Foreign Currency Exposure in the

Department of Defense
GERALD M. GROSHEK

The Department of Defense (DoD) incurs numerous costs denominated in foreign

currencies in fulfilling U.S. alliance and security agreements overseas. Between fiscal
years 1993 and 1997, the DoD expended over $10.4 billion in foreign currencies to op-
erate and maintain its overseas facilities, and estimates for fiscal years 1998 and 1999 are
$5.4 billion. In line with the government’s general, risk-neutral approach to finan-cial risk,
the DoD makes no attempt to control its foreign exchange exposure against currency
fluctuations. As such, there are inevitable differences in amounts budgeted to fund the
DoD’s overseas operations and amounts subsequently required to pay them. This paper
examines the implications of DoD foreign exchange rate policy and applies an alternative
approach to foreign exchange rate risk—one more in line with private-sector practices and
overall efforts to reform government operations. The re-sults indicate that forward
contracts would inject greater certainty into the budgeting and administration of these
programs and might release limited defense funds for use elsewhere.

INTRODUCTION

The realization that a gap exists between post–Cold War national security requirements and
budgetary resources has led the Department of Defense (DoD) to undertake a series of policy
reforms aimed at improving its acquisition, logistics, and financial management procedures.
The extent to which these policies have been affected is reflected in such ef-forts as the
Defense Reform Initiative, the Defense Acquisition Goals 2000, and the Fi-nancial
Management Improvement Plan. These efforts represent the DoD’s response to the political
realities embodied in such government-wide initiatives as the president’s Na-tional
Performance Goals 2000 as well as to the economic requirement to free-up re-sources for force
modernization and personnel recruiting and retention incentives. A

Gerald M. Groshek, University of Redlands, Redlands, CA 92373. Phone: (909) 748-6243. Fax: (909)
335-5125. E-mail: groshek@uor.edu

Groshek / Foreign Currency Exposure in the Department of Defense 15

major emphasis throughout the reforms has been to replace the regulations that governed DoD
practices during the Cold War period with a greater reliance on private-sector busi-ness
practices. One policy area that has escaped consideration to date, however, is the DoD’s
approach to its foreign currency exposures.
Like an enterprise engaged in international trade, the DoD is often required to make
payment in foreign currency when acquiring equipment and materiel from overseas sources.
Additionally, the Cold War establishment of a significant overseas U.S. military presence has
entailed a requirement for foreign currency payments. In fulfilling U.S. alli-ance and security
agreements, the DoD’s overseas activities are similar to those of a multi-national firm engaged
in overseas production that involve numerous costs denominated in foreign currencies.
Between fiscal years (FY) 1993 and 1997, the DoD expended over $10.4 billion in foreign
1
currencies to operate and maintain its overseas facilities. This pa-per examines current DoD
foreign exchange rate policy in light of the pressures imposed by government-wide reform
initiatives, limited defense budgets, and the continued re-quirement to “produce” defense
2
services overseas.
Numerous techniques exist to counter the foreign currency exposure inherent in inter-
national trade and production. The magnitude of the DoD’s exposure to foreign exchange
fluctuation would be the focus of considerable concern and effort to control if incurred by a
3
private enterprise. For private-sector firms, a response might entail (1) a switch in the location
of production to countries with relatively weak or weakening currencies, (2) the use of various
hedging mechanisms available in the financial markets, or (3) a “pass-through” of the negative
4
cost consequences to the consumer.
The first alternative is precluded since the DoD cannot relocate its foreign bases in re-

1. Estimates for fiscal years 1998–99 are $5.4 billion. Department of Defense, “Foreign Currency Fluc-
tuations: Comparison of Base Rates and Current Rates,” mimeographed, 1998; and Defense Finance and
Accounting Service (DFAS), “Foreign Currency Reports,” mimeographed, 1997.
2. The defense budget has declined 23 percent in constant FY1998 dollars since 1991. The asymmetry of
real reductions in operations and maintenance (–31.5 percent) and procurement (–49 percent) have produced
efforts to lower expenses in the former as a means to increase the latter. W. Cohen, Annual Re-port to the
President and the Congress (Washington, D.C.: Department of Defense, 1997).
3. Ellsworth notes the consequences for three Navy procurement programs and estimates that 1.9–2.1
percent of each program’s life-cycle cost ($114 million) is lost due to currency fluctuation. C. Ellsworth,
Foreign Currency Fluctuation Allowances in Department of Defense Acquisition Appropiations (Mon-terey,
Calif.: Naval Postgraduate School, 1993).
4. For the first approach, see R. Baldwin and P. Krugman, “Persistent Trade Effects of Large Exchange Rate
Shocks,” Quarterly Journal of Economics 104 (1989): 635–654; and R. C. Marston, “Pricing to Market in
Japanese Manufacturing,” Journal of International Economics 29 (1990): 217–236. For the second ap-proach,
see D. DeMeza and F. Van der Ploeg, “Production Flexibility as a Motive for Multinationality,” Jour-nal of
Industrial Economics 35(1987): 343–351. For the third approach, see J. Taylor and F. Mathis, A Primer on
Foreign Exchange (Philadelphia: Robert Morris Associates, 1985); J. Doukas and B. Arshanapalli, “Deci-sion
Rules for Corporate Management of Foreign Exchange Risk,”Journal of Multinational Financial Man-agement
1 (1991): 39–48; S. Khoury and K. Chan, “Hedging Foreign Exchange Risk: Selecting the Optimal Tool,” in
The International Finance Reader, ed. R. Kolb (Miami: 1991), 328–340; and D. Klein and G. Katschka, “On the
Use of Different Markets to Control for Currency Fluctuations: Implications of Corpo-rate Hedging Practices,”
Journal of Multinational Financial Management 2 (1992): 77–94.

