The Effects of Nominal Exchange Rate Changes and Inflation on Apex Philippines
*Peso prices and costs are assumed to increase at the 20% rate of Philippine inflation.
Of course, the conclusion in the Apex Philippines application does not hold if the firm enters into contracts fixed in terms of the foreign currency. Examples of such contracts are debt with fixed interest rates, long-term leases, labor contracts, and rent. However, if the real exchange rate remains constant, the risk introduced by entering into fixed price contracts is not exchange risk; it is inflation risk. For instance, a Mexican firm with fixed-rate debt in pesos faces the same risk as the subsidiary of an American firm with peso debt. If the rate of inflation declines, the real interest cost of the debt rises, and the real cash flow of both companies falls. The solution to the problem of inflation risk is to avoid writing contracts fixed in nominal terms in countries with unpredictable inflation. If the contracts are indexed and if the real exchange rate remains constant, exchange risk is eliminated.