Managing Foreign Currency Risk in Business
Managing Foreign Currency Risk in Business
Real appreciation/depreciation of the Irish Punt, US Dollar, French Franc, Japanese Yen and Deutsche Mark
The real exchange rate is the nominal exchange rate adjusted for changes in the relative purchasing power of each currency (Shapiro, 1999). This concept can be linked to the theory of Purchasing Power Parity (PPP), first introduced by Gustav Cassel in 1918 and defined as:
e (home)/e (foreign) = p (home)/p (foreign) (formula 1)
e = spot rate
p = Inflation
In absolute terms, it states that currencies should have the same purchasing power all over the world. Transportation costs, tariffs, quotas, restrictions and product differentiation are ignored though.
The relative version of PPP states that the exchange rate between home and foreign currency will adjust to reflect changes in price levels of the two countries. So, if inflation in the US is 5% and 3% in the UK, then sterling must rise by 2% in order to equalise the dollar price of goods in the two countries.
Vice versa, when calculating real appreciation or depreciation, it is necessary to adjust for inflation rates. Therefore, real appreciation or depreciation of a currency is that adjusted for inflation and is calculated using the following formula:
e(real) = e(nominal)*[p(foreign)/p(home)] (formula 2)
Similarly, the real interest rate must be adjusted to reflect inflation. The real interest rate, according to the Fisher effect, measures the exchange rate between current and future purchasing power. Together with (expected) inflation, it represents the nominal rate. This can be approximated by the equation r = a + i, where r is the nominal rate, i is the rate of inflation, and a is the real rate of interest.
Based on these calculations, it clearly emerges that the US$ is overvalued by about 36% since the exchange rate differential is greater than the relative inflation between the USA and Ireland.
We can thus assume that if PPP holds, the controller has a convincing argument with regards to his fears of the US$ weakening against the punt. But it is widely accepted that PPP generally does not hold for major currencies bought for investment purposes such as the US$, and that if it does hold, it will only do so over the long term (Shapiro, 1999).
Please see overleaf for calculations.
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