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Macroeconomic uncertainty: International risks and opportunities for the corporation
Book reviews
rather the conditions that lead them to be either high or low. Of course, whether a forecast is too high or low is not the only source of error in judgmental forecasts. But, most components of a time-series (e.g. seasonal patterns, autoregressive patterns, volatility) can be described in similar terms, and the point is that describing the factors that increase or decrease the extent to which a component appears in judgmental forecasts may be of greater interest than accuracy itself. For, such an understanding allows the explanation not only of when to expect error, but of what sort of error to expect, and the sort of corrective measures that should be undertaken. Such an understanding may still be long way off, and for those interested in a single prediction problem, these concerns undoubtedly appear of minor relevance. However, the book does include several chapters that practitioners will find of considerable use. Delphi techniques for eliciting forecasts from expert judges, which are often used in ambiguous areas such as technological forecasting, are reviewed in several of the chapters. Several detailed summaries of particular applications and the problems that arose are offered, and one chapter, by Geistauts and Eschenbach, includes some promising suggestions on how to get policy makers to pay attention to a forecasting model once it has been constructed. Given that the accuracy of a forecast often depends on how policy makers react to the forecast, this area should receive considerable attention in the future. It would not be surprising if forecasting errors are often countered by errors in executing the forecast. This volume is a good compendium and it is to be hoped that it will stimulate theoretical, empirical and applied research. There are many important areas of judgmental forecasting that are in need of much further exploration. Surprisingly little research has been done on judgmental forecasting in common everyday circumstances, undoubtedly because techniques to explore unquantified situations are not well developed and because, in such cases, probability information is often vague. The excellent chapter by Vlek and Otten includes a detailed discussion on the results of a study on verbal scenarios, with a forthright coverage of how many common sense hypotheses were not confirmed. Budescu and Wallsten present an innovative review of how people might
617
react differently in situations in which uncertainties are vague, and discuss some of their recent work exploring the quantification of verbal probability terms. This work is most important, for as several of the authors point out, we are all judgmental forecasters, and most forecasts are judgmental. Paul B. Andreassen Department of Psychology Harvard University Cambridge, MA 02138, USA
L. Oxelheim and C. Wihlborg, Macroeconomic Uncertainty: International Risks and Opportunities for the Corporation (Wiley, Chichester, UK, 1987) pp. 272, &29.50/$58.45 (hardcover) and &12.95/ $29.95 (paperback). Looking at the title and cover of this book, the reader could be forgiven for believing that it is about country risk and its management. In fact, the actual subject of the book is confined to only a subset of its grand title: how to handle foreign exchange risk. But, because exchange rates (or more correctly, foreign exchange receipts) are influenced by a large number of macroeconomic factors - monetary and fiscal policies, for example _ the authors have chosen to use the broader title of macroeconomic risk. The book itself is divided into eight relatively self-contained chapters (most of which also have grand titles): (1) The international environment of the firm; (2) Corporate risks: who cares?; (3) Managing corporate macroeconomic exposure: A review of current approaches; (4) A comprehensive approach to measuring and hedging macroeconomic exposure; (5) A framework for determination of exposure management strategy and information needs; (6) The impact of macroeconomic disturbances on the firm: A scenario approach; (7) Evaluation and feedback; and (8) Concluding remarks. The best chapters are the third (on the traditional views of foreign exchange rate risk) and the fifth (strategic aspects of exposure management). The worst chapters are the second (an introduction to the capital asset pricing model (CAPM)) and the fourth (the authors’ alter-
618
Book reviews
