International Financial Management

Comercial Mexicana, Mexico's third largest retailer and a competitor of Wal-Mart, sells many goods imported from the United States. Because Comercial's revenues are in Mexican pesos, a strengthening of the dollar relative to the Mexican peso increases Comercial's costs and lowers its earnings. In general, when the delivery of and payment for goods takes some time, future fluctuations in exchange rates give rise to potential losses, and possible gains, for the parties involved. The possibility of taking a loss in such a transaction is called transaction exchange risk.

In Chapter 2, we examined the organization of the spot foreign exchange market, in which the exchange of currencies typically happens in two business days. This chapter examines the forward foreign exchange market (or the forward market, for short). It is the market for exchanges of currencies in the future. One of the major reasons for the existence of forward markets is to manage foreign exchange risk in general and transaction exchange risk in particular.

The forward markets for foreign exchange allow corporations, such as Comercial Mexicana, to protect themselves against transaction exchange risks by hedging. To hedge against such risks, the corporation enters into an additional contract that provides profits when the underlying transaction produces losses. To evaluate the costs and benefits of hedging for a future transaction involving foreign currencies, the hedging party must have some way to quantify the degree of uncertainty it faces about future spot exchange rates. It accomplishes this by figuring out the likelihood of observing various ranges for future exchange rates.

Unfortunately, prior to the global financial crisis, Comercial Mexicana neither assessed nor hedged its transaction exchange risk properly. Instead, it dabbled excessively in complex foreign exchange derivatives contracts. As the dollar strengthened in the autumn of 2008, Comercial lost $1.4 billion and was forced to default on its debt. Numerous other companies throughout the developing world took enormous losses on foreign exchange contracts, including Citic Pacific of Hong Kong, an infrastructure firm, which lost $1.89 billion; and Aracruz Celulose S.A. of Brazil, the world's biggest eucalyptus-pulp maker, which lost $0.92 billion.

We begin the chapter by defining transaction exchange risk and continue by formalizing how to think about the uncertain future exchange rate movements that cause it.