atmarkets.r Markets are inherently inefficient – The idea of financial markets being perfectly efficient isan elegant nonsense, which clearly deals with a perfect rather than a human being. Marketmispricing happens all the time. Heuristic and frame dependence create consistent errors andtherefore consistent losses. Learning how to distinguish such behavioural patterns meansone can reduce such losses.Heuristics, frame dependence and any belief in the supposed efficiency of financial marketsare all aspects that lie outside of the rigorous trading discipline of the four analysis signal gridand the risk appetite indicator. For those currency speculators who use the rigorous, disciplinedapproach, there are no such things as “rules of thumb”. In addition, the very act of using fourtypes of analysis rather than just one should eliminate the risk of frame dependence.
9.8 SUMMARYThis chapter has sought to delve into the world of the currency speculator in greater detailthan has hitherto been tried, both for the purpose of shedding light on them and their methodsand also to attempt some ideas on how to be better at currency speculation. There can beno doubt that the issue of currency speculation will remain controversial. The aim here hasbeen to take out some of the emotional aspects of the issue and try to look at it coolly anddispassionately. Speculators can accelerate change but they cannot cause it in the first place. To2For more on the field of behavioural finance, readers should consult the excellent work by Hersh Sheffrin, Beyond Greed andFear: Understanding Behavioural Finance and the Psychology of Investing, Harvard Business School Press, 2000.
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forbid speculation is to forbid the market’s evaluation of risk and thus to leave the market blindto policy error. If anything, that would be the real speculation. Having looked at the real worldof corporations, real money investors and currency speculators, we turn in the last chapter tobringing together the ideas that have been presented in this book into an integrated analyticalframework for the purpose of making corporate executives or investors better currency analystsand thus boosting their bottom line.
ADDITIONAL SECTION FOR THE SECOND EDITIONThe art of currency speculation has gone through a number of important cycles, both in termsof its history and investment trends. Between 1945 and 1970, currency speculation to all intentsand purposes did not exist. However, with the collapse of the Bretton Woods Agreement in1971–1973, the modern age of currency speculation was born.HistoryLooking at the history of currency speculation with very broad-brush strokes, we see a numberof important key trends:The 1970s: Here, the initial market focus was on soaring oil prices, a plunging dollar and theVietnam War – a time that bears remarkable similarities to the present period in many ways,particularly with regard to the similarity in the external and internal balance deterioration if notnecessarily in music! During this period, currency speculation was very much in its infancyand all but focused on the major currencies, notably the G5.The 1980s: In turn, the 1980s saw the rise of various types of currency speculator, includingprop traders, hedge funds and the first currency overlay funds. Here, I include currency overlayfunds as a “currency speculator” for two reasons, despite having written about them earlier inChapter 8. Firstly, the definition of currency speculator for the purpose of this book is:“The trading of currencies with no underlying asset”This would also seem to be an excellent definition for currency overlay, which after all wascreated for the purpose of managing currency risk as a specific and separate asset class from the“underlying”. The second reason for including currency overlay in this section – albeit briefly –is to show how close the various strategies have become over the years. Barriers betweensupposedly very different strategies are dissolving. Moreover, any differentiation or distinctionshould not necessarily be between “real money” and “speculators” but between relative returnand total return. If one uses this, it is clear that currency overlay is a relative return. However,the term is also applied to “real money” and “speculator”, thus making irrelevant this particulardistinction. A far more useful way to distinguish currency overlay is as a relative return strategy.The 1980s saw an explosive rise in equity markets in the first half and a violent collapse inthe second. In addition, the dollar started to fall in 1985 in the wake of the Plaza Accord andcontinued to fall despite the Louvre Accord of 1987, which sought to stem that decline.The 1990s: These years saw currency speculation really come into its own in the form ofthe large, successful attacks against pegged currencies or exchange rate systems. In 1992, theUK and Italy were forced out of the ERM under overwhelming “speculative” pressure. The