native approach to measuring exposure). Because of the organization of the book, it is perhaps appropriate to comment briefly on each chapter, and then make the overall commentary. The first chapter introduces the reader to the concepts of risk (as used in the book) and provides an overview of the rest of the book. The second chapter introduces the CAPM, but it does so in a very haphazard fashion. For instance, the concepts of covariance, correlation, the risk-free rate of interest and the market portfolio are al! used in context long before they are appropriately defined. As stated earlier, the third chapter is one of the best. In it, the authors present the concepts of transaction, translation and economic risks and introduce the traditional techniques for the management of these exposures, even though they occasionally insist on using the terms in an unstandard way. In addition, the authors comment about the effects of accounting regulations (devoting an appendix to an example illustrating the differences between FASB 8 and FASB 52 in the context of translation exposure), and interest rate risk management (with two appendices analyzing the empirical viability of purchasing power parity and other real exchange rate theories; and briefly, interest rate parity/Fisher’s international). Overall, each of the individual sections in this chapter was clearly written and well organized. Chapter 4 presents the authors’ alternative approach to foreign exchange risk management (when historical cash flow data is available and macroeconomic policy is stable). In brief, the company needs to break down its foreign exchange earnings according to currency, product line and/or business operation. Assuming that the operating environment is stable, the next step is to collect historical data on the subset’s unanticipated real cash flows (X) (in the company’s appropriate accounting/reference currency), on the unanticipated inflation (Pd and P’), the unanticipated exchange rate movements (e), the ~na~ticiputed interest rate movements (id and if) and the unanticipated changes in the product’s relative price (r). If the operating environment is not stable (but government policy is), then the company must collect data on the subset’s unanticipated real cash flows (X) (in the company’s appropriate accounting/reference currency), on the unanticipated nominal money supplies ( Md and Mf ), the unan-
ticipated government budget deficits (Gd and G'), and the unanticipated changes in the product’s relative price (r). Note that most of the variables are defined for both the home country (superscript d) and the foreign country, operating region, or the rest of the world (superscript f), depending on how narrowly the cash flows have been broken down. Having collected the data, the company should then, for each sub-stream of exchange payment, estimate one of the following regressions: (1) Stable operating environment:
X= b,Pd + b,P’+ (2) Unstable
b,e + b4id + h,if + b6r_
operating environment:
X= b,Md + b,Mf
+ b3Gd + b4Gf + b,r.
The authors then go on to show how these coefficients can be used to hedge the appropriate risk (e.g., unanticipated domestic inflation), but the vast array of econometric problems - multicollinearity, the derivation of the unanticipated variables, parameter stability, the estimation of the implied system of simultaneous equations system, and the properties of the error processes of the equations - are all glossed over. Clearly, this is a very serious drawback of the chapter (and, more generally, of the book). It would seem as though an assumption is being made that the reader is well versed in econometric techniques, but given the intended audience, this assumption is entirely unjustified. In the appendix to the chapter (inappropriately entitled: ‘The exposure of manufacturing industries: Econometrics’), the authors look at some sample data for Swedish manufacturing firms and get an average R2 (adjusted) of 72.67% using the first formulation above. However, in their estimation, all the variables used are actual changes, and not unanticipated changes, and the parameter estimates were far from stable so the empirical validity of their approach remains to be shown Chapter 5 is a very quick paced chapter and a few of the very important issues raised therein could have done with additional attention. In it, the authors illustrate how a firm’s exposure management strategy can be derived from the firm’s risk preferences, target variable (e.g., whether it acts to maximize profits or stock market value), and time horizon. The final strategy also reflects the firm’s assumptions about adjustment in the
Book reviews
international goods and financial markets, and implies a particular need for accounting information. In turn, the availability of accounting information can be used to determine the appropriate strategy and the two exposure management strategies (if different) provided an interval for strategic convergence. Chapter 6 presents a very detailed analysis of an unanticipated increase in (1) the domestic money supply, and (2) the domestic government deficit. Like the previous chapter, it tends to be a bit quick paced. It illustrates the massive advantage of having someone in the finance department that understands how financial and goods markets operate (i.e., a well-trained and experienced economist), especially when the historical data is either unreliable or useless. Chapter 7 points out the need to tie together the strategic aspects of the firm with the appropriate organizational structure and highlights the importance of evaluating the firm’s exposure management strategy. Chapter 8 is an excellent summary