back ofthis move. For a time, “real money” asset managers did the same, increasing their currencyexposure as a result of their buying of Polish bonds. There was no incentive to hedge thatcurrency risk. Indeed, there appeared to be every incentive not to hedge – the high cost, theappreciating trend in the zloty and the desire to keep the carry of the original investment (whichhedging would reduce or even eliminate).6.2.3 Phase III: Fundamental Deterioration – The Local Currency Becomes VolatileTheoryFundamental investors and speculators do not necessarily sit easily together. They have different investment aims and parameters, the first looking for regular investment capital gain orincome over time, the latter looking frequently for short, quick moves. Granted, this is a grossexaggeration and generalization, but it gives at least something of a flavour for the differentdynamics at work between the two investor types. The longer the trend continues the morespeculative it becomes in a number of ways. In the first case more and more speculators jointhe trend, sure of easy money to be had. Equally, however, the longer this trend appreciationgoes on, the more damage it does to the external balance and thus the more speculative itbecomes in the sense of not being fundamentally justifiable. Real exchange rate appreciationmust lead to external balance deterioration. Indeed, fundamental market participants, such asasset managers and corporations, increasingly reduce their currency risk for the very reasonthat there are such fundamental concerns. The ability of speculative inflows to offset fundamental outflows from the currency is increasingly reduced. Because of this increasing tensionbetween fundamental and speculative flows, option implied volatility picks up in the face ofincreasingly choppy and volatile price action.PracticeFrom March through mid-June 2001, the Polish zloty continued to appreciate, albeit in anincreasingly erratic and volatile manner. Frequent sell offs would be followed by sharp rallies.Asset managers became increasingly aware of the degree of slowdown in the Polish economy.While this should conversely be good news for fixed income investors as it caused inflationarypressures to decline further, it was a source of increasing concern for equity investors. Themarket’s overall appetite for risk remained relatively high, helped in large part by continuedmonetary easing by the Federal Reserve. Further, the National Bank of Poland was also cuttinginterest rates, albeit cautiously in the face of clear evidence of abating price pressures. However,both the pace and extent of zloty strength were a cause of concern to investors, and it seemsalso to the Polish government. Ahead of elections in September (in which it was subsequentlyrouted by the opposition SLD party), the AWS-led government was increasingly desperate toboost the flagging economy, whether by interest rate cuts, fiscal expansion or a weaker zloty.Markets feared a change in exchange rate policy, either by the existing government or more
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likely by the opposition, which looked increasingly likely to win the election and in the enddid indeed do so. Around June, given the gains seen by then in both Polish bonds and thecurrency, a combination of market concerns over fundamental deterioration in the economy,notably in the trade balance, and over the prospect of a likely SLD election victory in Septembertriggered increasing interest by investors, particularly offshore investors, to take profit on thosegains.6.2.4 Phase IV: Speculative Flow Reverses – The Local Currency CollapsesTheoryThe tension between speculative inflows and fundamental outflows continues to increase,causing violent price swings, until such point as those inflows are not sufficient to offset therising tide of outflows. Like an inventory overhang that seems to appear out of nowhere inthe wake of over-investment, the result is a supply–demand imbalance in the exchange rate.Demand collapses in order to restore equilibrium. In this case, that means a sharp reversalof speculative inflows, which are by nature more easily and more quickly reversed than theirfundamental counterparts. Markets overshoot on both the upside and the downside, whichmeans that the correction in the exchange rate to offset over-appreciation is likely to exceedwhat fundamentals suggest is required. Eventually it manages to stabilize again, starting offa new round of appreciation as fundamental inflows are attracted anew. The sharp correctionin the exchange rate should help restore lost trade competitiveness. Just as real exchangerate appreciation must lead to external balance deterioration, so the cure for the latter is realexchange rate depreciation. This can happen either through nominal exchange rate depreciationor through a sharp fall in inflation. The easiest and most efficient way for this to happen isthrough the former. Once that correction or nominal depreciation happens however, the externalbalance should respond positively.PracticeAt the June 27 FOMC meeting, the Federal Reserve cut interest rates by 25 basis points asexpected. Notably, risk appetite indicators did not improve in the wake of this, the first timeall year that Fed monetary easing had failed to boost risk appetite. In hindsight, this shouldhave proved a major warning signal, and not just for the Polish zloty but for global financialmarkets as a whole. A week later, the tremors of the earthquake to come were starting to befelt. On the Thursday, the dollar–zloty exchange rate was already heading higher, boosted byprofit-taking on long zloty positions by asset managers and by a lack of fresh