In plain English
When money crosses a border it changes price. Exchange rates and hedges exist so a business can plan in one currency while earning in another.
The advanced view
The parity conditions form a consistent system: covered interest parity is enforced by arbitrage, uncovered parity and PPP are expectations statements that hold only on average and over long horizons. Practical exposure management separates transaction (contracted flows), translation (accounting) and economic (competitive position) exposure.
An exchange rate is a price with two directions, and most FX errors are direction errors. Fix the convention first: in EUR/USD 1.10, one euro buys 1.10 dollars — the base currency is quoted first. A rise in the number means the base currency strengthened. Get this wrong in an interview and every subsequent number is inverted.
Parity conditions
Covered interest parity: F/S = (1 + i_quote) / (1 + i_base) Uncovered parity: E[ΔS] ≈ i_quote − i_base Relative PPP: ΔS ≈ inflation_quote − inflation_base Cross rate: A/C = A/B × B/C Real exchange rate = Nominal × (Price level foreign / Price level domestic)
Interest rate parity is the arbitrage backbone: a currency with higher interest rates trades at a forward discount, otherwise a riskless profit would exist. Purchasing power parity is the long-run anchor — currencies drift toward equalising the price of tradable goods — but it holds over years, not quarters. In the short run, capital flows, rate expectations and risk appetite dominate, which is why carry trades work until they suddenly do not.
Corporates face three exposures. Transaction exposure is contracted cash flows in foreign currency, hedged with forwards, futures or options. Translation exposure is the accounting effect of consolidating foreign subsidiaries, managed by matching the currency of assets and liabilities. Economic exposure is the competitive effect of currency moves on volumes and prices — the largest and least hedgeable. For valuation, either discount foreign cash flows at a foreign-currency rate and convert at spot, or convert cash flows using forward rates and discount at the domestic rate; never mix the two.
Essential vocabulary
- Spot / forward rate
- The rate for immediate settlement versus a contracted rate for a future date, set by interest rate differentials.
- Natural hedge
- Matching revenue and cost currencies so exposures offset without derivatives.
- Carry trade
- Borrowing in a low-yield currency to invest in a high-yield one. Profitable until the currency moves.
- Currency crisis
- A rapid collapse in a currency, usually after defending an unsustainable peg with finite reserves.
- Country risk premium
- Extra discount-rate spread for political, legal and convertibility risk in emerging markets.
Strategy connection
Currency shapes where you produce and where you sell. A sustained real appreciation can erase a cost advantage that no operational programme can recover, so market-entry and footprint decisions should be tested against currency scenarios, not just today's rate.
Hedging instruments and what each buys you
FX forward
Locks a rate for a future date at no upfront cost. Removes both downside and upside; the standard tool for contracted cash flows.
FX option
Right, not obligation, to transact at a strike. Costs a premium but keeps the upside — used when the exposure itself is uncertain, such as a bid pipeline.
Collar / participating forward
Buy a floor, sell a cap to fund it. Zero or low premium in exchange for capped upside.
Cross-currency swap
Exchange principal and interest in two currencies. Turns domestic debt into foreign-currency debt, hedging a foreign asset base for years rather than months.
Money-market hedge
Borrow and deposit in the two currencies to replicate a forward synthetically; useful where forwards are illiquid.
Natural / operational hedge
Match revenue and cost currencies, invoice in your own currency, or shift sourcing. Free, permanent, and slow to change.
Worked example: forward rate, hedge decision and country risk in WACC
Step 1 of 11
- 1Spot EUR/SEK = 11.50; SEK rate 3.5%, EUR rate 2.0%, 1 year
Must know cold
- ✓Higher-interest-rate currency trades at a forward discount (covered interest parity).
- ✓Forward = Spot × (1 + i_quote)/(1 + i_base) with the quote currency on top.
- ✓Three exposures: transaction (contracted), translation (accounting), economic (competitive).
- ✓Hedge cash flows either at forward rates and a domestic discount rate, or at spot with a foreign discount rate — never mix.
- ✓Country risk premium adjusts the discount rate; expropriation and convertibility risk may need scenario cash flows instead.
- ✓PPP is a multi-year anchor, not a forecast for next quarter.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
Spot USD/SEK is 10.40, the 6-month SEK rate is 3.6% and the USD rate 4.8% (annualised). Find the 6-month forward and say which currency is at a premium.
Exercise 2
A Swedish company earns 60% of revenue in EUR and incurs 25% of costs in EUR. Quantify the net exposure on revenue of SEK 4bn with a 12% EBIT margin, and say what a 10% EUR depreciation does.
Exercise 3
Structuring exercise: a client asks whether to hedge a five-year EUR investment programme. Structure the recommendation.
Intuition
Exchange rates are relative prices, so every parity condition is a no-arbitrage statement: interest-rate differences show up in forwards, inflation differences show up in expected spot moves. When a case crosses borders, decide first whether the risk is transaction, translation or economic — the hedge differs for each.
Common pitfalls
- ×Quoting a cross rate upside down; always write the units.
- ×Hedging translation exposure with cash instruments and calling it economic protection.
- ×Comparing nominal returns across currencies without adjusting for the forward discount.
Worked example — covered interest parity
Step 1 of 4
- 1Spot 10.50 SEK/USD, SEK rate 4%, USD rate 5%, one year
Why it works
Covered interest parity works because two ways of holding a currency for a year — deposit at home, or convert, deposit abroad and sell the proceeds forward — are riskless and must therefore yield the same. Any gap is a free lunch that traders close within seconds, so the forward rate is arithmetic, not a forecast.
How it is used — hedge a contracted receivable
Step 1 of 4
- 1You will receive USD 10m in 12 months. Spot 10.50 SEK/USD, SEK 4%, USD 5%.
Deeper
Deeper: three parities and three exposures
Covered interest parity fixes the forward from the interest differential. Uncovered interest parity says the expected spot change equals the differential (it fails empirically — the carry trade exists). Purchasing power parity says the spot change equals the inflation differential in the long run, which is a decades-long statement, not a trading rule.
Corporate FX exposure comes in three types. Transaction exposure (a contracted foreign-currency payment) is hedged with forwards. Translation exposure (consolidating foreign subsidiaries) is an accounting effect, often hedged with foreign-currency debt. Economic exposure (competitiveness against foreign rivals) cannot be hedged financially — it is an operating decision about where you produce.
Must know cold
- ✓F = S × (1 + r_dom) ÷ (1 + r_for).
- ✓Higher-interest currencies trade at a forward discount.
- ✓Transaction, translation and economic exposure need different tools.
- ✓Always state the quote convention before doing arithmetic.
Exercises
Try each one on paper before revealing the worked solution.
Exercise 1
A Swedish exporter invoices 10M USD in six months. Spot 10.50, SEK 4%, USD 5%. What does the forward lock in?
Exercise 2
Its main competitor produces in the eurozone. Does the forward hedge protect its margins?