of the book. In it, the authors provide a decision tree for the recommended techniques to be used for measuring macroeconomic exposure given data availability, policy and regime stability and the individual’s knowledge about the macroeconomic structure and relative prices. Overall, the book covered three subjects: (1) the management of foreign exchange risk (chapter 3); (2) a regression approach to risk management (chapter 4); and (3) the strategic and organizational aspects of risk management (chapters 5 and 7). The first and last chapters were an overview and a summary, the second was out of place with only one minor reference made to it elsewhere in the book, and the sixth presented a basic concept, but was too technical and fast paced in the presentation for the non-technical reader. On the first subject, the book was very good. The details provided were insightful and the examples were well
619
chosen. On the last subject, the book was too quickly paced and referred too much to the second subject. As a result, the key points made in these chapters failed to be given the emphasis they deserved. The problems with the second subject have already been dealt with above, so there is no need to repeat the serious flaws. The ideas behind the book were good ones, but they have suffered damage in the final presentation. Firstly, the key missing element in this book is the intended audience. Most finance directors would find it far too technical or academic in its detail, and most academics would find it far too simplistic in its outlook. Secondly, the authors’ decision to try and make each chapter self-sufficient leads to some minor repetition of material, but it also prevents the book from developing a ideological track for the reader to follow. In other words, the chapters do not flow into one another as they would in a ‘wholesome’ textbook. Finally, while the authors rightly point out the importance of the covariance in risk management, their discussions fail to emphasise the point and no recommendations are made in which those covariances need to be recognized. In brief, a thumbs up or thumbs down verdict on the book is impossible. Some parts of it were sheer brillance (e.g., the sections on the strategic and organizational aspects of risk management), but other parts were entirely unacceptable (e.g., the authors’ suggested econometric approach). The book could do with being about 40% longer so as to allow the authors additional room in which to address some of the objections raised here and maybe these will be corrected in a second edition. For now, however, the book is a hodge-podge trying to appeal to an unknown audience and essentially offering them one chapter at a time without tempting them to read on.
Manchester
Harold Cataquet Business School, U.K.
rather the conditions that lead them to be either high or low. Of course, whether a forecast is too high or low is not the only source of error in judgmental forecasts. But, most components of a time-series (e.g. seasonal patterns, autoregressive patterns, volatility) can be described in similar terms, and the point is that describing the factors that increase or decrease the extent to which a component appears in judgmental forecasts may be of greater interest than accuracy itself. For, such an understanding allows the explanation not only of when to expect error, but of what sort of error to expect, and the sort of corrective measures that should be undertaken. Such an understanding may still be long way off, and for those interested in a single prediction problem, these concerns undoubtedly appear of minor relevance. However, the book does include several chapters that practitioners will find of considerable use. Delphi techniques for eliciting forecasts from expert judges, which are often used in ambiguous areas such as technological forecasting, are reviewed in several of the chapters. Several detailed summaries of particular applications and the problems that arose are offered, and one chapter, by Geistauts and Eschenbach, includes some promising suggestions on how to get policy makers to pay attention to a forecasting model once it has been constructed. Given that the accuracy of a forecast often depends on how policy makers react to the forecast, this area should receive considerable attention in the future. It would not be surprising if forecasting errors are often countered by errors in executing the forecast. This volume is a good compendium and it is to be hoped that it will stimulate theoretical, empirical and applied research. There are many important areas of judgmental forecasting that are in need of much further exploration. Surprisingly little research has been done on judgmental forecasting in common everyday circumstances, undoubtedly because techniques to explore unquantified situations are not well developed and because, in such cases, probability information is often vague. The excellent chapter by Vlek and Otten includes a detailed discussion on the results of a study on verbal scenarios, with a forthright coverage of how many common sense hypotheses were not confirmed. Budescu and Wallsten present an innovative review of how people might
