Special：Xing Talk—Celebrities Interview

Prof. Robert Hodrick

Editor’s Note: Xing Talk is a new column runs regularly by Xing Zong, a Chinese graduate student at Duke University pursuing a Ph.D. degree in physics. As a rocket scientist, Xing’s passion also lies in writing and interacting with people. He contributes to China.com regularly with his interesting interviews of Presidents in U.S. top universities, Nobel Laureates, business/law school deans and leading academicians. As Xing said, “my biggest discovery after arriving in U.S. was that my first name “Xing” had a nice interpretation of the on-road sign crossing. Indeed, I stand at the cross road of two different cultures and eager to connect Uncle Sam and Red Dragon.” Recently Xing held an exclusive interview with Judy Woodruff, the former CNN news anchor.


About Prof. Robert Hodrick,
Professor Hodrick teaches both fundamental and advanced courses in international finance in Columbia University Business School. His expertise is in the valuation of financial assets. His current research explores the empirical implications of theoretical pricing models that generate time-varying risk premiums in the markets for bonds, equities and foreign currencies. He is also a research associate of the National Bureau of Economic Research.


Xing Zong: Prof. Hodrick, thanks for talking with me. As Chinese companies start to look for global opportunities, they will inevitable face challenges. International financial management is the one that managers definitely can’t neglect. In my opinion, interest rate changes, inflation and exchange rates are three important components. Could you please talk first about the effect of interest rate changes?

Hodrick: The first important point to understand is the difference between what economists call the nominal interest rate and the real interest rate. Nominal interest rates indicate the amount of money, say 6%, that you get back as interest on your loan. The real interest rate measures the return to the lender in terms of the purchasing power of the money. If prices of goods rise by 6% during the life of my loan, the return of monetary principal and 6% interest merely leaves me with the same purchasing power that I had before I lent the money. That is why lenders demand higher interest rates when there is higher expected inflation. Changes in interest rates change the cost of capital, but you have to be clear about whether the real interest rate is changing. If inflation increases more than the nominal interest rate, the cost of capital is actually going down.

Xing Zong: Many public forecasts of inflations are available for Chinese company staff. In your opinion, how is this different from the forecasts of nominal exchange rate changes? And how do you combine these two?

Hodrick: In the very long run, exchange rates tend to move to offset the differential rates of inflation between two countries. For example, over the last twenty year, the U.S. has had higher inflation than Japan, and the yen has strengthened versus the dollar. But, economists understand that this is a very weak force. When China has higher inflation than the U.S. with the yuan per dollar stable, there is a real appreciation of the yuan. U.S. goods seem relatively cheaper in China and Chinese goods seem relatively more expensive in the U.S. This is the same effect as if the exchange rate changed to strengthen the yuan directly. The difference in nominal interest rates tends to be the best forecast of the rate of change of the exchange rate.

Xing Zong: The pursuit of the value maximization mission of the enterprise can lead to a host of decisions which include locations of productions and sales in many currency zones. Currency risk may have major strategic implications for the Chinese companies. What are your thoughts on the action at the strategic level in order to better hedge the risks?

Hodrick: I think it is important to put in a mention here of my forthcoming textbook, International Financial Management. The book is being published by Prentice Hall in the spring of 2008. My co-author, Geert Bekaert, and I go into extensive discussions of managing international financial risks with forward contracts, futures, options, and swaps. I think the most important risk management message is that companies invariably fund future projects out of internally generated cash flow. Thus, it is strategically important that the company be managed to assure an on-going supply of internally generated funds. If a company is generating a lot of foreign currency revenue, it had better get some foreign currency liabilities, either through borrowing foreign currencies, contracting to sell the foreign currencies forward or buying options to sell the foreign currency. Otherwise, it is vulnerable to an appreciation of the home currency that wipes out its cash flow. It will then not be able to continue with its strategy for growth.