When evaluating investments outside, two approaches are used: 1. Forecasting is done by the investor in the organization’s base currency or 2. Forecasting is done in the target country’s currency, and conversion occurs after discounting.

The more common practice is the first, but both should yield the same result in valuation and have some nuances to consider.

  1. If financial forecasts are made in the investor’s base currency, but the organization’s main operations are tied to a volatile market, then it’s necessary to perform forecasted exchange rates and subsequent use of corresponding discount rates, which integrate systemic risks of the target country (previously discussed and not repeated);
  2. In cases where forecasts are made in the local currency and conversion occurs after valuation, it’s still necessary to forecast exchange rates because the discounting exercise will be affected by varying inflation rates in different years.

Some authors argue that detailed forecasted exchange rates are not necessary because differences in purchasing power parity or interest rate parity models can account for short-term fluctuations.

Self-currency risk, a non-systematic deviation from forecasted exchange rates, shouldn’t be considered. It’s assumed that these risks shouldn’t be taken into account in investment decisions. However, in practice, managers sometimes underestimate or overestimate it.

Currency risks are divided into three parts: operational, transactional, and financial. Operational risks relate to the sensitivity of operational results to changes in exchange rates (e.g., increase in expenses or decrease in revenues); transactional risks are similar but more specific to certain transactions; financial risks involve the structure of financing in different currencies…

It’s important to note that hedging specific transactional and financial risks is a simpler task and can be achieved through changes in exchange rates, which may lead to significant variations in operational risks… Thus, scenario simulation would provide a good solution.

Source:
Corporate Valuation Theory, Evidence and Practice
Mark E. Zmijewski; Robert W. Holthausen
Second Edition