Incorporating Foreign-Currency Risk in the Valuation  519 Analysis of purchasing power parity (PPP) indicates that, in general, cur- rencies indeed revert to parity levels following changes in relative rates of inflation, albeit not immediately.10 Short-term deviations from exchange rates at purchasing power parity potentially leave corporations exposed to real- terms currency risk. However, shareholders are typically able to diversify this risk. To see how, consider Exhibit 27.4, which shows the monthly volatility of real exchange rates for a selection of Latin American and Asian currencies, as well as the British pound, and compares them with four currency portfolios. Although some of the currencies are highly volatile, holding a regional portfo- lio already eliminates a lot of the resulting real currency risk, as shown by the lower volatility of the regional portfolios. Combining a developing-markets portfolio with a British-pounds portfolio diversifies the real risk even further. If shareholders can disperse most real currency risk by diversifying, there is no need for a currency risk premium of any significance in the company’s cost of capital. Sometimes currency exchange rates move fast and far from PPP. As Ex- hibit 27.3 showed, during a period of just two weeks in 1999, Brazil’s currency weakened by more than 50 percent relative to the U.S. dollar in nominal terms. When conducting a valuation in a currency that shows large deviations from PPP, you should account for the risk of a few weeks or even several years pass- ing before the currency moves back toward PPP. Do not adjust the cost of capi- tal, but instead use scenarios to account for this risk, as described in Chapter 4. EXHIBIT 27.3  Brazilian Inflation-Adjusted Exchange Rate Real effective exchange rate (REER) index and U.S. $ nominal exchange rate index, 7/1/1994 = 100 400 450 350 300 250 200 150 100 50 1994 – 1995 – 1996 – 1997 – 1998 – 1999 – 2000 – 2001 – 2002 – 2003 – 2004 – 2005 – 2006 – 2007 – 2008 – 2009 – 2010 – 2011 – 2012 – 2013 – 2014 – 2015 – 2016 – 2017 – 2018 – 2019 – REER USD exchange rate index 0 Source: Banco Central do Brasil. 10 See Taylor and Taylor, “The Purchasing Power Parity Debate.” 520  Cross-Border Valuation If the foreign business being valued has limited international purchases and sales, the impact of any exchange rate convergence toward PPP is likely to be limited as well. In this case, value the business’s forecast cash flows using either the spot-rate or forward-rate approach to obtain a valuation in your do- mestic currency. Apply two different currency scenarios: one using spot and forward rates based on the actual exchange rate, and one based on a deemed convergence of the exchange rate toward PPP. The valuation results in the local currency of the foreign business will be identical for both scenarios. But that won’t be the case for the result in your domestic currency, highlighting the exposure to a potential exchange-rate change. If the business has significant cash flows in international currencies, such as an exporting oil company, exchange-rate adjustments toward PPP will af- fect cash flows in local currency. Prepare the local cash flow forecasts for the business based on two scenarios: one with convergence of the exchange rate toward PPP, and one without. Then value the cash flows for both currency scenarios using the spot-rate or forward-rate approach. Ensure that the spot and forward rates correctly reflect the assumptions on the convergence of the exchange rate made in your currency scenarios. The result will again be a valuation range in domestic currency, indicating the potential impact of an exchange-rate convergence to PPP. EXHIBIT 27.4  Diversification of Real Currency Risk 10-year monthly real exchange rate1 volatility, % Individual currencies Currency portfolios Argentina Equal-weighted Latin America portfolio 50% Latin America and 50% U.K. portfolio Equal-weighted Asian portfolio 50% Asian and 50% U.K. portfolio Venezuela Brazil Mexico Chile Indonesia Thailand Philippines Malaysia Singapore Korea 28.4 8.2 4.5 7.4 4.1 15.9 12.7 10.8 4.4 17.5 14.3 8.7 6.6 6.2 3.0 United Kingdom 3.4 1 Exchange rates to U.S. dollar. Source: International Monetary Fund.