demand for zlotyfrom this quarter. Having bottomed out at around 3.92, dollar–zloty broke back above the 4level to retest 4.10. Come Friday morning, dollar–zloty broke above 4.20, then 4.25 and then itbroke above 4.30. Speculative money that had been long zloty, both against the US dollar andthe Euro, either decided to close out their long zloty positions or were stopped out of them.Despite fundamental outflows, there were still asset managers who had substantial positions inPolish bonds and most of these were unhedged from a currency perspective. The spike higher inEuro–zloty and dollar–zloty forced these to currency hedge their bond positions, in the processgreatly accelerating the move. Dollar–zloty leapt forward, screaming through 4.40, 4.45, 4.50,only peaking out at around 4.55. In the first six months of 2001, the zloty appreciated by around10% against its old basket value, only to lose that and more in two days in July. From a peak of
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around +15.5% against its basket, the zloty fell to as low as +2.5% before finally managingto stabilize. The fall provided a major competitiveness boost to Polish exporters, who quicklytook advantage of the opportunity to hedge forward by selling US dollars and Euro against thezloty at such elevated levels. In this way, fundamental buyers returned to both the zloty andto the Polish asset markets, in the form of corporations on the one hand and investors on theother. The cycle began again. Over the next six months, the zloty appreciated from +2.5% toover +14% before again correcting, this time to around +6.8% before stabilizing.Thus, where we have the CEMC model for pegged or fixed exchange rates, the speculativecycle model can be used for floating exchange rates. Readers will of course note that these twomodels have been used in the context of emerging markets. The dynamics of the developedcurrency markets are slightly different in so much as they are much more liquid and thereforethe transmission from portfolio flows to currency strength is less immediate. Equally, very fewdeveloped market currencies are pegged – indeed one could argue that the very act of movingfrom a pegged to a floating currency is itself one necessary aspect of progression from emergingto developed country status. Thus, while the CEMC is not of much use for developed marketexchange rates in this context, the speculative cycle model can be used for both emerging anddeveloped exchange rates.One should note however that the time period over which speculative cycles last in thedeveloped exchange rate markets can be significantly longer – years rather than months – thanis the case in the emerging markets. This is so because developed exchange rate markets aresubstantially more liquid, but more importantly because the size of capital flows has such adisproportionately larger impact on the real economy of emerging markets than is the case withdeveloped economies. Capital flows that can have only a lasting impact on the real economyof a developed market after a substantial period of time are so large by comparison with thesize of an emerging market economy that they have a much more significant impact.If we look at what happens within the developed exchange rates, the speculative cycle ofexchange rates also has major relevance, with the proviso that it takes place over a muchlonger period of time. The starting place for developed market exchange rates is of coursethe US dollar. If we examine the performance of the US dollar from 1991 to 2001, we canindeed see the speculative cycle of exchange rates at work. Roughly speaking, from 1991 to1995, the US dollar was in a clear downtrend. Initially, this was due to fundamental concerns,both of valuation and of growth prospects. The Gulf War in 1990–1991 gave way to a deepif brief recession in 1991–1992. From 1993, this was exacerbated by the market’s increasingview that the new Clinton administration had a deliberate policy of devaluing the US dollarin order to boost US export competitiveness and reduce the US trade and current accountdeficits, particularly against Japan. While US officials now say that this was never the case,at the time US officials made repeated statements that could easily have been interpreted assuch, suggesting the US wanted a weaker currency. Fundamental investors increasingly soldtheir US assets during 1991–1993, and during 1993–1995 this process increased despite USeconomic recovery on the view that the US was deliberately devaluing the dollar. Eventually,as these things tend to do, this fundamental selling attracted the attention of the speculators,who also started to sell en masse. The speculative pressure grew and grew, causing the USdollar to fall in value against all of its major currency counterparts, such as the Japanese yenand the German Deutschmark. This increasingly happened as the fundamentals of the US werestarting to improve, helped in large part by the dollar depreciation that had reduced that UStrade deficit by making US exports more competitive. Fundamental investors started to getback into US assets, however the speculators, attracted even more by irresponsible US official