16 Public Budgeting & Finance / Winter 2000

sponse to currency fluctuations. Because of political and institutional constraints regard-ing the
perceived speculative nature of the foreign currency markets, the DoD makes no attempt to
manage its exposure via market-hedging mechanisms. In effect, the DoD at-tempts a risk-
neutral stance similar to that adopted relative to other financial risks. For ex-ample, when
inflation rises above expectations, the funds budgeted to implement planned objectives may
become insufficient. To correct the shortfall, additional appropriations be-come necessary if
operations cannot be curtailed. In a similar fashion, the DoD addresses its currency exposure by
“passing-through” the negative budgetary consequences of ex-change rate fluctuation to the
taxpayer.
The current, “risk-neutral” approach is somewhat paradoxical in that the proscriptions
against currency hedging involve the speculative assumption that no significant exchange rate
change will occur between the creation of a foreign currency obligation and its pay-ment.
Might an alternative approach to foreign exchange rate risk—one more akin to pri-vate-sector
practices—inject greater certainty into the administration of these programs while releasing
funds for other objectives?
As a basis for the subsequent discussion, the second section of this article examines the
manner in which current procedures generate differences between the amounts budgeted for
overseas operational expenses and their subsequent payments. The third section de-velops and
applies a model of the effects of foreign currency fluctuation to a series of U.S. Air Force
(USAF) expenditures. The fourth section uses the same data to measure the ef-fects of using
forward foreign exchange contracts as an alternative to the current ap-proach. The fifth section
summarizes the costs of the current procedures in the context of the government’s general
approach to financial risk. Despite efforts to achieve pri-vate-sector efficiencies through the
reform of government practices, constraints remain in areas unfamiliar to policymakers. As an
example, the DoD remains exposed to the inde-terminate behavior of the foreign exchange
markets and continues to face uncertainty in the formulation, budgeting, and execution of its
overseas operations.

ACCOUNTING FOR FOREIGN EXCHANGE TRANSACTIONS

Current Limitations

Before considering the effect of a forward rate strategy, it is useful to examine current DoD
procedures for addressing currency rate fluctuation. Pentagon regulations on the re-duction of
foreign currency exposure are limited to the disposition of funds once a foreign currency
position has been liquidated. These regulations address the exchange rate and counterparty risk
on foreign currency stocks held by DoD agents and the exposure due to timing differences in
5
the settlement of a liquidated (paid) obligation. The vast majority of foreign exchange
exposure, however, comes from the difference between the exchange

5. Department of Defense, DoD Financial Management Regulation—Foreign Disbursing Operations, vol.

5, chap. 12 (Washington, D.C.: Department of Defense, 1987); and Department of Defense, DoD Fi-nancial
Management Regulation—Procurement/Disposition of Foreign Funds, vol. 5, chap. 13 (Washing-ton, D.C.:
Department of Defense, 1987).

Groshek / Foreign Currency Exposure in the Department of Defense 17

rate existing when obligations are budgeted and that existing when obligations are subse-
quently liquidated.
The DoD addresses the inevitable fluctuation of exchange rates between ex ante bud-geting
and ex post payment by formally ignoring it under an assumed risk-neutral stance. First, no
methodology is employed to appraise future exchange rates. Any indication that public officials
might use the government’s overseas financial obligations to speculate on foreign currency
movements would be politically unacceptable. Consequently, budget rates are determined for
each fiscal year by the Office of the Under-Secretary of Defense (Comptroller) based on the
spot exchange rate at some point in the budget formulation process—usually in December of
the previous fiscal year. Second, Pentagon regulations prohibit all foreign currency transactions
6
other than for spot (or immediate) delivery. The resulting inability to offset exposures in the
forward, options, or futures markets, how-ever, assures a difference between ex ante and ex post
exchange rates as well as in the funds available to settle the DoD’s foreign currency obligations.
Third, to avoid cost-of-funds issues and increased transactions costs, Pentagon regulations
disallow pay-ments, such as premium or margin amounts, that are not tied directly to the receipt
of goods or services. Considering the impossibility of accurately predicting future exchange
rates and the responsibility to ensure proper management of public funds, these restric-tions
seem reasonable and necessary.

Centrally Managed Allotments

The current restrictions are inconsequential in a fixed- or appreciating-dollar environ-ment.

However, the arrival of floating exchange rates and general dollar depreciation pro-duced, by
the end of the 1970s, consistent and sizeable shortages in the funds budgeted to pay for
overseas defense operating expenses. At the time, these shortages were funded from the
affected appropriation and often forced operational personnel to curtail lo-cal-currency
expenditures on such items as utilities, housing, and local hires. Beginning in FY1979,
Congress established an account to fund significant losses and transfer gains due to exchange
rate fluctuations in the overseas operating appropriations of the DoD. To prevent foreign
currency losses from adversely affecting mission readiness and effective-ness, this account—
Foreign Currency Fluctuations, Defense (FCFD)—funded the inevita-ble differences between
7
obligations recorded at the budget rate of exchange and the actual liquidated rate of exchange.
In FY1987, an additional account was established to cover losses and gains not covered under
the original FCFD account. A separate ac-count—Foreign Currency Fluctuations, Construction,
Defense (FCFCD)—was initiated to isolate the longer-term military construction appropriation.
This includes expenses not only for military construction, but also for family housing
construction, family housing op-erations and maintenance, and NATO infrastructure.

