Question

Give an analysis of the financial and nonfinancial factors that influence foreign currency risk. In your analysis, do the following:

Compare purchase power parity and interest rate parity.

Differentiate between the use of home currency and foreign currency approaches.

Discuss the effect of global political uncertainty on exchange rate risk.

Answer 1

Purchase power parity means that a basket of goods in one country should cost the same in a different country after considering and taking into account exchange rates. Foreign currency risk comes into factor in the absence of purchase power parity. For instance if a basket of goods is cheaper in France compared to England then people will prefer buying the goods from France. This will lead to higher demand for the French currency and as a result the English pound will depreciate. Interest rate parity means that money should earn an equal rate of interest in different countries. In the absence of interest rate parity foreign currency risk comes into picture. Suppose that France has an interest rate of 5% against England’s rate of 3%. This will lead investors to park more of their money in France.

In the home currency approach cash flows are estimated in foreign currency. This is then converted to home currency using the projected exchange rate. The NPV (net present value) of a project is then computed using the home currency’s cost of capital as the discount rate. In the foreign currency approach cash flows are estimated in foreign currency. The cash flows are then used to compute NPV using the foreign currency cost of capital. Next, the conversion is done to home currency using the spot exchange rate.

Political uncertainties have a direct and significant impact on exchange rate risk. Political uncertainty and risk increases the level of uncertainty and stress within the economy of a country. During times of political unrest there is short term as well as long term risks. Political uncertainty can lead to chaos, hyper inflation, mass unemployment etc. All these have a direct bearing on exchange rate risk.