With international trade: One party will end up having to deal with a foreign currency and will thus assume the CURRENCY RISK.

To avoid this risk should you require all transactions be in dollars?

In many cases, your customer or supplier may be more accustomed to dealing in dollars than you are accustomed to dealing in their currency. This may be particularly true in cases where the foreign currency has a poor reputation (for example, Latin America). However, an unwillingness to take on currency risk may harm your business in the long run.

For example:

(1) The party assuming the currency risk can usually extract other concessions.

(2) The other party may not be ready to deal with currency risk - you will lose their business to a competitor.

(3) Many "third-world" currencies are becoming more globally accepted - especially from the "ABC" countries in South America.

Finally, even if you can consistently avoid dealing in FOREX, (foreign exchange) you still may be subject to an indirect form of currency risk: Consider the exporter who sold goods to Mexico in 1994. Due to the strength of the Mexican economy at that time, this exporter was able to price and demand payment in dollars. However, when the value of the peso collapsed in late 1994 and early 1995, the exporter found that not only were his Mexican customers now unable to afford his exports, but in some cases they were unable to pay the dollars that they owed on goods already shipped.

Does the above mean that you should always hedge your currency exposure? Not necessarily, but you should monitor the currency just as you monitor the business climate of your target country.

Some currency (half) myths:

Myth # 1 hedging is expensive: The cost of hedging consists of transactions fees - and loss on the contract if the hedge "backfires". That is, if you were better off not having hedged. Forward hedges through your money-center bank involve significantly higher fees (primarily the spread between bid and ask rates) than hedges with futures contracts.

 The main drawback with futures contracts is the limited number of currencies available: Those of Great Britain, Germany, Switzerland, Australia, Canada, Japan and France. These were no help during the "Mexican Meltdown." However in 1996 we saw the beginning of the trading in the Mexican and Brazilian currency futures.

 What the cost of Hedging Isn't.

It is not the discount you might pay to hedge. Suppose the spot rate on the Mexican Peso is $.11500 /peso and your Mexican customer owes you Pesos due in ten months (Dec.). You could "sell" Pesos forward at the future rate of $.10580 - a drop of 9.2%. This not a hedging cost, however, (since you can also buy Dec. Pesos at $.10580) but is a reflection of the differences in borrowing costs in each country (which, annualized, appear to be 10-11% higher in Mexico) and is a result of arbitrage. Often we confuse the cost of a hedge with this forward rate of the currency. Since we tend to only want to hedge ourselves against holding "weak" currencies - those that are expected to lose value over time we associate hedging with selling for FOREX at a discount. Mexico currently has high inflation, thus high interest rates, and the forward rate simply reflects the rate difference. Further, given the higher inflation, this discounted forward rate probably is a reasonable estimate of the markets expectations of the Peso's valuation in December. If you expect a future payment in some FOREX you should always value the currency at the relevant forward rate - it is a good estimate of the value of the currency when you are to get.

Myth # 2 The dollar should rise against the Yen or Swiss Franc, etc because those currencies seem to buy less at home (Japan and Switzerland). Such thinking derives from a belief in something called the Law of One Price - Absolute Purchasing Power Parity.

The Law of One Price: An ounce of gold cost about the same around the world. This is because gold is a Tradable good.

(1) There are few restrictions (nowadays) on the import or export of gold.

(2) Transportation and trading costs are relatively low as a percentage of price.

Other commodities such as oil also TEND to follow the law of one price but transportation and storage costs can be much higher. Plus there are quality differences.

However a visitor to Switzerland cannot fail to notice that the cost of living in Switzerland appears to be much higher than in the United States. The reverse is usually true in South America. Does this mean the Swiss Franc is overvalued (and likely to fall) and that the Mexican Peso is undervalued and likely to rise?

The Big Mac Index: While a tongue-in-cheek measure, the Big Mac is interesting as both a non-traded good and a pure commodity in that there are no quality differences from nation to nation. The factors that go into the production of the Big Mac consist of agricultural products, retail rent, utilities, and labor costs. These factors are all non-tradable. "Extensive studies" have shown that the price of a McDonald's Big Mac can serve as a proxy for a country's market basket of good and thus a cost-of-living index.

One observation: overvalued currencies, as measured by high costs-of -living, tend to stay overvalued and vice versa. So while Absolute PPP does not hold, RELATIVE PPP may hold for long time. To see why relative PPP may be fairly stable we list factors affecting relative PPP (and thus also violations of absolute PPP.)

(1) Trade restrictions: import restrictions tend to raise the value of the currency of the nation with the restrictions. Japan? Since agricultural commodities are most likely to be subjected to government restrictions (protecting local food producers, ostensive health reasons, etc.) net producers of agricultural commodities are the likeliest victims of import restrictions and thus have undervalued currencies. Examples. New Zealand, Australia, Canada, South America, United States.

(2) Local taxes: in most European countries a value-added tax is included in the price. This may be as high as 20 percent and is typically well into the teens. Also American travelers often forget to include their own local sales and occupancy taxes when comparing the cost of meals and lodgings.

(3) Non-traded goods: These include housing, services, utilities, and largely set the prices that the typical tourist sees when abroad. Rents are impacted by land availability (which is determined by both geography and zoning laws) and helps explain Japan's high cost of living. Labor costs are directly linked to labor productivity in the manufacturing sector! Developed countries have much more capital (physical and human) in place per worker than do less developed countries. This translates to higher productivity in rich countries and higher wages. While a barber in a wealthy country may not cut hair any faster than a barber in a poor country, the barber in the rich country will earn considerably more, in part because that barber could switch to a job in the more productive manufacturing sector. Also, the level of the "social safety net" plays a role: workers in, say, Europe may prefer their relatively high unemployment benefits to holding a low paying job - thus setting a de facto high minimum wage.

(4) The degree of local price competition: where local prices are set through some type of private-sector collusion or government price minimums. Or where entry into the market is significantly restricted. Retail in Japan?

All of the above factors will affect the purchasing power of a particular currency and all of these factors tend to change slowly - if they change at all. Thus, you should not expect "overvalued" currencies like the Yen and the "Euro-currencies" to fall simply because they don't buy as much locally as the dollar does in the United States. There is a tendency for some to believe in a "regression to the mean" for over- or undervalued currencies, but we observe little evidence that there is a strong convergence toward a "one price" world.

 However, given this stability of Relative PPP, when this stability is violated - for example when a traditionally Aundervalued@ currency like the Mexican Peso achieved "parity" even becoming overvalued compared to the dollar in 1994 - there is cause for concern. In cases like this, you may expect a regression to the mean - back to the long-standing relative purchasing power.

In conclusion, the PPP condition is a relative PPP condition. It has been shown to hold over long periods of time as the factors that create the difference in absolute PPP tend to be long lived. When we do observe deviations from relative PPP, it is often a single that the currencies affected are temporally misaligned and thus may eventually revert to the relative values of the past.