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following year, 1993, the ERM was effectively devalued as the trading bands were widenedfrom +/− 2.25% to +/− 15%. Thereafter there followed a series of currency crises in theEmerging Market countries, which had spent the late 1980s and early 1990s opening up theirmarkets, if not their exchange rate regimes. Starting in Mexico in December 1994, a series ofEM countries were forced to devalue or de-peg their currencies, including most spectacularlyRussia in 1998. In the 1990s, the dollar went down in the first half and headed up again in thesecond; which is somewhat of an oversimplification but that was the “long” and “short” of it.The 2000s: In the 2000s, the period of speculation against pegged exchange rates continuedin the form of Argentina and Turkey, forcing talk of a “bi-polar world” between very hard pegs(e.g. Hong Kong) and freely floating exchange rates. With the majors now freely floating, thiswas entirely focused on the EM countries. In the 2000s, the dollar has been very choppy, risingin 2000–2001, and declining across the board from 2002, before rebounding in 2005.Investment TrendsIn addition to how the currency speculation industry evolved through a series of distinct periods,there have been important investment trends, that have helped to accelerate this process:Pegged exchange rates: The initial focus of currency speculation and currency speculatorswas pegged exchange rates. These were exchange rates that were not allowed to move, orcould only move within very tight bands. As a result, they became increasingly misalignedwith economic fundamentals and fell sharply, eventually due to currency speculation. The seriesof currency crises in pegged exchange rates has resulted in an increasing number of countriesmoving to freely-floating exchange rate regimes, which act as a buffer against changes in thereal economy. As such, one of the major focuses or investment trends in currency speculationwas in attacking pegged exchange rates.Increasing cross-border investment: As the G10 markets opened up, so cross-border portfolio investment exploded. This resulted in an increasing need for fund managers to managethe currency risk associated with that increasing cross-border portfolio investment, either bymanaging it in in-house or hiring specialist currency managers for the job. In line with this,currency speculators sought to react to real or perceived changes in cross-border portfolioinvestment; a second key investment trend.Increasing foreign direct investment: In a similar fashion, the opening up of trade in goodsand services between countries, coupled with the fact that many countries have much cheaperlabour costs, has caused an explosion in foreign direct investment over the past 10 years.As with portfolio flows, this too has had a significant impact on the behaviour of currencyinvestors.Declining returns on benchmarked assets: A major factor impacting currency speculation,particularly by leveraged or funded investors, has been that of declining returns on traditionalbenchmarked assets. This is not the place to go into this subject in the mathematical detail thatwould require by academic standards to prove such a suggestion. Nevertheless, it is commonlyaccepted that there has been a trend decline in the traditional benchmarked returns of the stocksand bonds of the major, developed markets. In the case of equities, this is a typical reaction in
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a post-bubble period as P/E multiples are reduced through corporate de-leveraging. In the caseof fixed income, this has been reflected by a trend decline in inflation. The “defeat” – howevertemporary – of inflation expectations has in the short term produced tremendous returns forfixed income portfolios. In the medium to long term, however, the trend decline in inflationlevels and coupon levels on government bonds has led to a trend decline in returns. Both ofthese have resulted in two major developments:
r Increasing focus by relative return investors on “off index” allocations.r Increasing focus on alternative investment, total return strategies.
In the first case, fixed income investors who are benchmarked against government bondshave focused increasingly on (1) credit and (2) Emerging Markets in order to generate thenecessary alpha in their portfolio and make up for the decline in their benchmark returns.Initially, this focus has been on USD-denominated credit and EM sovereign debt. Increasingly,however, it has been on EM local debt, which of necessity incorporates local currency risk.In the second case, the rebound in “alternative investment” or total return strategies has beenphenomenal. Hedge funds now manage well over USD1 trillion in assets under management,a remarkable recovery following the LTCM débâcle in 1998. This is not to say that hedgefunds only “speculate” in currencies – far from it. They are extremely active across all assetclasses. However, it is surely no coincidence that the rebound in overall FX market volumeshas happened at the same time as hedge funds have themselves exploded in both size andnumbers.The opening up of Emerging Markets: This is a theme that we will discuss in greater detail inChapter 11. For now, suffice to say that the opening up of EM economies has led to an explosionin investment both into and out of these countries. Currency speculators have been blamed formany of the currency crises that have hit EM currencies over the past 10 years or so. For themost part, this blame is misplaced. Pegged exchange rates became increasingly untenable andunsustainable, given changing economic fundamentals. As a result, fundamental flows – i.e.according to our definition, those attached to an underlying asset – were the main drivers ofcurrency weakness. Using the Asian currency crisis as an example, currency speculation fedfrom such fundamentally induced pressure and may have exacerbated it to an extent – butdid not cause it. Nor did currency speculation per se cause EM currencies to collapse. Thesecurrencies did so because they were no longer fundamentally sustainable.Presently, the conventional wisdom is that floating exchange rate regimes are preferableover pegged and offer the best protection for economies against economic shocks. As thesethings tend to do over long periods of time; however, this conventional wisdom may change.Note that this is the first sustained period in history where currencies have not been peggedto some sort of commodity. However, at present, floating exchange rates are the order of theday, albeit under varying forms of currency management by the national authorities of eachcountry concerned.In line with this, currency speculation – in all its forms – has become fully accepted in themajor, developed markets and is increasingly also in the emerging markets. Granted, there aresome notable exceptions, particularly in Asia. Many African and Middle Eastern exchange ratemarkets remain undeveloped. However, for now that trend is clear – open economies, openmarkets and open investment/speculation.In this relatively favourable environment, how then to be a better currency speculator? Wehave gone through some of the main approaches to currency speculation in this chapter along