6. Department of Defense, DoD Financial Management Regulations—Foreign Disbursing Operations, vol.

5, chap. 12.
7. Department of Defense, DoD Financial Management Regulation—Foreign Currency Reports, vol. 6,
chap. 7 (Washington, D.C.: Department of Defense, 1987).

18 Public Budgeting & Finance / Winter 2000

 As outlined by the DoD, the foreign currency fluctuation accounts act as a source of buffer
8
funds. Amounts represent taxpayer funds that are transferred to a centrally man-aged allotment
(CMA) for each service or operational component and are available to fund currency losses in
9
any of sixteen currencies, subject to need and budgetary con-straints. Using the relevant
annual budget exchange rate, overseas operational compo-nents convert their projected
unliquidated foreign currency obligations to U.S. dollars for the budget year. As the fiscal year
progresses, unliquidated balances and their accrued variances are reported to each service’s
designated accounting agency along with liqui-dated amounts and the realized variances on
10
liquidated amounts. At the time of liquida-tion, differences between the dollar value of the
foreign obligation recorded at the budget rate and dollar outlay at the then-current spot rate are
charged or credited to the CMA of the relevant military service. Only amounts resulting from
actual currency fluctuation can be charged to the CMA. Differences due to changes in the cost,
magnitude, or scope of re-quirements must be charged to the relevant operating appropriation.

To determine realized variances on overseas operations and maintenance (O&M) obli-

gations, DoD policy assesses the actual liquidated amount against the budget rate of the fiscal
year in which the obligation was initially appropriated. For example, an obligation recorded in
FY1993, but liquidated in August 1995, is evaluated at the FY1993 budget rate to determine the
realized variance. O&M appropriations remain active up to five years, during which time
drawings can be made and transactions charged against FCFD. For liq-uidated obligations
charged against the longer-term FCFCD appropriation, such as family housing operations and
maintenance (FHO&M), the current fiscal-year budget rate is ap-plied regardless of when the
obligation was originally recorded. In contrast to O&M ex-penses, an FHO&M obligation
recorded in FY 1993, but liquidated in August 1995, carries the FY1995 budget rate to
determine the realized variance.
Operationally, there is a further difference regarding the liquidated rate applied to these two
major expense categories. Because obligations are settled throughout the month, the liquidated
rate used in reporting is not the actual exchange rate for each trans-action. Instead, the monthly
average rate of exchange is applied against O&M expenses, and the end-of-month rate is used
for FHO&M expenses.

MODEL AND FINDINGS

The current arrangement and the circuitous reporting procedures make it difficult to dis-cern
the precise link between cause and effect in the DoD budget process. To illustrate the

8. Department of Defense, DoD 7220.9-M Foreign Currency Reports, chap. 97 (Washington, D.C.: De-
partment of Defense, 1987).
9. Currencies currently covered include Belgian franc, British pound, Canadian dollar, Danish krone, Dutch
guilder, French franc, German mark, Greek drachma, Italian lira, Japanese yen, Norwegian krone, Portugese
escudo, Singapore dollar, South Korean won, Spanish peseta, and Turkish lira. Seven of the Eu-ropean
currencies will be subsumed by the euro.
10. Department of Defense, DoD 7220.9-M Foreign Currency Reports, chap. 97.

Groshek / Foreign Currency Exposure in the Department of Defense 19

effect of exchange rate fluctuations on public funds, Figure 1 presents a model of the link
between exchange rates (measured in dollars per unit of foreign currency) and their effect on
the CMA position. The difference between the budget rate and the subsequent liqui-dated rate is
measured along the figure’s horizontal axis. Points to the right of the origin correspond to
budget rates that are lower than the subsequent liquidated rate, and points to the left of the
origin result from budget rates that are greater than the liquidated rate. Movement above
(below) the origin corresponds to debits from (credits to) the CMA re-sulting from an
underfunded (overfunded) operating budget. An upward-sloping diago-nal through the origin
(AB) represents a series of possible spot rates of exchange at the time of liquidation.

By comparing budget rates to the rates at which obligations are liquidated, the poten-tial for
a funding gap becomes evident. At point p, the spot rate of exchange at the time of liquidation
(and therefore the liquidated rate) is greater than the budget rate. The operat-ing appropriation
(O&M or FHO&M, for example) is ex ante underfunded (a positive re-alized variance), thereby
requiring an ex post transfer from the relevant CMA to offset the shortfall. Conversely, at q, the
spot rate of exchange at the time of liquidation is lower than the budget rate. In this instance,
the operating appropriation is overfunded and re-quires an ex post credit to the relevant CMA.
When the two rates are equal at the origin, no variance is realized and no transfer is required.
Because the current approach makes no attempt to produce a budget rate that can approximate
the origin in Figure 1, transfers between the CMA and operating accounts are persistent.

Figures 2a through 2e compare the budget rate against the liquidated rate for the Ger-man
mark, Japanese yen, British pound, Spanish peseta, and Italian lira, respectively, for fiscal years
1993–97. Consideration is limited to these currencies because they repre-sented 75 percent
($7.8 billion) of total foreign currency exposure for O&M and FHO&M over this period. The
rate at which obligations were liquidated is the spot rate on the date of payment, which for ease
of exposition is proxied by the average monthly rate. Each fig-ure also tracks the combined
realized variance on O&M and FHO&M obligations for the overseas activities of the USAF in
11
each of the five currencies.
Throughout most of FY1993–95, the liquidated rate for German mark obligations (Fig-ure
2a) remained above the budget rate. This resulted in a positive realized variance or liquidated
amounts in excess of those that had been originally budgeted. Relative to Fig-ure 1, this
outcome is represented by points to the northeast of the origin requiring debits from the CMA
to fund the shortfall in the operating budget. In FY1996–97, the apprecia-tion of the dollar
resulted in a liquidated rate below the budget rate. Here realized vari-ances on German mark
liquidated obligations tended toward zero and fell consistently below zero by FY1997. The
exchange rate environment shifted such that the relation be-tween spot rate and budget rate
corresponded to points to the southwest of the origin in Figure 1 resulting in a credit to the
CMA to offset the overfunded operating budget.
By May 1997, this favorable condition was expected to persist and resulted in an addi-