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comments on the currency, were still selling. Eventually, the patience of the US authoritiessnapped and the Federal Reserve intervened on several occasions in 1995 to stem the tide ofspeculative selling. The former Undersecretary of the US Treasury, Peter Fisher, was at thetime the head of open market operations at the New York Fed and therefore responsible forthe Fed’s intervention in the foreign exchange markets. Fisher explained the Fed’s aim not somuch as to defend a specific currency level or to of necessity stop a currency from weakening,but rather to intervene in order to recreate a sense of two-way risk in the markets.2 The Feduses a number of market pricing indicators to tell whether or not two-way risk – the risk thata currency can go up or down – exists and most if not all of these were at the time suggestingthat the market viewed all the US dollar risk as being to the downside. The Fed’s intervention,carried out in conjunction with the Bank of Japan and also with monetary policy change bythe BoJ, helped cause a sea change in market sentiment. The US thus achieved what they werelooking for, two-way risk in the dollar. In the wake of this, the fundamental buyers increasedsignificantly in number and the speculators reversed and also started buying.Thus, the speculative cycle worked, albeit with somewhat of a delay due to the view thatthe US was deliberately trying to devalue its own currency. From 1995, the US dollar thushas been on a trend of appreciation, more than reversing the weakness seen in 1991–1995.Readers will of course be aware that the speculative cycle works both ways, when a currencyis appreciating and also when it is depreciating. Thus, the US dollar strength that we have seensince 1995 has indeed caused fundamental deterioration. If the speculative cycle holds up, thespeculative buying will be overwhelmed by the fundamental selling by asset managers and theUS dollar will reverse sharply lower. The warning sign for that to come will be when we see asharp spike in options volatility without any major moves in the spot market, reflecting majorflow disturbance in the market as the fundamental selling pressure intensifies.In recent years, the economic community has developed a very large number of exchangerate models for analysing currency crises, and it is certainly not for here to repeat a list ofthem. That said, they can be classified into three broad categories of currency crisis model.First-generation crisis models focus on the “shadow price” of the exchange rate; that is theexchange rate value that would prevail if all the foreign exchange reserves were sold. Thesemodels generally view as doomed a central bank’s efforts to defend a currency peg usingreserves if the shadow price exchange rate is in a long-term uptrend. It is assumed that rationalspeculators will immediately eliminate a central bank’s foreign exchange reserves as soon asthe shadow price exceeds the peg level. A key feature of first-generation currency crisis modelsis that they generally see currency crises as being due to poor government economic policy;that there was a degree of blame involved, that poor government policy caused the currencycrisis.Unlike with the first-generation model, second-generation crisis models do not see a currency crisis as being due to poor government economic policy, but instead due to the currencypeg being at an uncompetitive level. The main inspiration for second-generation crisis modelswas the ERM crises of 1992–1993. In 1992, the UK was not willing to take the economicpain required to keep their peg of 2.7778 against the Deutschmark. In August 1993, most ofcontinental Europe was forced to abandon their 2.25% bands. However, instead of allowingtheir currencies to float freely, they widened the 2.25% band to 15%, a compromise solutionbetween a full flotation and a pegged exchange rate. In the cases of the UK and of continental2
1995.
As explained by Peter Fisher at the quarterly meetings at the New York Federal Reserve to discuss foreign exchange activity,
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Europe, the de-pegging of the exchange rate did not cause the much anticipated economicrecession. Indeed, the cost of defending the peg was very high interest rates, thus hurting theeconomy. With the currency pegs gone, there was no longer any need for such high interestrates. Thus, the de-pegging of the exchange rate was on the one hand due to the government’sunwillingness to take the economic pain needed to defend the peg, but on the other hand thatpain was due to an uncompetitive exchange rate peg level. For the UK in particular, the depegging of sterling, which came to be known as “Black Wednesday”, was the best thing that hadhappened to the UK economy for several years. Interest rates are lowered and exchange ratesstabilize at a much more competitive and appropriate level when currency pegs are broken,according to second-generation models.Third-generation currency crisis models, which developed in the wake of the Asian currency crisis, involved “moral hazard”, that is the idea that private sector investment in a specificcountry will result if a sufficient number of investors anticipate that country will be bailed outby multinational organizations such as the IMF. Inward investment and external debt rise inparallel as a country continues to be bailed out until such time as the situation is untenable.The currency is one main expression of that situation’s collapse.With the first-generation currency crisis model, the focus is on blaming poor governmenteconomic policy, particularly poor fiscal policy. With the second-generation model, the issueof blame is less clear and the focus is more on an uncompetitive exchange rate rather than poorgovernment economic policy. For its part, the third-generation model focuses not on the reasonfor the currency crisis but the result, or more specifically the massive real economic shock thatcame from “moral hazard” investment caused by the combination of currency devaluationand external debt. Put simply, second-generation models can be “good”, but third-generationmodels are unequivocally “bad”.
