Discounting future foreign exchange risk is the process of adjusting the value of future cash flows that are denominated in a foreign currency to account for the uncertainty and volatility of exchange rates. This is done to estimate the present value of these cash flows in the investor’s home currency, which is the basis for valuation and decision making.
There are different methods and assumptions for discounting future foreign exchange risk, depending on the approach and the data available. One common method is to use the forward exchange rate, which is the agreed-upon rate for exchanging two currencies at a future date. This rate reflects the market’s expectation of the future exchange rate, as well as the interest rate differential between the two currencies. By using the forward rate, the investor can lock in the future exchange rate and eliminate the exchange rate risk.
Another method is to use the spot exchange rate, which is the current rate for exchanging two currencies, and adjust it for the expected inflation and interest rates in both countries. This method is based on the uncovered interest rate parity, which assumes that the exchange rate will move in line with the interest rate differential. By using the spot rate and the expected rates, the investor can estimate the future exchange rate and discount the foreign cash flows accordingly.
A third method is to use the global capital asset pricing model (CAPM), which incorporates the exchange rate risk into the discount rate. This method requires the estimation of the risk-free rate, the market risk premium, and the beta of the foreign cash flows. The beta measures the sensitivity of the foreign cash flows to the exchange rate movements, and it can be derived from the covariance between the cash flows and the exchange rate. By using the global CAPM, the investor can discount the foreign cash flows at a risk-adjusted rate that reflects the exchange rate risk.
Each method has its advantages and disadvantages, and the choice depends on the availability and reliability of the data, as well as the investor’s preferences and objectives. The main goal of discounting future foreign exchange risk is to compare the value of different investments in different currencies on a common basis, and to make informed and rational decisions.
Basic Theory
Discounting future cash flows is based on the time value of money concept, which asserts that a sum of money today is worth more than the same sum in the future. When dealing with foreign exchange risk, this concept is applied to adjust future cash flows, denominated in a foreign currency, to their present values. The discount rate used reflects the cost of capital or the desired rate of return and accounts for the risk associated with currency fluctuations.
Procedures
- Identify Future Cash Flows: Determine the expected future cash flows denominated in a foreign currency.
- Determine the Discount Rate: Select an appropriate discount rate that reflects the cost of capital and the risk associated with currency fluctuations. This rate can be based on the company’s cost of capital or adjusted for the specific risks of the foreign exchange market.
- Apply the Discount Factor: Use the formula:
Present Value = Future Value / (1 + Discount Rate)^Number of Periods
Practical Implementation with Excel
Scenario
Consider a company, XYZ Inc., based in the United States, exporting goods to Europe. The company expects to receive €100,000 in one year. The current exchange rate is 1 USD = 0.85 EUR. The company’s cost of capital is 8%.
Excel Calculation
- Set up an Excel table:
| Description | Currency | Future Value | Exchange Rate | Discount Rate |
|---|---|---|---|---|
| Data | USD | 100,000 | 0.85 | 8% |
- Calculate the discounted value using the formula:
In cell E2, enter the formula:
=B2/(1+C2)
- Convert the present value to USD using the exchange rate:
In cell F2, enter the formula:
=E2/B2
Results
After performing the calculations, the present value of €100,000, discounted at 8%, is approximately $92,592.59.
Other Approaches
Sensitivity Analysis
Perform sensitivity analysis by changing the discount rate and exchange rate to assess the impact on the present value. This helps in understanding the sensitivity of the results to changes in these variables.
Hedging Strategies
Explore hedging strategies, such as forward contracts or options, to manage and mitigate foreign exchange risk. These strategies can be integrated into the analysis to provide a more comprehensive risk management approach.