11. Data are from the Defense Finance and Accounting Service—Denver.

20 Public Budgeting & Finance / Winter 2000

 FIGURE 1
Model of Exchange Rate Influence on CMAs

tional, mid-year revision of budget rates within the operations and maintenance (FCFD)
appropriation. The adjustment was made to all outstanding FY1997 O&M obligations to
account for the appreciation of the dollar (except against the British pound) and to “recog-nize
that Congress will utilize estimated foreign currency gains throughout FY97 to par-tially
12
finance the Department’s contingency operation costs.” Rates for longer-term construction
expenses (FCFCD) were not altered.
The Japanese yen (Figure 2b) exhibits similar behavior in terms of both the relation be-
tween budgeted rates and liquidated rates and the resulting realized variances. From FY1993
through FY1995 yen liquidated rates were above corresponding budget rates, which led to
positive realized variances or shortages in budgeted funds. In FY1996, the com-bination of a
high budget rate and dollar appreciation against the yen led to negative real-

12. OUSD(C), “Memorandum: Revised FY1997 Foreign Currency Execution Rates for the Operation and
Maintenance and Military Personnel Appropriations” (April 30, 1997), p. 1.

Groshek / Foreign Currency Exposure in the Department of Defense 21

 FIGURE 2a
Rates and Dollar Variance on German Mark Liquidated Obligations (O&M, FHO&M)

Note: Left-hand scale shows variance; right-hand scale shows exchange rates.
a
Budget rate on FHO&M.
b
Budget rate on O&M.

ized variances or liquidated obligations below their originally funded amounts. As with the
German mark, yen obligations were initially positioned to the northeast of the origin in Fig-ure
1 and migrated to the southwest during FY1996. Additionally, the May 1997 budget rate
adjustment allowed the DoD to use Japanese yen CMA credits elsewhere.
Despite their link to the German mark through the Exchange Rate Mechanism (ERM)

FIGURE 2b
Rates and Dollar Variance on Japanese Yen Liquidated Obligations (O&M, FHO&M)

Note: Left-hand scale shows variance; right-hand scale shows exchange rates.
a
Budget rate on FHO&M.
b
Budget rate on O&M.

22 Public Budgeting & Finance / Winter 2000

 FIGURE 2c
Rates and Dollar Variance on British Pound Liquidated Obligations (O&M, FHO&M)

Note: Left-hand scale shows variance; right-hand scale shows exchange rates.
a
Budget rate on FHO&M.
b
Budget rate on O&M.

of the European Monetary System (EMS), the British pound, Spanish peseta, and Italian lira
(Figures 2c through 2e) fail to track the behavior of German mark obligations. In FY1993, the
budget rates for these currencies persisted above the liquidated rates that subsequently emerged.
The problems experienced by these currencies within EMS during September 1992 resulted not
only in a general devaluation relative to the German mark,

FIGURE 2d
Rates and Dollar Variance on Spanish Peseta Liquidated Obligations
(O&M, FHO&M)

Note: Left-hand scale shows variance; right-hand scale shows exchange rates.
a
Budget rate on FHO&M.
b
Budget rate on O&M.

Groshek / Foreign Currency Exposure in the Department of Defense 23

 FIGURE 2e
Rates and Dollar Variance on Italian Lira Liquidated Obligations (O&M, FHO&M)

Note: Left-hand scale shows variance; right-hand scale shows exchange rates.
a
Budget rate on FHO&M.
b
Budget rate on O&M.

13
but also a forced exit from the ERM. As a result, liquidated obligations for FY1993 were
consistently below levels originally funded at the budget rate. However, downward adjust-
ments in FY1994 generated budget rates below the spot rate at the time of liquidation. This
subsequently produced a series of underfunded operating budgets similar to p in Fig-ure 1 that
continued for the most part through FY1997.
Table 1 lists the annual realized variances by currency for USAF O&M and FHO&M
expenses. Recall that positive variances correspond to liquidated amounts in excess of budgeted
funds. As shown in parentheses, the variances reflect underfunded obligations up to 26 percent
(for 1994 yen O&M) and overfunded obligations up to 23 percent (for 1993 lira FHO&M) of
annual USAF obligations within each currency. The exposure across countries and the
asymmetric behavior of exchange rates provides a natural hedge on the DoD’s obligations, one
that produced surpluses in some currencies sufficient to off-set shortfalls in others (e.g., in
14
FY1993 and FY1996). The combined position of the ex-penditure categories for FY1993–97
amounted to a net underfunding and a charge, via the CMA, of approximately $146 million to
the FCFD and FCFCD accounts.

AN ALTERNATIVE APPROACH

The findings above illustrate that, in addition to the uncertainty caused by substantial shifts
between underfunded and overfunded obligations, the USAF has required addi-

13. M. Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Fed-eral
Reserve Bank of St. Louis Review 75 (Sept.–Oct. 1993): 41–56; and M. Fratianni and M. Artis, “The Lira and the
Pound in the 1992 Currency Crisis: Fundamentals or Speculation?” Open Economies Review 7, suppl. 1 (1996):
573–589.
14. This effect will weaken with currency unification in the European Union.