6.3 SUMMARYIn Chapter 5, we looked at how the type of exchange rate regime can affect currency marketconsiderations. Here, in Chapter 6, we have tried to extrapolate this, looking at currency modelsfor fixed and floating exchange rate regimes. While the aim of both chapters has been to showthe practical aspects of these themes, the methodology has largely been theoretical rather thanpractical, that is the focus for the most part has been on the theory of how exchange rateregimes affect economic behaviour and equally the theory of how currency crises develop.In the next three chapters however, we take an entirely different line, focusing on practicerather than theory, looking at how the practitioners themselves can use currency analysis andstrategy to conduct their business. We start this process by off by looking at how multinationalcorporations might seek to manage their currency risk.
Part ThreeThe Real World of the CurrencyMarket Practitioner
7Managing Currency Risk I – TheCorporation: Advanced Approaches toCorporate Treasury FX StrategyThe management of currency risk by corporations has come a long way in the last three decades.Before the break-up of Bretton Woods currency risk was not a major consideration for corporateexecutives, nor did it have to be. Exchange rates were allowed to fluctuate, but only withinreasonably tight bands, while the US dollar itself was pegged to that most solid of commodities,gold. The responsibility for managing currency risk, or rather maintaining currency stability,was largely that of governments. Needless to say, that burden, that responsibility has nowpassed from the public to the private sector.This chapter deals with the corporate world, how a corporation is affected by and howcorporate Treasury deals with the issue of currency or exchange rate risk. More specifically,this chapter will look at:
r Currency risk – defining and managing currency riskr Core principles for managing currency riskr Corporate Treasury strategy and currency riskr The issue of hedging – management reluctance and internal hedgingr Advanced tools for hedgingr Hedging using a corporate risk optimizerr Advanced approaches to hedging transactional and balance sheet currency riskr Hedging emerging market currency riskr Benchmarks for currency risk managementr Setting budget ratesr Corporations and predicting exchange ratesr VaR and beyondr Treasury strategy in the overall context of the corporation
In short, there is a lot to cover. This chapter is aimed first and foremost at corporate FinanceDirectors, Treasurers and their teams. In addition, it attempts to give corporate executivesoutside of the Treasury a greater understanding of the complexity and difficulty entailed andthe effort required in managing a corporation’s exchange rate or currency risk. As we shall seelater in the chapter, many leading multinationals have set up oversight or risk committees tooversee the Treasury strategy in managing currency and interest rate risk. This is an importantcounter-balance for the corporation as a whole, but of course it requires that the committeeitself is as up-to-date with the latest risk management ideas and techniques as are the Treasurypersonnel themselves.The way the corporation has dealt with currency risk has changed substantially over time.Corporations, many of which were reluctant to touch anything but the most vanilla of hedgingstructures, have now greatly increased the sophistication of their currency risk managementand hedging strategies, particularly over the last decade. In this regard, two developments have
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helped greatly – the centralizing of Treasury operations, particularly within large multinationals, and the focus put on hiring specifically experienced and qualified personnel to manage theday-to-day operations of risk management.Before going on I would point out that perhaps to some reading this, it may seem strangeand slightly out of touch to be examining advanced approaches to the management of currencyrisk at a time when the number of currencies worldwide seems to be rapidly diminishing. Thecreation of the Euro-zone has eliminated a large number of western European currencies, withthe prospect that many countries within Eastern Europe will enter it from 2004–5 onwards,giving up their own currencies in the process. In the Americas, the creation of the NorthAmerican Free Trade Area has created a de facto US dollar bloc. Though some may not liketo see it that way, that is surely the reality and on the whole it has been a positive development.As yet, the talk that there may be a unification of the US and Canadian dollars is just that, talk,but who knows for the future? There is no such talk about unification with the Mexican peso,as it is doubtful whether any Mexican administration that suggested any such would survive.That said, there is little question that the economic impact of NAFTA appears to have addedgreatly to the stability of the Mexican peso, rendering the question redundant for now. In Asia,there are occasional mutterings that there could be a single currency, either in Asia as a whole(i.e. the Japanese yen) or more specifically within the ASEAN region of countries. On thefirst, any prospect of a pan-Asian currency seems far off, not least because a number of Asiancountries, notably China, would not accept the dominant role that any such currency wouldautomatically give Japan. In addition, given Japan’s slow economic descent in the 1990s, it isquestionable whether anyone in their right mind would want to unify their currencies with theyen and thus by doing so import deflation. The more specific idea of an ASEAN currency isa greater possibility, at least in relative terms, though it has not yet been raised to any seriousextent. Moreover, the idea of the Asian Free Trade Area (AFTA) has yet to see fruition. Itwould probably be best to focus on that first, before considering a single currency area.There is no question however that the number of national currencies is on a downtrend.This may cause some to assume that the need for currency risk management should similarlybe on a downtrend. In fact, quite the opposite is the case. The desire of corporate executives“just to be able to get on with the company’s underlying business” is a natural one, but it willbe some time – if ever – before they will be able to ignore currency risk. There may be asingle currency in the Euro-zone, but there is not worldwide – whatever we think of the roleof the US dollar – and there is unlikely to be any time soon. Even in the brave new worldof the Euro-zone, where currency risk should in theory be a thing of the past, it remains animportant consideration. To use John Donne, just as no man is an island, the same is true for thecorporation. Within the Euro-zone, currency translation and therefore direct currency risk hasbeen eliminated. However, corporations are still exposed to competitive threats from exchangerate movements between the Euro-zone and the rest of the world. A single currency area suchas the Euro-zone can eliminate only one form of currency risk, that is the direct kind. However,it cannot eliminate indirect currency risk for the very reason that the Euro-zone is but one area,albeit an important one, within the global economy. National currencies still have to be dealtwith and that is unlikely to change near term.