617
react differently in situations in which uncertainties are vague, and discuss some of their recent work exploring the quantification of verbal probability terms. This work is most important, for as several of the authors point out, we are all judgmental forecasters, and most forecasts are judgmental. Paul B. Andreassen Department of Psychology Harvard University Cambridge, MA 02138, USA
L. Oxelheim and C. Wihlborg, Macroeconomic Uncertainty: International Risks and Opportunities for the Corporation (Wiley, Chichester, UK, 1987) pp. 272, &29.50/$58.45 (hardcover) and &12.95/ $29.95 (paperback). Looking at the title and cover of this book, the reader could be forgiven for believing that it is about country risk and its management. In fact, the actual subject of the book is confined to only a subset of its grand title: how to handle foreign exchange risk. But, because exchange rates (or more correctly, foreign exchange receipts) are influenced by a large number of macroeconomic factors - monetary and fiscal policies, for example _ the authors have chosen to use the broader title of macroeconomic risk. The book itself is divided into eight relatively self-contained chapters (most of which also have grand titles): (1) The international environment of the firm; (2) Corporate risks: who cares?; (3) Managing corporate macroeconomic exposure: A review of current approaches; (4) A comprehensive approach to measuring and hedging macroeconomic exposure; (5) A framework for determination of exposure management strategy and information needs; (6) The impact of macroeconomic disturbances on the firm: A scenario approach; (7) Evaluation and feedback; and (8) Concluding remarks. The best chapters are the third (on the traditional views of foreign exchange rate risk) and the fifth (strategic aspects of exposure management). The worst chapters are the second (an introduction to the capital asset pricing model (CAPM)) and the fourth (the authors’ alter-
618
Book reviews
native approach to measuring exposure). Because of the organization of the book, it is perhaps appropriate to comment briefly on each chapter, and then make the overall commentary. The first chapter introduces the reader to the concepts of risk (as used in the book) and provides an overview of the rest of the book. The second chapter introduces the CAPM, but it does so in a very haphazard fashion. For instance, the concepts of covariance, correlation, the risk-free rate of interest and the market portfolio are al! used in context long before they are appropriately defined. As stated earlier, the third chapter is one of the best. In it, the authors present the concepts of transaction, translation and economic risks and introduce the traditional techniques for the management of these exposures, even though they occasionally insist on using the terms in an unstandard way. In addition, the authors comment about the effects of accounting regulations (devoting an appendix to an example illustrating the differences between FASB 8 and FASB 52 in the context of translation exposure), and interest rate risk management (with two appendices analyzing the empirical viability of purchasing power parity and other real exchange rate theories; and briefly, interest rate parity/Fisher’s international). Overall, each of the individual sections in this chapter was clearly written and well organized. Chapter 4 presents the authors’ alternative approach to foreign exchange risk management (when historical cash flow data is available and macroeconomic policy is stable). In brief, the company needs to break down its foreign exchange earnings according to currency, product line and/or business operation. Assuming that the operating environment is stable, the next step is to collect historical data on the subset’s unanticipated real cash flows (X) (in the company’s appropriate accounting/reference currency), on the unanticipated inflation (Pd and P’), the unanticipated exchange rate movements (e), the ~na~ticiputed interest rate movements (id and if) and the unanticipated changes in the product’s relative price (r). If the operating environment is not stable (but government policy is), then the company must collect data on the subset’s unanticipated real cash flows (X) (in the company’s appropriate accounting/reference currency), on the unanticipated nominal money supplies ( Md and Mf ), the unan-
ticipated government budget deficits (Gd and G'), and the unanticipated changes in the product’s relative price (r). Note that most of the variables are defined for both the home country (superscript d) and the foreign country, operating region, or the rest of the world (superscript f), depending on how narrowly the cash flows have been broken down. Having collected the data, the company should then, for each sub-stream of exchange payment, estimate one of the following regressions: (1) Stable operating environment:
X= b,Pd + b,P’+ (2) Unstable
b,e + b4id + h,if + b6r_
operating environment:
X= b,Md + b,Mf
+ b3Gd + b4Gf + b,r.