24 Public Budgeting & Finance / Winter

2000
Groshek / Foreign Currency Exposure in the Department of Defense
TABLE 1
Annual Realized Variances in USAF O&M and FHO&M
Liquidated Amounts Less Budgeted Amounts

FY Expense German Mark Japanese Yen British Pound Spanish Peseta Italian Lira

1993 a –490,194 (–0.2) 13,164,633 (14.1) –16,881,948 (–10.9) –4,588,573 (–11.5) –6,755,383 (–16.2)
O&M
b
FHO&M –842,125 (–0.4) 8,977,258 (13.1) –6,612,228 (–16.0) –25,344 (–13.5) –392,994 (–22.8)
1994 O&M 43,055,094 (20.3) 23,774,359 (26.3) 7,232,977 (7.8) –3,179,105 (–3.3) 1,019,652 (0.4)
FHO&M –189,509 (–0.1) 14,876,047 (19.2) 1,465,033 (2.6) –31,424 (–13.9) –218,166 (–5.1)
1995 O&M 45,828,268 (20.2) 29,717,664 (20.6) 10,851,627 (8.6) 1,450,638 (7.9) 618,197 (0.5)
FHO&M 8,857,404 (21.1) 13,677,368 (16.6) 1,500,535 (6.2) 22,139 (9.8) 326,401 (4.0)
1996 O&M 11,072,363 (3.2) –8,056,158 (–3.6) 2,865,425 (1.2) 849,559 (1.2) 4,068,471 (5.8)
FHO&M 5,693,190 (5.4) –29,686,365 (–6.9) –493,260 (–0.3) 22,553 (5.6) 512,477 (3.0)
1997 O&M –8,167,298 (–0.5) –10,669,541 (–10.7) 8,140,001 (1.3) –1,008,623 (–1.2) –580,118 (–0.1)
FHO&M –6,095,303 (–14.8) –4,657,081 (–9.8) –3,996,301 (–14.9) –205,523 (14.7) –73,444 (–1.1)
Total O&M 91,298,233 (3.9) 47,930,957 (7.4) 12,207,082 (1.0) –6,476,104 (–2.1) –1,629,181 (–0.1)
FHO&M 7,423,657 (1.2) 3,187,227 (0.5) –8,136,221 (–2.4) –217,599 (–8.9) 154,274 (0.4)
a Budget versus average spot rate.
b Budget versus end-of-month spot rate.
Note: Number in parentheses represents percentage by which operational accounts were over (_)/under(+)funded when converted at budget rates.
25
tional net funds from its CMA because of foreign currency fluctuations on its overseas O&M
and FHO&M expenditures. Because the CMAs are replenished with public funds as they
become depleted, the current practice does not eliminate risk from foreign cur-rency
fluctuation. Instead, the realization of variances is deferred beyond the budgeting phase and
directed away from the operating budgets. Current procedures, rather than a method of self-
insurance, act as a means to socialize foreign exchange losses by passing the costs to the
taxpayer. Alternatively, foreign exchange gains are absorbed into other DoD activities, which as
a source of non-authorized, non-appropriated funds might be equally problematic.

The question posed at this point is whether an alternative strategy exists to better insu-late
the DoD from the adverse effects of foreign currency fluctuations. In effect, might an-other
approach produce a closer approximation to the origin in Figure 1? As noted, numerous
strategies exist for managing foreign exchange rate risk, yet institutional re-strictions prevent
their application within a DoD context. One approach involves chang-ing the manner in which
budget rates are determined. Ellsworth suggests an adaptive expectations approach that would
15
establish the budget rate as a weighted moving average of past rates. Alternatively, forward
exchange rates might be applied in the determina-tion of budget rates.

Employing an alternative heuristic to set the budget rate, whether it is based on a weighted
average or on forward rates, might affect the magnitude of the transfers between the CMA and
the operational accounts, but it would not eliminate the need for them. Most empirical
16
investigations reject the notion that forward rates are a valid predictor of future spot rates. Wu
and Zhang present evidence that the forward rate provides no in-formation and sometimes the
17
wrong information relative to future spot rates. Average rates, which are backward looking,
and forward rates, with their dependence on initial spot rates, provide no better approximation
to the origin depicted in Figure 1. As such, op-erational appropriations remain uncertain and at
risk to significant realized variances with losses socialized via transfers from the CMA.

Forward Contracts

Achieving a position at the origin in Figure 1 does not require the ability to accurately predict
future spot exchange rates. If the objective is to determine a budget rate that better
approximates subsequent liquidated rates, an alternative is to employ forward cur-rency
contracts. Instead of attempting to accurately predict rates on any specific day, the

15. Ellsworth, Foreign Currency Fluctuation Allowances.

16. J. F. O. Bilson, “The ‘Speculative Efficiency’ Hypothesis,” Journal of Business 54 (1981): 435–452; and
L. Hansen and R. Hodrick, “Risk Averse Speculation in the Forward Foreign Exchange Market: An Econometric
Analysis of Linear Models,” in Exchange Rates and International Macroeconomics, ed. J. Frenkel (Chicago:
University of Chicago Press, 1983), 113–152.
17. Y. Wu and H. Zhang, “Forward Premiums as Unbiased Predictors of Future Currency Deprecia-
tion: A Non-parametic Analysis,” Journal of International Money and Finance 16 (1997): 609–623.