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with tips regarding risk management. In this Additional Section, we will look at some of themost important guiding principles of currency speculation.The Big PictureThese days, so much work is spent on fundamental or technical analysis at the micro level.There is no better illustration of this than the recent and increasing focus on flow analysis. Ihave nothing against this, but I would argue that it makes much more sense to focus on the BigPicture first – on that set of factors that is likely to drive the flow in one direction or another.How does one set out to achieve this? One answer is by asking a number of key questions ona regular basis:
r What is the world’s most important economy?r What state of the economic cycle are we in for this economy?r Are interest rates going up or down in this economy?r Is fiscal policy being loosened or tightened?r Is this currency over- or under-valued?This is far from exclusive for important Big Picture questions. However, from this, we canfocus on a number of Big Picture issues. On the face of it, they may seem overly basic, but thefocus must always be on getting the Big Picture right before moving on to the micro level oftechnicals and flows:
r The state of the economic cycle in the US and other key countriesr Policy trends in the US and other key countriesr Whether the USD is in an up-trend or a down-trendThis last point may cause some controversy, as there are an increasing number of othercountries and currencies that are taking on ever-greater importance in the global economy.However, here I would remind readers that we are focusing on the Big Picture – and the USis still the biggest picture around and will remain that way for the foreseeable future. The BigPicture is whether the USD is going up or down – it is that simple.Market FocusHaving looked at the really Big Picture, we can now go down one level and focus on themarkets themselves, but still from a macro rather than a micro perspective at this stage. Justas economies go through cycles, so do markets. The focus of financial markets switches fromexternal balances to interest rate spreads, to equity returns, to valuation – and back. It is criticalto know what currency markets are focusing on at any given point, and why.There are two ways to determine this. At the macro level, a currency speculator can usethe Speculative Cycle Model of exchange rates, as described in Chapter 2. Fundamentalmarket participants deem a currency to under- or over-valued and start buying/selling it on asustained basis, thus creating a currency trend. Eventually, speculative buying/selling joins andexacerbates this trend, with the eventual result that fundamentals are changed. Fundamentaldeterioration/improvement eventually reaches a tipping point whereby the exchange rate cycleends violently and the trend either stabilizes or reverses. You must know what part of theeconomic and currency market cycle that you are in.
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At the micro level, use the available tools such as Reuters and Bloomberg to track theperformance of the USD against other asset markets to see what it is focusing on at any giventime. Useful comparisons would be the following, using the DXY index as a proxy for theoverall USD:
r DXY index vs. DXY-weighted 3M rate spreadsr DXY index vs. hedged/unhedged US FI benchmark returnsr DXY index vs. hedged/unhedged US equity benchmark returnsr DXY index vs. TIC data – current account deficitTrading CrossesHaving focused on the Big Picture and made sure of what the market is focusing on with regardto the USD, it is clearly time to take the analysis down a further level, to look at specific crossesand exchange rates. Here, what the market is focusing on with regard to the overall USD isextremely important and a deciding factor in terms of what to focus on with regard to specificexchange rates. If we assume that the overall USD is currently focused on interest rate spreads,then an excellent idea would be to overlay (on Bloomberg using HMS or G functions) theexchange rate concerned with the short-term rate spread to see whether the exchange rate isunder- or over-valued relative to the exchange rate implied by the rate spread. For this exactreason, getting the Big Picture and Market Focus right from the start is absolutely critical.Domestic DynamicsEmerging Market currencies are becoming increasingly liquid and, as such, should eventuallytrade increasingly like G10 currencies. However, for now, most are subject to EM-specificfactors such as politics, illiquidity, convertibility risk and event risk. For this, we need a muchmore micro-based approach.Having got the overall Big Picture on the USD, and determined the current market focus,speculators who trade in EM currencies need to see how these “macro” factors play out at a“micro” level to varying extents against EM currencies. Sometimes EM currencies trade verymuch in line with the overall USD trend, and sometimes they do not. You need to know the“when” and the “why” of those two developments. Within this, you need to know the Domestic(Flow) Dynamics that affect each specific EM currency – because they differ widely.TimingHaving drilled down to the level of Domestic Dynamics we can now go down one furtherlevel to Timing. How do we decide on timing? We have our Big Picture, we know what theMarket Focus is, we have selected exchange rates and looked at Domestic Dynamics in detail.But how do we decide on timing?For this, we need short-term indicators, which can give some approximation of short-termvalue not hitherto available in medium/long-term valuation models such as:
