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Chapter 18
Forward Exchange and International Financial Investment
Overview
This chapter presents the uses of forward foreign exchange rates and the returns and risks of
international financial investments, both covered and uncovered. It begins by noting that in many
situations people or organizations are exposed to exchange rate risk, because the value of the
individual's income, wealth, or net worth changes when exchange rates change unexpectedly in
the future. A net asset position in the foreign currency is called a long position; a net liability
position is called a short position. Some individuals want to reduce their risk exposure by
hedging—an action to reduce a net asset or net liability position in a foreign currency. Other
individuals may actually want to take on risk exposure in order to profit from exchange rate
changes, by speculating—an action to take on a net asset or net liability position in a foreign
currency.
A forward foreign exchange contract is an agreement to exchange a certain amount of one
currency for a certain amount of another currency on some date 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 kind of derivative contract based on exchange rates. A box in the text
discusses other foreign-exchange derivative contracts—currency futures, options, and swaps.
Because the forward exchange contract establishes a position in foreign currency, it can be used
to hedge or to speculate. A key hypothesis based on the use of forward foreign exchange
contracts to speculate is that the pressures on the supply and demand of forward foreign
exchange should drive the forward exchange rate to equal the average expected value of the
future spot exchange rate.
International financial investment has grown rapidly in recent decades. Decisions about
international investments depend on both returns and risks. The text focuses on calculating
returns. It also discusses risks, including mention of risk as a portfolio issue (although a full
treatment of international portfolio diversification is not provided).
An investor who calculates her wealth and returns in her home currency can easily calculate
returns on investments denominated in her own currency. Investments in foreign
currency-denominated assets are more complicated. She must first convert her own currency into
the foreign currency at the spot exchange rate. Then she uses this foreign currency to buy the
foreign asset, and earns returns in foreign currency. Then, she must convert this foreign currency
in the future back into her own currency (either actually or simply to determine the value of her
wealth). She could contract now for the future currency conversion using a forward exchange
contract, in which case she has a covered international investment, and she is hedged against
exchange rate risk. Or, she can wait until the future and convert currencies at the spot exchange
rate that exists at that date in the future, in which case she has an uncovered international
investment, and she is exposed to exchange rate risk.
An investor can compare the return on a covered international investment to the return on a home
investment using the covered interest differential (CD). The exact expression is CD = (1 + if)f/e
− (1 + i), where the i's are the foreign (subscript f) and domestic interest rates, e is the spot
exchange rate, and f is the forward exchange rate. A useful approximation is CD = F + (if− i),
where F is the forward premium (discount if negative) on the foreign currency. If CD is not zero
(or within a small range close to zero, determined by transactions costs), then international
investors can engage in covered interest arbitrage—buying a country's currency spot and selling
it forward, while making a net profit from the combination of the interest rate difference and the
forward premium or discount. Because covered interest arbitrage is essentially riskless (as long
as there is no threat of exchange controls or similar government impediments), this arbitrage
should drive the covered differential to be essentially zero—covered interest parity. Covered
interest parity links four current market rates together—the forward exchange rate, the spot
exchange rate, and the interest rates in the two countries. If one of these rates changes, then at
least one other also must change to reestablish covered interest parity.
At the time that an investor makes the investment, he can calculate the return expected on an
uncovered international investment using the spot exchange rate that he expects to exist in the
future. He can compare this expected return to the return on a home investment using the
expected uncovered interest differential (EUD). The exact expression is EUD = (1 + if)eex/e − (1
+ i), where eex is the expected future spot exchange rate. A useful approximation is that EUD
equals the expected rate of appreciation (depreciation if negative) of the foreign currency plus
the interest differential (if− i). The box on “The World’s Greatest Investor” provides a profile of
George Soros, who has made (and sometimes lost) billions of dollars with large uncovered or
speculative international investment positions.
An uncovered international investment is exposed to exchange rate risk. Nonetheless, the
investor may still undertake the uncovered investment, because the expected return is high
enough to compensate for the risk, or, more subtly, because the uncovered investment may
actually reduce the risk of the investor's overall portfolio because of the benefits of
diversification of investments. If risk considerations are small, then investors will shift toward
investments with higher (expected) returns. Demand-supply pressures on market rates will drive
rates to eliminate the return differential, so that the uncovered interest differential is essentially
zero—uncovered interest parity.
The final section of the chapter presents some evidence on whether the various parity conditions
actually hold. In normal times covered interest parity holds well between currencies of countries
whose governments permit free movements of international capital. The box “Covered Interest
Parity Breaks Down,” a combined global financial and economic crisis and euro crisis box,
documents and discusses deviations from covered interest parity that developed during the crises.
It is more difficult to test uncovered interest parity, because we cannot observe the expected
future spot exchange rate in the market. (If we use the forward rate as an indicator of the
expected future spot exchange rate, then we are really just testing covered interest parity.)
Indirect tests of uncovered interest parity suggest that it does not hold as tightly as covered
interest parity. While divergences from uncovered interest parity could simply indicate risk
premiums to compensate for exposure to exchange rate risk, some studies suggest that the
deviations are larger than seem necessary to compensate for such risk. Instead, expectations of
future spot exchange rates seem to be biased. Such an apparent bias would not be troubling if
market participants are correctly anticipating the probability of a large shift in the exchange rate
at some time in the future (even if the rate does not actually change). The apparent bias is
troubling if it reflects consistent errors, implying inefficiency in the foreign exchange market.
Tips
In presenting this material, it is useful to build the overall return on a foreign financial
investment step-by-step: spot exchange (e), invest in the foreign currency-denominated financial
asset (1 + if), and exchange back into home currency (f or eex). The lake diagram (Figure 18.1)
pictures this process for covered investments and permits movements in any direction. A
comparable diagram for uncovered investments could be provided to the class, in which f is
replaced by eex (for analysis ex ante).
This points out a broader goal of the style of presentation used in the text. We strive to show how
similar covered and uncovered investments are (as well as the specific ways in which they are
different). The focus on the similarities allows students to transfer insights from the discussion of
covered investments to their analysis of uncovered investments.
An excellent device for getting students to plunge into the foreign exchange market and to gain
insights into exchange rate risk and future spot exchange rates is to ask them to predict what
exchange rates (and perhaps the price of gold) will be one or three months in the future. This
exercise can be submitted at the beginning of the term, at the beginning of the material on
international finance (if this is not the beginning of the term), or at the conclusion of the
presentation of the material in this Chapter 18. If desirable, prizes can be offered to the best
guessers, either rate-by-rate or overall (using lowest average absolute percentage errors). The
sample assignment on the accompanying page offers one version of this exercise. After all
guesses are submitted, the instructor could provide graphs showing the distributions of guesses
by the class. In addition, the "debriefing" at the conclusion of the contest could include charts of
how the rates moved day-by-day during the contest time period, along with information on the
class median guess and the instructor's guess.