26 Public Budgeting & Finance / Winter 2000

application of forward rate contracts isolates the exposure from currency movements in either
direction. It is constructive to explore how the application of forward contracts ac-cords with
the constraints outlined above.
With a forward rate contract, no expectation about future currency values is required, nor do
cost-of-funds issues arise, as funds are not disbursed until the expiration date. Un-like options
and futures contracts, a forward contract requires both buyer and seller to ex-change the pre-
determined amount of two currencies at the specified future date and rate. If only an
approximate future date is known, the forward contract may specify a range of future dates for
exchange. The rate at which this exchange occurs depends on the spot rate of exchange, the
time-to-expiration of the contract, and the interest rate differential on se-curities of comparable
risk and maturity in the countries affected at the time the contract is agreed. The resulting
discount or premium might cause the forward rate to be different from the spot rate, but there
exist no additional transactions costs above those currently resulting from spot transactions.

Using interest rates on euro-currency deposits of similar maturity, the premium or dis-count
adjustment to the spot rate is found through the covered-interest parity condition:
rf = rs 1 n i b −ib )
(
+
us c

12

where:
rf = forward rate of exchange,
rs = spot rate of exchange at time of budgeting,
us
ib = euro-dollar interest rate at time of budgeting,
c
ib = euro-currency interest rate for country c at time of budgeting, and n =
number of months until maturity.

Assuming that the timing and magnitude of unliquidated monthly foreign currency obli-gations
are known during the budget process, forward rate contracts may be applied against those
currencies with sufficiently liquid forward markets. The use of forward mar-kets presents little
problem in relation to the five most actively used currencies, but might be problematic or
impossible relative to infrequently traded currencies (e.g., Turkish lira, Korean won). However,
DoD expenditures in currencies that lack a forward market are not sufficiently large to alter the
analysis.

Effect of Forward Contracts on CMAs

When foreign currency exposures are committed to forward exchange contracts, the ef-fects of
exchange rate fluctuation on Air Force operations and maintenance and family housing
obligations dissipate. The potential for differences between budgeted and liqui-

Groshek / Foreign Currency Exposure in the Department of Defense 27

dated payment amounts is eliminated, because the forward rate is both budget rate and
liquidated rate. There is no movement away from the origin in Figure 1, no funding imbal-ance
in the operating appropriations, no effect on the CMAs, and no reason to maintain funds in the
FCFD and FCFCD accounts. A greater degree of stability is introduced into the process of
planning, budgeting, and liquidating foreign obligations by isolating expo-sures from the
effects of foreign currency fluctuation. As noted in Levi and Sercu, hedging foreign exchange
18
risk might provide improved internal information and decision-making capabilities.

Relative to leaving obligations exposed, however, an opportunity cost results from the
commitment required with forward contracts. Again Figure 1 illustrates the point. Al-though
foreign exposures are fixed at the origin, there persists the potential that the spot rate at the time
of liquidation will be less than the budget (or forward) rate. The require-ment to exchange at the
pre-determined forward rate means that points to the southwest (point q, for example) are no
longer attainable. Instead of a surplus in the operating bud-get resulting in a transfer to the
CMA, as under the current approach, the DoD expends more to settle the foreign obligation
than the spot rate at the time of payment would have required. On the other hand, the DoD is
isolated from the effects of a spot rate at the time of liquidation that is greater than the budget
(or forward) rate. Forward contracts elimi-nate the need to debit the CMA when points lay in
the northeast quadrant of Figure 1, such as at p.

Forward Estimates

Two series of forward exchange rates are calculated from spot rates by adjusting for differences
in euro-currency interest rates (for maturities up to fifteen months) and for differences in
interest rate swap yields (for longer maturities) in the respective curren-cies. Budget rates might
be adjusted throughout the budgeting cycle up to the point of submission to Congress.
Therefore, an initial series of forward rates is calculated using exchange and interest rate
parameters at the time of budget submission: the end-of-January of the previous fiscal year. A
second set of forward rates for each fiscal year adopts end-of-July parameters given recent
experience with the congressional budget approval process. The source for spot exchange rate
and interest rate data is the Finan-cial Times.

Because of the procedural differences in the application of budget rates between O&M and
FHO&M obligations, the forward rates and the estimate of losses and gains differ to mimic
current procedures within each expenditure category. Depending on the expiration of each
obligation, the forward rate applied on O&M expenses ranges from nine to sixty-eight months
for January forward rates and from three to sixty-two months for July

18. M. D. Levi and P. Sercu, “Erroneous and Valid Reasons for Hedging Foreign Exchange Rate Expo-
sure,” Journal of Multinational Financial Management 1 (1991): 25–37.

28 Public Budgeting & Finance / Winter 2000

forward rates. For example, an obligation recorded in FY1993 but liquidated in August 1995 is
evaluated at the forty-three-month forward rate when January 1992 is the theoreti-cal
establishment of FY1993 forward rates. When July 1992 is used to determine FY1993 forward
rates, the thirty-seven-month forward rate applies. Because FHO&M obligations do not carry
over from one fiscal year to the next, the corresponding forward rate extends from nine to
twenty months for January forward rates and from three to fourteen months for July forward
rates.
Based on the above procedures, forward rates are applied to the foreign-currency equivalents
of liquidated obligations over 1993–97. Figures 3a through 3e compare the se-ries of exchange
rates—current budgeted, liquidated, and the July forward—for each of the five currencies. For
brevity, the January forward rates are not presented. (They are available from the author.)
Currencies that have a lower interest rate relative to dollar in-terest rates at the time of
budgeting trade at a forward premium against the dollar and thereby have a discernible upward
trend in the figures. This is evident for the Japanese yen throughout FY1994–97, for the
German mark in FY1995–97, and for the British pound in FY1995 and FY1997. The premium
is assessed to offset the interest rate difference in fa-vor of dollar assets and thereby increases
the cost of funding foreign currency obligations relative to the spot rate. For the remaining
periods and currencies, forward currency rates trade at a discount, which results when foreign
interest rates are greater than those in the United States. In the latter instances, forward
currency rates are declining and thereby lower the cost of funding future obligations relative to
the spot rate.