r Flow analysisr Technical analysisr Option analysis
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If we look at flows, charts and option market indicators, we can get a much more real-timeimage of how the market is positioned and what it might look for in the future. Clearly, noindicators are perfect, but used together for this purpose these three indicators should helpsignificantly in improving timing on the basis of all three showing “green” or “red” lights.ExecutionFinally, there are, for the currency speculator, three key components to successful currencyspeculation:
r Trade strategyr Trade tacticsr Trade execution
We have looked above at the overall strategy – Big Picture and Market Focus. This is whetheryou have a specific currency view and what it is. Trade tactics focus on how you want to expressthat currency view via, for instance, a directional or a vol trade. Trade execution deals withwhat instruments you want to use – that is, spot, options, forwards, swaps and so forth. All ofthis together seems a lot to take in and follow. The essentials are (1) to know what frameworkto use, (2) to follow the guiding principles of that framework – such as outlined above – and(3) to prepare the necessary analytical models and spreadsheets ahead of time so that strategycan flow efficiently to tactics and on to execution.
10Applying the FrameworkSo far in this book, we have looked at the various key components that go into currency strategy.The aim in this last chapter is therefore simple – to pull together all these components into asingle, integrated framework of analysis. To this end, it is important first to crystallize (ratherthan repeat) the main points we have learned to date, both to further clarify their importanceand to make them more easily remembered. Having done that, we then need to apply thiscurrency strategy framework to the practical world of corporations, investors and speculators,showing how they may use it to boost their bottom line.First, briefly we recap and crystallize the main points made to date. Thus, currency strategyis the analytical discipline that consists of the following:1. Currency economics2. Flow analysis3. Technical analysis4. Long-term valuation
10.1 CURRENCY ECONOMICSClassical economics has sought and failed to explain short-term exchange rate moves on aconsistent basis. Currency economics is an attempt to fine tune economic theory to the practicalrelevance of the currency market. Broadly speaking, it seeks to analyse those aspects of theeconomy that are relevant to the exchange rate value, such as:
r Trends within the balance of payments, including the current and capital accounts;r The accounting identity for economic adjustment (S − I = X − M);r The Real Effective Exchange Rate (REER) and the external balance;r Relative productivity measures.Naturally, all other aspects of the economy should be considered such as growth, inflationand so forth, but the ones mentioned above are the key indicators relevant for our purposeof currency analysis and strategy. Growth per se does not make a currency rise or fall on aconsistent basis. Currency market practitioners, while keeping an eye on other parts of theeconomy as well, should seek to focus primarily on those specific aspects of the economy thataffect the exchange rate.
10.2 FLOW ANALYSISAs barriers to trade and capital have broken down in the last two decades, so capital flows havebecome increasingly important, both in terms of their impact on the economy and in turn on theexchange rate. At USD1.2 trillion in daily volume, the currency markets trade the equivalent ofannual global merchandise trade every day of the year. Like any market, the currency market isaffected by demand and supply, which in this case is reflected by order flow. It has been found
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that tracking order flow can provide both a useful explanation of past price activity in currencymarkets and – more importantly – can be used as a predictor of future price action. The basicpremise behind this is that changes in order flow, if sufficiently large, can have predictable andsustainable impact in the currency markets in terms of price action. There are several short andmedium-term flow indicators that the reader should be aware of.Short-term flow data:
r The IMM Commitments of Traders report
Medium-term flow data:
r US Treasury “TIC” capital flow reportr Euro-zone portfolio reportr IMF quarterly report on emerging market financingr IIF capital flows report
In addition to flow data provided by the trading exchanges as in the case of the IMM and byofficial sources as with the TIC and Euro-zone reports, there are also proprietary flow modelscreated by commercial and investment banks to analyse client flows going through the bank’scurrency dealing rooms.
r Order flow/sentiment models
Flow data and models provide direct evidence of the effect of order flow on market pricing.A more indirect but no less useful to way to do that is to look at market sentiment indicatorssuch as:r Option risk reversalsThese are a very useful gauge of the market’s “skew” or bias towards an exchange rate.Analysing risk reversal trends over time relative to the spot rate may allow one to makepredictions as to future spot rates based on the risk reversal.