7.1 CURRENCY RISKSo, what precisely is currency risk? There is no point in focusing on an issue if one cannot firstdefine it. Although definitions vary within the academic community, a practical description of
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currency risk would be:The impact that unexpected exchange rate changes have on the value of the corporationCurrency risk is very important to a corporation as it can have a major impact on its cash flows,assets and liabilities, net profit and ultimately its stock market value. Assuming the corporationhas accepted that currency risk needs to be managed specifically and separately, it has threeinitial priorities:1. Define what kinds of currency risk the corporation is exposed to2. Define a corporate Treasury strategy to deal with these currency risks3. Define what financial instruments it allows itself to use for this purposeCurrency risk is simple in concept, but complex in reality. At its most basic, it is the possiblegain or loss resulting from an exchange rate move. It can affect the value of a corporationdirectly as a result of an unhedged exposure or more indirectly.Different types of currency risk can also offset each other. For instance, take a US citizenwho owns stock in a German auto manufacturer and exporter to the US. If the Euro falls againstthe US dollar, the US dollar value of the Euro-denominated stock falls and therefore on theface of it the individual sees the US dollar value of their holding decline. However, the Germanauto exporter should in fact benefit from a weaker Euro as this makes the company’s exports tothe US cheaper, allowing them the choice of either maintaining US prices to maintain marginor cutting them further to boost market share. Sooner or later, the stock market will realizethis and mark up the stock price of the auto exporter. Thus, the stock owner may lose on thecurrency translation, but gain on the higher stock price.This is of course a very simple example and life unfortunately is rarely that simple. Forjust as a weaker Euro makes exports from the Euro-zone cheaper, so it makes imports moreexpensive. Thus, an exporter may not in fact feel the benefit of the currency translation throughto market share because higher import prices force it to raise export prices from where theywould otherwise would be according to the exchange rate.The first step in successfully managing currency risk is to acknowledge that such risk actually exists and that it has to be managed in the general interest of the corporation and thecorporation’s shareholders. For some, this is of itself a difficult hurdle as there is still majorreluctance within corporate management to undertake what they see as straying from theircore, underlying business into the speculative world of currency markets. The truth howeveris that the corporation is a participant in the currency market whether it likes it or not; if it hasforeign currency-denominated exposure, that exposure should be managed. To do anythingelse is irresponsible. The general trend within the corporate world has however been in favourof recognizing the existence of and the need to manage currency risk. That recognition doesnot of itself entail speculation. Indeed, at its best, prudent currency hedging can be defined asthe elimination of speculation:The real speculation is in fact not managing currency riskThe next step, however, is slightly more complex and that is to identify the nature and extentof the currency risk or exposure. It should be noted that the emphasis here is for the most parton non-financial corporations, on manufacturers and service providers rather than on banksor other types of financial institutions. Non-financial corporations generally have only a smallamount of their total assets in the form of receivables and other types of transaction. Most oftheir assets are made up of inventory, buildings, equipment and other forms of tangible “real”
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assets. In order to measure the effect of exchange rate moves on a corporation, one first has todefine the type and then the amount of risk involved, or the “value at risk” (VaR). There are threemain types of currency risk that a multinational corporation is exposed to and has to manage.