FIGURE 3a
Dollar Rates against German Mark

a
Budget rate on FHO&M.
b
Budget rate on O&M.
Source: DFAS–Denver; author’s calculations.

Groshek / Foreign Currency Exposure in the Department of Defense 29

 FIGURE 3b
Dollar Rates against Japanese Yen

a
Budget rate on FHO&M.
b
Budget rate on O&M.
Source: DFAS–Denver; author’s calculations.

Results

To reveal whether a forward contracting strategy improves on current procedures, Table 2

presents disaggregated estimates of the variances between O&M and FHO&M obligations
liquidated at the July forward rate against the same obligations had they been liquidated at

FIGURE 3c
Dollar Rates against British Pound

a
Budget rate on FHO&M.
b
Budget rate on O&M.
Source: DFAS–Denver; author’s calculations.

30 Public Budgeting & Finance / Winter 2000

 FIGURE 3d
Dollar Rates against Spanish Peseta

a
Budget rate on FHO&M.
b
Budget rate on O&M.
Source: DFAS–Denver; author’s calculations.

the actual spot rate. As reflected in Figures 3a through 3e, all currencies exhibit periods where
July forward rates are lower than the subsequent spot rate at the time of liquidation. In these
instances, the dollar equivalent of foreign obligations liquidated at the forward rate (which is
also the budget rate) is less than that which would have resulted if exposed to the spot rate. The
forward contract isolates the DoD from the effects of a spot rate at liquida-

FIGURE 3e
Dollar Rates against Italian Lira

a
Budget rate on FHO&M.
b
Budget rate on O&M.
Source: DFAS–Denver; author’s calculations.

Groshek / Foreign Currency Exposure in the Department of Defense 31

32

TABLE 2
Estimated Annual Variances in USAF O&M and FHO&M Expenses
July Forward Amounts Less Unhedged Amounts at Spot Rate

FY Expense German Mark Japanese Yen British Pound Spanish Peseta Italian Lira

1993 a 10,039,371 (3.7) –11,662,345 (–10.9) 21,038,876 (15.2) 5,135,839 (14.6) 6,216,365 (17.8)
O&M
b
FHO&M 11,174,234 (4.9) –7,879,735 (–10.2) 7,656,362 (22.1) 30,395 (18.8) 358,754 (26.9)
1994 O&M –14,921,718 (–5.8) –8,376,908 (–7.3) 1,479,046 (1.5) 18,825,004 (20.0) 8,530,245 (3.4)
FHO&M –13,676,316 (–7.3) –1,548,316 (–1.7) –878,142 (–1.5) –18,757 (–9.7) –154,870 (–3.8)
1995 O&M –25,385,483 (–9.3) –11,986,463 (–6.9) –5,868,571 (–4.3) 116,652 (0.6) 1,759,334 (1.3)
FHO&M –5,290,124 (–10.4) –4,316,060 (–4.5) –965,011 (3.8) –6,877 (–2.8) 74,828 (0.9)
1996 O&M 15,987,827 (4.4) 45,142,653 (20.9) 3,995,189 (1.6) –64,032 (–0.1) –4,708,495 (–6.4)
Public Budgeting & Finance / Winter 2000

FHO&M 9,922,957 (8.9) 114,352,871 (28.7) 3,235,939 (1.7) 11,756 (2.8) –684,009 (–3.9)
1997 O&M 185,569,876 (11.5) 24,278,957 (27.4) –31,570,184 (–4.8) 6,114,502 (7.2) 61,971,007 (8.4)
FHO&M 5,998,045 (17.1) 5,148,109 (12.0) –1,229,392 (–4.3) 157,592 (13.3) 243,259 (3.7)
Total O&M 171,289,873 (6.2) 37,395,894 (5.3) –10,925,644 (–0.9) 30,127,965 (9.9) 73,768,456 (6.0)
FHO&M 8,128,796 (1.3) 105,756,869 (14.9) 7,819,756 (2.4) 174,109 (7.8) –162,038 (–0.4)
a Budget versus average spot rate.
b Budget versus end-of-month spot rate.
Note: Number in parentheses represents estimated percentage potential gain (_) or loss (+) when converted at forward rates.
tion located to the northeast of the origin (such as p) in Figure 1. Because the forward con-tract
equates the budget rate and the liquidation rate at the origin, the DoD benefits from increased
planning certainty and the elimination of CMA debits.
The result is made less encouraging for the German mark in FY1993 and throughout
FY1996–97. During these periods, the benefit of ex ante budget certainty is accompanied by
final payments in excess of those obtainable had foreign obligations been exposed to market
fluctuation. The Japanese yen after FY1996, the British pound in FY1993 and 1996, the
Spanish peseta during FY1994–95 and FY1997, and the Italian lira during FY1993–95 and the
latter part of FY1997 also produce this result. Although ex ante bud-get uncertainty is
eliminated, the subsequent spot rate at the time of liquidation is below that to which the DoD
commits under the forward contract. This results from points to the southwest of the origin in
Figure 1.
For the five years examined, the use of forward contracts in these five currencies at the July
forward rates produces a net cost over the current, unhedged approach of $302 mil-lion on
O&M expenses and $122 million for FHO&M expenses. Ex post payment on over-seas USAF
obligations equals ex ante funding, however, payments are higher than the alternative of
leaving unliquidated obligations unhedged and exposed to currency fluctua-tion. A similar
analysis using the January forward rates produces shifts in estimated gains and losses similar to
those in Table 2. However, net funding requirements for the five ma-jor currencies are $17
million below the unhedged alternative. Taken together, these two observations show that the
use of forward exchange contracts eliminates exchange rate uncertainty from the budget
process but might not guarantee that final expenditures will always be lower than the unhedged
alternative.
Groshek and Felli applied Monte Carlo simulation to the DoD’s foreign exchange obli-
gations and found that the use of forward contracts—relative to the current proce-dures—
19
resulted in lower foreign currency expenditures 63.6 percent of the time. The expected
average annual cost reduction due to the use of forward contracts equated to $139.5 million.
This amount—indeed, all incremental cost reductions from program and operating reforms—
might appear to be insignificant when compared to annual DoD ex-penditures in excess of $260
billion. One must assess these cost reductions, however, in relation to the procedures governing
the specific foreign currency–denominated expendi-tures. When compared to the relevant
foreign currency outlays, the estimated $139.5 mil-lion cost reduction from the application of
forward contracts equates to a non-trivial, ex post savings of 3.5 percent. These estimated
reductions are larger than the effect of for-eign currency fluctuations on the life-cycle costs of
20
three Navy procurement programs es-timated by Ellsworth.

