• Covered interest arbitrage causes interest rate parity
• focuses on a forward premium or discount to equalize interest rate
• ensures that the return on a hedged foreign investment will equal the domestic return
• deviations tend to be small and short lived

exchange rates adjust to reflect inflation rate differentials so that the cost of a domestic good is similiar to the cost of a foreign good (Offset Inflation)

the change in the spot rate is due to inflation rate differentials

exchange rate adjust to reflect interest rate differentials.  Simple extention of purchasing power parity.

suggest that currencies with high interest rates will have high expected inflation

Expected inflation rate derived by subtracting the each country's real interest rate from its nominal interest rate is subject to error

it relies on PPP theory

• variables must be forecasted
• timing of the impact is uncertain and changing
• inability to identify all factors

First look at net cash flows

once net cash flow is determine, apply and exchange rate to determine a range of possibilities

Focus is on future cash flows

identify net transaction exposure - a centralized system is optimal

Future Hedge

Money Market Hedge

Currency Option Hedge

Forward Hedge

Available to small companies

• Purchase - appropriate for a future payment
• Sale - appropriate expects to receive foreign currency

• Long-term forward contract - five to ten years
• Currency Swap - contractual agreement to exchange a principle amount of two different currencies and, after a period of time return the priciple

Leading

Lagging

Encompassing view of the effects of exchange rates on a company

even purely domestic companies may have economic exposure

includes how revenues and expenses will be influences by exchange rate fluctuation

any companies whose revenues or costs are affected by curency changes has economic exposure

Pro Forma income statements based on expected changes

regression of cash flows based on exchange rate changes

Market Management

Production Management

Financial Management

Market Selection - base on currency strength

Pricing Strategy - market shar or profit margin

Product Strategy - time new products

product sourcing and plant location

input mix

Shifting Production

Structure liabilities so they match assets

• move debt to countries producing revenues
• finance expansion or assets with profits

degree of foreign involvement

location of foreign subsidiaries

Accounting methods of Foreign countries

Funds Adjustment

Forward Contracts

Exposure Netting

Cost and Benefits of standard hedging techniques

centralization versus Decentralizaiton- generally, centralized is more effective

derivatives expose companies to substatial potential loss

• segregate duties
• hedging purposes only