10.3 TECHNICAL ANALYSISCrucial to both flow and technical analysis is the idea that financial markets are not in factinherently efficient and that the past can in fact impact the future. With flow analysis, oneis dealing with trends in order flow. With technical analysis, one is analysing past pricing tomake predictions about the future. At its most basic, technical analysis uses such conceptsas “support” and “resistance” to denote points of dynamic market tension between supplyand demand for an exchange rate, equity, bond or commodity. At a more sophisticated level,technical analysis relies on patterns in mathematics to suggest they may be reproduced inmarket pricing. Fibonacci, Elliott Wave and Gann analysis are examples of these.“Charting” remains a controversial subject for some within the financial and academiccommunities who appear to regard it as little more than voodoo. In the real world of trading,hedging and investing however, nothing counts except results. Unlike in the economic worldwhere the quality of the story is seen as important, almost irrespective of its accuracy, fortraders, investors and corporations the bottom line is the bottom line. To that end, whileclassical economics has failed to explain short-term exchange rate moves on a sustained basis,flow and technical analysis have stepped into the void. Just as in economics, there are “good”and “bad” chartists or technical analysts. The profession of technical analysis however hasconsistently outperformed the returns generated by random walk theory and frequently also
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those by economists. In analysing exchange rates, currency market practitioners who do notuse technical analysis in addition to fundamental analysis are hampering their own ability toproduce consistently high returns.
10.4 LONG-TERM VALUATIONThe dividing line between currency economics and long-term valuation analysis is somewhatblurred. There is a difference however and it concerns the time span involved in one’s analysis.The aim of currency economics is to look at the parts of the economy that affect and are affectedby the exchange rate, such as the balance of payments and inflation differentials, in order togive an idea about that exchange rate’s current valuation and direction. Long-term valuationmodels, such as those that focus on REER or FEER, are trying to give a multi-month or morelikely a multi-year view of exchange rate valuation. In line with this, the main exchange ratemodels that focus on long-term valuation are the following:
r Purchasing Power Parityr The Monetary Approachr The Interest Rate Approachr The Balance of Payments Approachr The Portfolio Balance Approach
Most of these models focus on the relative price of an asset or good, which should over timecause an exchange rate adjustment to restore “equilibrium”.
10.5 THE SIGNAL GRIDThe four analytical disciplines of currency economics, flow analysis, technical analysis andlong-term valuation which come together to make a currency strategy decision can be expressedin the form of a signal grid, as shown in Table 9.1. To be sure, this is a very simple model.However, what is important here is having the discipline to create it. Only when all fouranalytical indicators are reading buy or sell together should one put out an official currencystrategy recommendation. Granted, this is still no guarantee of success. It should however havea number of positive effects on one’s trading or analytical performance:
r It should eliminate the bias created by relying only on one analytical typer By nature, four buy signals make up a more powerful buy signal than just oner The bottom line – it should improve one’s performance and total returns10.6 RISK APPETITE INDICATORS
When there is no clear, unequivocal signal from the signal grid, that is when not all foursignals are pointing in the same direction, currency traders and investors can still boost theirtotal return by using a risk appetite indicator to gauge overall market sentiment in terms of“risky” or “safe” assets, both in terms of putting on new positions and in terms of measuringtheir existing positions. Risk sentiment can be divided up into three levels:
r Risk-seeking/stabler Risk-neutralr Risk-aversion/unstable
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When the indicator is in risk-seeking or risk-neutral mode, be long a basket of higher carrycurrencies, either in the developed or emerging markets. Conversely, when it is in risk-aversionmode, obviously having moved there from risk-neutral, cut and reverse the position, going shortthe carry basket of currencies. Risk appetite has become an increasingly important concept notjust because of the need to create more accurate models for forecasting short-term currencymoves, but also because the last few years have shown a marked pick-up in cross-asset marketvolatility. There are several risk appetite indicators created by the private sector for this purpose.Not just currency traders or speculators can use this. A risk appetite indicator can be a crucialtool for corporate Treasurers and institutional investors, not least in providing them with aninformed context within which their exposure exists.
