Thinking of foreign exchange risk – or why I don’t believe the PH peso will go to P40/USD

Hedging hogs - Is it spring yet?

The IMF is famous for having the best brains on tap to think about the most important economic issues.

One issue is whether and how one should hedge against foreign exchange risk.

Here’s an excerpt of an expert opinion on the IMF staff on the question of foreign exchange hedging:

“Sophisticated corporate treasuries, however, are developing efficient frontiers of hedging strategies as a more integrated approach to hedge currency risk than buying a plain vanilla hedge to cover certain foreign exchange exposure (Kritzman, 1993). In effect, an efficient frontier measures the cost of the hedge against the degree of risk hedged. Thus, an efficient frontier determines the most efficient hedging strategy as that which is the cheapest for the most risk hedged. Given a currency view and exposure, hedging optimization models usually compare 100 percent unhedged strategies with 100 percent hedged using vanilla forwards and option strategies in order to find the optimal one. Although this approach to managing risk provides the least-cost hedging structure for a given risk profile, it critically depends on the corporate treasurer’s view of the exchange rate. Note that such optimization can be used for transaction, translation or economic currency risk, provided that the firm has a specific currency view (i.e., a possible exchange rate forecast over a specified time period).”

What does it mean?

In translation, it means roughly this.  Exchange rates move around, and to protect its profits, should a firm hedge?  If so, how and to what extent?  The correct answer requires measuring the risk of volatility (which is not easy to do) and depends on whether the firm, through its corporate treasurer, has a view on the future level of the exchange rate.

But how does the corporate treasurer come to a view on the future exchange rate?  Does he rely on advice from his bankers, or from economists?  What happens if the exchange rate is inherently unpredictable?  One school of thought says that if the market is rational, the exchange rate cannot be predicted except by the latest adjusted for interest differentials.  Another school of thought says the exchange rate is unpredictable because of unpredictable “animal spirits.”  Thus, either way, whether the market is rational or irrational, exchange rates cannot be predicted.

The extent of optimal hedging also depends on the error band given to the forecast future exchange rate.  Obviously, if the (estimated or thought-of) error band is narrow, but there is a wide gap between current and forecasted exchange rates, it pays to hedge fully.  If the band is wide, and the best forecast is the current level, it pays to do nothing.

The story is therefore a bit unsatisfying.  You should hedge if you have a view, but how you get to have that view is the Hamlet question.  And if your view is wrong, but you did your hedging on the basis of that view, can you, as a corporate treasurer argue that you should continue to keep your job?  I believe not, unless you can get the corporate board to agree with you on that view before you did your hedging.

That the story is unsatisfying is not the fault of the experts or economists.  It is just, as Walter Cronkite used to say, “the way it is.”

What to make of “forecasts” by self-appointed experts

Why don’t I believe the forecast exchange rates in the newspaper?  Those who claim to know should act on that belief and move the rate closer to what they claim.  If PH peso will go to P40 by end-2011, and today it is P44, it pays to hedge. It would even be a great “carry” strategy:  borrow US dollars at lower interest rates than Ph P, invest in peso-denominated assets that carry a higher interest rate, and then collect the 10% appreciation from P44 to P40 to the USD.

But if everyone thought the same, the peso would go to P40 tomorrow, not in some later time horizon.  Since not everyone will think the same, the correct error band for the future exchange rate must be wide, or at least wide enough to generate skepticism.

As stated earlier, if you can’t know the future, the best response is to do nothing.

A related question is this:  Why do banks or their economists go out on a limb to forecast exchange rates?

One reason is that if they turn out to be right, they can say “I told you so.”  (If they turn out wrong, they can keep quiet and hope everyone forgets.)

Another possible reason is that some corporate treasurers and their willing corporate boards need an “outside” forecast to justify ex ante what they will do today, so that if things go wrong they will have an excuse before their shareholders.

Still a third reason is that economists think that economics can be used to forecast exchange rates.  Unfortunately, this kind of reason will tend to erode trust in economics as a profession.  (I have yet to see a serious study that showed economists have been able to beat the foreign exchange market without using “inside” information.)

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