Additionally, forward contracts eliminate the need to maintain CMA balances as a buffer
against adverse exchange rate fluctuations. Absent this requirement, financial re-

19. G. Groshek and J. Felli, “Foreign Exchange and Lost Opportunity in the U.S. Department of De-fense,”
Journal of Multinational Financial Management 10 (2000): 73–89.
20. Ellsworth, Foreign Currency Fluctuation Allowances.

Groshek / Foreign Currency Exposure in the Department of Defense 33

sources equivalent to the opportunity cost of maintaining CMA funds would be released for use
elsewhere—perhaps making a contribution toward the DoD’s force moderniza-tion and
recruitment objectives. In FY1998, CMA balances totaled $449 million, which equates to an
annual opportunity cost of $31.4 million (using the Office of Management and Budget discount
rate of 7 percent). When this foregone opportunity cost is added to the estimated average
savings directly resulting from the use of forward contracts, total ex post reductions equate to
4.3 percent of foreign currency expenditures.
Aside from the budgetary implications, the current procedures make it impossible to assess
the effect of individual overseas obligations on CMA balances. Much information is lost in
terms of identifying, measuring, and evaluating both the sources of claims against these
reserves and the uses of foreign currency gains. Undoubtedly, the application of for-ward
contracts to DoD foreign exchange expenditures would require a greater level of de-tail.
However, the accounting mechanisms contained in commercially available foreign exchange
software programs provide increased reporting efficiencies and would inject greater
transparency into the management of DoD overseas expenditures. Regardless of whether
forward contracts are implemented, the adoption of standard, private-sector soft-ware
21
applications needs to be investigated.

SUMMARY

This article has addressed the exposure of the DoD to fluctuation in foreign exchange rates.
Unlike fluctuation in rates of inflation and interest that affect government opera-tions on a
general level, exchange rate fluctuation imposes an additional uncertainty on a specific set of
operational expenditures. The negative consequences of this risk motivated the establishment
and maintenance of a pool of funds to buffer the DoD’s overseas opera-tional budgets. Instead
of an ex post budgetary reaction, current DoD policy maintains an ex ante reserve of public
funds to compensate for changes in exchange rates. In the pro-cess, however, there continues a
formal neglect of the exposure to exchange rate fluctua-tion, which in itself is speculative.

The preceding evaluation of two major overseas operating expense categories for the USAF
revealed the magnitude of over- and underfunded budgets during FY1993–97. The search for
alternative heuristics to determine budget rates offers little in terms of reducing these variances
by better matching budgeted obligations with final payments. Transfers between operating
accounts and the CMA persist with only their magnitude affected. If the timing and size of
future obligations are known, the use of forward exchange rate con-tracts improves the
planning process by equating budgeted obligations with realized out-lays at the time of budget
determination. Additionally, forward exchange rate contracts avoid cost-of-funds issues and ex
post transactions costs and comply with current restric-tions on currency speculation.

21. Levi and Sercu, “ Erroneous and Valid Reasons,” cite the provision of better internal information as a
motivating factor in hedging foreign currency exposure.

34 Public Budgeting & Finance / Winter 2000

 Estimates from the application of forward contracts indicated that the DoD might make an
ex ante payment commitment in excess of that required by the ex post spot rate. Using July
forward rates, the distribution of USAF payments during FY1993–97 produced potential gains
for certain currencies and periods that were outweighed by potential losses in others. However,
this result was reversed with the use of January forward rates. Cognizant of this type of
uncertainty, recent work using Monte Carlo simulation of DoD foreign currency expenditures
revealed significant and consistent average cost reductions from the application of forward
contracts.
The inability to respond to currency fluctuation imposes costs on the DoD in terms of the
socialization of losses through the CMAs, the opportunity cost of maintaining CMA balances,
uncertainty in budget execution, and adverse operational effects when CMA funding is
constrained. The potential for foreign currency gains is also problematic in that it provides the
DoD with a source of non-appropriated, non-authorized funds. Given the consistent volatility of
foreign currency rates and an opaque understanding of foreign ex-change markets, the
application of forward contracts provides a means of reducing the un-certainty and cost of
maintaining U.S. military operations overseas that also accords with various reform initiatives
and enhances the military’s ability to concentrate on opera-tional missions.

Groshek / Foreign Currency Exposure in the Department of Defense 35