10.7 EXCHANGE RATE REGIMESThe signal grid and the risk appetite indicator should be the two main tools of the currencystrategist. There are however other aspects of the currency markets that still have to be considered. For instance, the type of exchange rate regime is an important consideration as it can havea significantly different impact on the economy depending on what type of regime is beingused. The latest fashion within the official community in Washington DC is to advocate theso-called “bi-polar” world of exchange rates, supporting the idea that in a world of free capitalmarkets only the hardest currency peg or a completely free-floating currency are appropriate,and that anything else is unsustainable. It seems likely that this will ultimately give way to anew trend, whereby there are significantly less currencies, all of which are freely floating. Asfar as currency market practitioners are concerned, key questions that a corporate executive oran investor must ask if they are exposed to a currency peg regime are:
r Does the currency peg itself contribute to macroeconomic stability?r What is the degree of participation in global capital flows of the country concerned?r Is the currency peg at the right value?Most soft or semi-pegged exchange rate regimes have gone, voluntarily or otherwise. Ifyou have currency exposure to a pegged exchange rate regime and you are concerned aboutcurrency risk, the rule to remember is that you should hedge when the market has no interestin hedging and thus when risk premiums are low. By the time the market is keen to hedgecurrency risk, liquidity and price conditions will have deteriorated and it will be too late toobtain anything but the most expensive of currency protection.The beauty of freely floating exchange rates is that they act as a self-adjusting mechanism,transmitting changes in fundamental dynamics across the economy. In that sense, a freelyfloating exchange rate regime cannot be defeated, unlike a pegged exchange rate regime. Thatsaid, they can still be highly volatile at times.
10.8 CURRENCY CRISES AND MODELS10.8.1 CEMCMost of the currency crises of the 1990s happened against soft currency pegs. In the wake ofthe Asian currency crisis, I made a stab at creating a model that focused on how exchange ratestypically performed in the run to and after the break down of a pegged exchange rate regime.For good or ill, the Classic Emerging Market Currency Crisis (CEMC) model was the result.
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To be sure, the title is a mouthful, but for the most part it tells the story of most emergingmarket currency crises during the 1990s and thus may serve as a useful barometer should anysuch crises be experienced going forward. This can be broken down into five phases duringwhich the currency crisis takes place:1. Capital inflows and real currency appreciation2. Fundamental deterioration and inevitable currency collapse3. A positive current account swing and a liquidity-based rally4. The economy hits bottom; a period of consolidation5. The fundamental rallyA key aspect of these crises was the relationship between the real exchange rate and the external balance. In floating exchange rate regimes, economic imbalances are usually smoothed outover time. In pegged exchange rate regimes, they can build up to unsustainable levels, thus forcing the collapse of the exchange rate peg, if not checked by changes in macroeconomic policy.10.8.2 The Speculative CycleWhile CEMC focuses specifically on pegged exchange rates, the “speculative cycle” modelfocuses instead on freely floating exchanges. This model consists of four phases, describingthe relationship between “fundamental” and “speculative” forces within the markets and theeffect they have on the economy:1. Capital flows are attracted and the local currency rallies2. Speculators join the crowd and the local currency continues to rally3. This causes fundamental deterioration, causing increased price volatility4. Fundamental selling overwhelms speculative buying and the currency collapsesThe basic idea behind this is that freely floating exchange rates are not random, but insteadtend to trade in cycles, though the length of those cycles can vary from weeks to years dependingon other factors such as capital flows.
10.9 MANAGING CURRENCY RISK I – THE CORPORATION10.9.1 Types of Currency RiskFor corporations, there are three key kinds of currency risk they have to manage. They are:1. Transactional risk (receivables, dividends, etc.)2. Translational risk (balance sheet)3. Economic risk (present value of future operating cash flows)Transactional risk or exposure is essentially cash flow risk. Translational risk, for its part,results from the consolidation of group and subsidiary balance sheets, and deals with theexposure represented by foreign investment and debt structure. Economic risk is an overallmeasure of the currency risk of the corporation, focusing on the present value of future operatingcash flows and how this present value in the base currency changes as a result of changes inexchange rates. Over the long term, however, exchange rates adjust through the concept of PPP,depending on relative inflation and domestic price levels. Thus, theoretically, a corporationwhose foreign subsidiaries experience price inflation in line with the general level of inflation
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should be returned to its original value through an adjustment in the exchange rate exactlyaccording to the PPP concept. In such circumstances, one might argue that economic risk orexposure is irrelevant. However, corporations rarely experience cost inflation exactly in linewith the general level of inflation. Therefore, economic risk does matter. The best way ofdealing with this is to finance operations in the currency to which the firm’s value is sensitive.10.9.2 In