The authors then go on to show how these coefficients can be used to hedge the appropriate risk (e.g., unanticipated domestic inflation), but the vast array of econometric problems - multicollinearity, the derivation of the unanticipated variables, parameter stability, the estimation of the implied system of simultaneous equations system, and the properties of the error processes of the equations - are all glossed over. Clearly, this is a very serious drawback of the chapter (and, more generally, of the book). It would seem as though an assumption is being made that the reader is well versed in econometric techniques, but given the intended audience, this assumption is entirely unjustified. In the appendix to the chapter (inappropriately entitled: ‘The exposure of manufacturing industries: Econometrics’), the authors look at some sample data for Swedish manufacturing firms and get an average R2 (adjusted) of 72.67% using the first formulation above. However, in their estimation, all the variables used are actual changes, and not unanticipated changes, and the parameter estimates were far from stable so the empirical validity of their approach remains to be shown Chapter 5 is a very quick paced chapter and a few of the very important issues raised therein could have done with additional attention. In it, the authors illustrate how a firm’s exposure management strategy can be derived from the firm’s risk preferences, target variable (e.g., whether it acts to maximize profits or stock market value), and time horizon. The final strategy also reflects the firm’s assumptions about adjustment in the
Book reviews
international goods and financial markets, and implies a particular need for accounting information. In turn, the availability of accounting information can be used to determine the appropriate strategy and the two exposure management strategies (if different) provided an interval for strategic convergence. Chapter 6 presents a very detailed analysis of an unanticipated increase in (1) the domestic money supply, and (2) the domestic government deficit. Like the previous chapter, it tends to be a bit quick paced. It illustrates the massive advantage of having someone in the finance department that understands how financial and goods markets operate (i.e., a well-trained and experienced economist), especially when the historical data is either unreliable or useless. Chapter 7 points out the need to tie together the strategic aspects of the firm with the appropriate organizational structure and highlights the importance of evaluating the firm’s exposure management strategy. Chapter 8 is an excellent summary of the book. In it, the authors provide a decision tree for the recommended techniques to be used for measuring macroeconomic exposure given data availability, policy and regime stability and the individual’s knowledge about the macroeconomic structure and relative prices. Overall, the book covered three subjects: (1) the management of foreign exchange risk (chapter 3); (2) a regression approach to risk management (chapter 4); and (3) the strategic and organizational aspects of risk management (chapters 5 and 7). The first and last chapters were an overview and a summary, the second was out of place with only one minor reference made to it elsewhere in the book, and the sixth presented a basic concept, but was too technical and fast paced in the presentation for the non-technical reader. On the first subject, the book was very good. The details provided were insightful and the examples were well
619
chosen. On the last subject, the book was too quickly paced and referred too much to the second subject. As a result, the key points made in these chapters failed to be given the emphasis they deserved. The problems with the second subject have already been dealt with above, so there is no need to repeat the serious flaws. The ideas behind the book were good ones, but they have suffered damage in the final presentation. Firstly, the key missing element in this book is the intended audience. Most finance directors would find it far too technical or academic in its detail, and most academics would find it far too simplistic in its outlook. Secondly, the authors’ decision to try and make each chapter self-sufficient leads to some minor repetition of material, but it also prevents the book from developing a ideological track for the reader to follow. In other words, the chapters do not flow into one another as they would in a ‘wholesome’ textbook. Finally, while the authors rightly point out the importance of the covariance in risk management, their discussions fail to emphasise the point and no recommendations are made in which those covariances need to be recognized. In brief, a thumbs up or thumbs down verdict on the book is impossible. Some parts of it were sheer brillance (e.g., the sections on the strategic and organizational aspects of risk management), but other parts were entirely unacceptable (e.g., the authors’ suggested econometric approach). The book could do with being about 40% longer so as to allow the authors additional room in which to address some of the objections raised here and maybe these will be corrected in a second edition. For now, however, the book is a hodge-podge trying to appeal to an unknown audience and essentially offering them one chapter at a time without tempting them to read on.
Manchester
Harold Cataquet Business School, U.K.