Elastic View of Exchange Rate

The exchange rate is an area within international finance which has generated and strong excitement and interest among policy makers, practitioners, academics and students.  The last fifteen years or so in particular have seen a great flurry of activity in exchange rate economics, with important contributions to exchange rate theory, empirics and policy.  In the last few decades or so exchange rate economics has seen a number of exchange developments, with substantial contributions to both the theory and the empirics of exchange rate determination.  Important developments in econometrics and the increasing availability of high-quality date have also been responsible for stimulating the large amount of empirical work on exchange rates published over this period.  The key distinction between international finance and finance is the exchange rate issue.  Issues of valuation, uncertainty about the future exchange rate, and its convertibility and transactions costs, lead to market segmentation.  If a forward rate, F, exists, it is centered at the expected exchange rate.  In the euro and the pound, there are futures up to two years.  Consequently, today’s forward quotations provided every bit of known information about the future, so they are unbiased predictors of the future spot exchange rate.  A firm’s free-cash flow from overseas operations is subject to exchange rate risk.  By changing economic variables or seeking offsetting matching currency flows, the firm can hedge against exchange rate losses.  To hedge, there are contractual hedges, operational hedges, and the trade documents that cover against unexpected changes in exchange rates.  The contractual hedges are mainly useful for one-time large future receipts or expenses in foreign exchange, while operational hedges provide matching natural offsetting flows in foreign currency in an ongoing basis.  Their core business and comparative advantage is in the production of goods and services, not in speculating on movements in the exchange rate by implicitly taking long and short positions in different currencies.