisbased on the use of forward foreign exchange contracts to speculate is that thepressures on the supply and demand of forward foreign exchange should drive theforward exchange rate to equal the average expected value of the future spotexchange rate.

 

International financial investment has grown rapidly in recentdecades. Decisions about international investments depend on both returns andrisks. The text focuses on calculating returns. It also discusses risks,including mention of risk as a portfolio issue (although a full treatment ofinternational portfolio diversification is not provided).

An investor who calculates her wealth and returns in her homecurrency can easily calculate returns on investments denominated in her owncurrency. Investments in foreign currency-denominated assets are morecomplicated. She must first convert her own currency into the foreign currencyat the spot exchange rate. Then she uses this foreign currency to buy theforeign asset, and earns returns in foreign currency. Then, she must convertthis foreign currency in the future back into her own currency (either actuallyor simply to determine the value of her wealth). She could contract now for thefuture currency conversion using a forward exchange contract, in which case shehas a covered international investment, and she is hedged against exchange raterisk. Or, she can wait until the future and convert currencies at the spotexchange rate that exists at that date in the future, in which case she has anuncovered international investment, and she is exposed to exchange rate risk.

 

An investor can compare the return on a covered internationalinvestment to the return on a home investment using the covered interestdifferential (CD). The exact expression is CD = (1 + i_f)×f/e - (1 + i), where the i's are the foreign (subscript f) anddomestic interest rates, e is the spot exchange rate, and f is the forwardexchange rate. A useful approximation is CD = F + (i_f - i), where Fis the forward premium (discount if negative) on the foreign currency. If CD isnot zero (or within a small range close to zero, determined by transactionscosts), then international investors can engage in covered interestarbitrage—buying a country's currency spot and selling it forward, while makinga net profit from the combination of the interest rate difference and theforward premium or discount. Because covered interest arbitrage is essentiallyriskless (as long as there is no threat of exchange controls or similargovernment impediments), this arbitrage should drive the covered differentialto be essentially zero—covered interest parity. Covered interest parity linksfour current market rates together—the forward exchange rate, the spot exchangerate, and the interest rates in the two countries. If one of these rateschanges, then at least one other also must change to reestablish covered interestparity.

 

At the time that an investor makes the investment, he can calculatethe return expected on an uncovered international investment using the spotexchange rate that he expects to exist in the future. He can compare thisexpected return to the return on a home investment using the expected uncoveredinterest differential (EUD). The exact expression is EUD = (1 + i_f)×e^ex/e - (1 + i), where e^ex is the expectedfuture spot exchange rate. A useful approximation is that EUD equals theexpected rate of appreciation (depreciation if negative) of the foreigncurrency plus the interest differential (i_f - i). The box on “TheWorld’s Greatest Investor” provides a profile of George Soros, who has made(and sometimes lost) billions of dollars with large uncovered or speculativeinternational investment positions.

 

An uncovered international investment is exposed to exchange raterisk. Nonetheless, the investor may still undertake the uncovered investment,because the expected return is high enough to compensate for the risk, or, moresubtly, because the uncovered investment may actually reduce the risk of theinvestor's overall portfolio because of the benefits of diversification ofinvestments. If risk considerations are small, then investors will shift towardinvestments with higher (expected) returns. Demand-supply pressures on marketrates will drive rates to eliminate the return differential, so that theuncovered interest differential is essentially zero—uncovered interest parity.

 

The final section of the chapter presents some evidence on whetherthe various parity conditions actually hold. In normal times covered interestparity holds well between currencies of countries whose governments permit freemovements of international capital. The box “Covered Interest Parity BreaksDown,” the third in the new series on the global financial and economic crisis,documents and discusses deviations from covered interest parity that developedduring the turmoil of the crisis.

 

It is more difficult to test uncovered interest parity, because wecannot observe the expected future spot exchange rate in the market. (If we usethe forward rate as an indicator of the expected future spot exchange rate,then we are really just testing covered interest parity.) Indirect tests ofuncovered interest parity suggest that it does not hold as tightly as coveredinterest parity. While divergences from uncovered interest parity could simplyindicate risk premiums to compensate for exposure to exchange rate risk, somestudies suggest that the deviations are larger than seem necessary tocompensate for such risk. Instead, expectations of future spot exchange ratesseem to be biased. Such an apparent bias would not be troubling if marketparticipants are correctly anticipating the probability of a large shift in theexchange rate at some time in the future (even if the rate does not actuallychange). The apparent bias is troubling if it reflects consistent errors,implying inefficiency in the foreign exchange market.