7.2 TYPES OF CURRENCY RISK1. Transaction risk (receivables, dividends, etc.)2. Translation risk (balance sheet)3. Economic risk (present value of future operating cash flows)7.2.1 Transaction RiskTransaction currency risk is essentially cash flow risk and relates to any transaction, such asreceivables, payables or dividends. The most common type of transaction risk relates to exportor import contracts. When there is an exchange rate move involving the currencies of such acontract, this represents a direct transactional currency risk to the corporation. This is the mostbasic type of currency risk that a corporation faces.7.2.2 Translation RiskTranslation risk is slightly more complex and is the result of the consolidation of parentcompany and foreign subsidiary financial statements. This consolidation means that exchangerate impact on the balance sheet of the foreign subsidiaries is transmitted or translated to theparent company’s balance. Translation risk is thus balance sheet currency risk. While mostlarge multinational corporations actively manage their transaction currency risk, many are lessaware of the potential dangers of translation risk.The actual translation process in consolidating financial statements is done either at theaverage exchange rate of the period or at the exchange rate at the period end, depending on thespecific accounting regulations affecting the parent company. As a direct result, the consolidated results will vary as either the average or the end-of-period exchange rate varies. Thus,all foreign currency-denominated profit is exposed to translation currency risk as exchangerates vary. In addition, the foreign currency value of foreign subsidiaries is also consolidatedon the parent company’s balance sheet, and that value will vary accordingly. Translation riskfor a foreign subsidiary is usually measured by the net assets (assets less liabilities) that areexposed to potential exchange rate moves.Problems can occur with regard to translation risk if a corporation has subsidiaries whoseaccounting books are local currency-denominated. For consolidation purposes, these booksmust of course be translated into the currency of the parent company, but at what exchangerate? Income statements are usually translated at the average exchange rate over the period.However, deciding at what exchange rate to translate the balance sheet is slightly trickier.There are generally three methods used by major multinational corporations for translatingbalance sheet risk, varying in how they separate assets and liabilities between those that needto be translated at the “current” exchange rate at the time of consolidation and those that aretranslated at the historical exchange rate:
r The all current (closing rate) methodr The monetary/non-monetary methodr The temporal method
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As the name might suggest, the all current (closing rate) method translates all foreigncurrency exposures at the closing exchange rate of the period concerned. Under this method,translation risk relates to net assets or shareholder funds. This has become the most popularmethod of translating balance exposure of foreign subsidiaries, both in the US and worldwide.On the other hand, the monetary/non-monetary method translates monetary items such asassets, liabilities and capital at the closing rate and non-monetary items at the historical rate.Finally, the temporal method breaks balance sheet items down in terms of whether they arefirstly stated at replacement cost, realizable value, market value or expected future value, orsecondly stated at historic cost. For the first group, these are translated at the closing exchangerate of the period concerned, for the second, at the historical exchange rate.The US accounting standard FAS 52 and the UK’s SSAP 20 apply to translation risk. UnderFAS 52, the translation of foreign currency revenues and costs is made at the average exchangerate of the period. FAS 52 generally uses the all current method for translation purposes, thoughit does have several important provisions, notably regarding the treatment of currency hedgingcontracts. Under SSAP 20, the corporation can use either the current or average rate. Generally,there has been a shift among multinational corporations towards using the average rather thanthe closing rate because this is seen as a truer reflection of the translation risk faced by thecorporation during the period.Translation risk is a crucial issue for corporations. Later in this chapter, we will look atmethods of hedging it. For now, it is important to get an idea of how it can affect the company’soverall value.ExampleTake an example of a Euro-based manufacturer, which has bought a factory in Poland. Needlessto say, the cost base in Poland is substantially below that of the parent company, one of severalmajor reasons why the acquisition was made in the first place. From 1999 to 2001, the Eurowas on a major downtrend, not just against its major currency counterparts but also againstmost currencies of the Central and East European area, such as the Polish zloty. Thus we getthe following simple model:EUR–USD ↓ = EUR–PLN ↓where:EUR–USD = The Euro–US dollar exchange rateEUR–PLN = The Euro–Polish zloty exchange rateThis is an over-simplification to be sure. For one thing, the Polish zloty was pegged to a basketof Euro (55%) and US dollar (45%) with a crawl and trading bands up until 2000, and thus wasunable to appreciate despite the ongoing decline in the value of the Euro across the board. Foranother, it does not take account of EUR–PLN volatility. That said, general Euro weaknesshas clearly been an important factor in the