International Financial Risk and Control - Essay Example

International Financial Risk and Control Overview The exchange rate of a particular nation’s currency determines the price at which it trades for another currency on the exchange market. The exchange rate amid the currencies of two nations is referred to as the bilateral exchange rate. It is defined as the number of units of either currency required to buy one unit of the other. The bilateral exchange rate is influenced by various issues. The assessment of these issues and their impact on the exchange rate between the two currencies is known as fundamental analysis. The major issues influencing the exchange rate comprise of interest rates, inflation, and foreign exchange reserves among others. It is imperative for transnational business organizations to recognise the determinants of exchange rates and whether the exchange rate variations can be forecasted. International parity conditions refer to the economic theories that connect exchange rates, level of prices as well as the interest rates. In this study, we would attempt to see whether the international parity conditions are effective in forecasting the variations in the exchange rates in the real world. In doing so, we would consider the bilateral exchange rate movements of Euro/Dollar over the past twelve months and observe whether the variations were consistent with one or more of the International Parity Conditions. Subsequently, we would conclude the study by discussing the extent of effectiveness of the International Parity Conditions as a forecasting tool (Eiteman et al., 2007, p.170). Bilateral Exchange Rate Movement of EUR/USD over last 12 months In this section of the study we would assess the relative exchange rate movement of Euro expressed in terms of United States Dollar. For the convenience of the study the Euro versus Dollar exchange rate fluctuations for the period of last twelve months were considered. However, to analyse the latest trend of the Euro/USD exchange rate, we would initially focus on the last 120 days movement of the currency. The figure below depicts the US dollars to 1 Euro values for the latest 120 days: Figure1: American Dollars to 1 EUR (120 days) (Source: X-Rates, 2012) During this period, the highest value for Euro was 1.3788 USD (as recorded on November 8, 2011) while the lowest value of Euro during the same period was 1.2669 (as recorded on January 16, 2012). The latest value of 1 Euro (as on April 20, 2012) was observed to be 1.3192 USD (Source: X-Rates, 2012). Figure2: US Dollar vs. Euro (USDEUR) Exchange Rate Chart (Source: ADVFN, 2012) The graph above represents the exchange rate movements EUR/USD for the period starting from May 2011 and ending at April 2012. A closer look at the exchange rate chart reveals that the value of Euro in terms of USD during the specified time frame had fluctuated from 1.45 to around 1.3 USD approximately. The change in the Euro value during the period from April 20, 2011 to April 20, 2012 was -0.1323, which is equivalent to a decline of 9.1% (European Central Bank, 2012). This implies that there has been a relative depreciation in the value to Euro as against that of Dollar. Determinants of Exchange Rate There are various determinants of the variations in the exchange rate of a particular currency, for instance terms of trade, investor sentiments, purchasing power parity, monetary and fiscal policies, economic growth rate and international parity conditions among others. In general, these determinants can be classified as short-term, medium-term and long-term determinants of exchange rate. The figure below depicts this classification of determinants of exchange rate movements: Figure 5: Determinants of Exchange Rate Variation. (Source: Jeffus, 2010) International Parity Conditions The international parity conditions forecast the exchange rate movements on the basis of Law of One Price, Relative Purchasing Power, Real Rate of Interest, International Fisher Effect and the Forward/Future Rate. The linkage between the anticipated variation in exchange rates and the forward rate, interest rate difference between the overseas and the domestic market and PPP are demonstrated in the figure below. Figure 6 (Source: Jeffus, 2010). The parity conditions reveal how the rate of interest, inflation, forward exchange rates as well as anticipated variations in exchange rates are connected globally. Currencies appreciate and depreciate over a period of time due to low or high rate of inflation prevalent in the country. The parity conditions also state that the forward exchange rates should be utilised as fair predictors of upcoming spot rates. However, it had been continuously observed that the parity conditions are not applicable for the short-term of medium-term time duration. As a result the international parity conditions fail to predict in the future spot rate of a particular currency unless the time frame considered for the assessment is of long-term. Nevertheless, this non-conformation to the parity conditions in the near-term ensures that profit prospects are available from overseas investments (Rosenberg, 2003, p. 109). The Purchasing Power Parity states that the anticipated variation in the spot exchange rate should be equivalent to the difference between the expected inflation rates of the two nations. This can be represented as follows, Anticipated Variation in Exchange rate = (Foreign Expected Inflation Rate – Domestic Expected Inflation Rate) (Rosenberg, 2003, p. 110) Thus, it is likely that the currency of the country that has higher inflation rate would depreciate over time, while the lower inflation country’s currency appreciates. The uncovered interest rate parity states that the risk free return generated from an investment in the domestic market should be equivalent to the summation of a similar return in an overseas instrument and an anticipated appreciation rate of the overseas currency. In view of the fact that the result of the future spot rate is unsure, an investor who has a dislike towards risk would be inclined to sell the entire proceeds inclusive of the principal and the interest earned in the forward market so as to hedge the risk. Consequently, a covered adaptation of interest rate parity is attained (Rosenberg, 2003, p. 111) According to the international parity conditions, the percentage return generated in the equity market of a particular country is expected to be equivalent to the exchange rate adjusted return in markets of an overseas country. This condition can be illustrated by the following example. For illustration, let us assume that the index return in the Euro Zone market is 9 %, whereas the analogous index return in the United States is 7 %. In such a circumstance the surplus 2 % return in the Euro Zone market will be counterbalanced by an identical extent of appreciation in the dollar value. This situation is more intricate than that of uncovered interest rate parity because it comprises of expectations for the stock returns as well as exchange rate variations. The developments of expectations for stock returns as well as exchange rates are administered primarily by various sets of economic basics as well as investor complexity, even though they may possibly share a few common factors. The unstable characteristic of stock returns appends an added hazard to the parity condition (Rosenberg, 2003, p. 112) A common characteristic among the principal international parity conditions is that associations among the domestic market returns as well as overseas-market returns go through the conduit of the foreign-exchange market. Consequently, a jolt in the currency exchange market would generate an exchange rate hazard which would concurrently impact the goods market in addition to the markets of stocks and bonds. Furthermore, if the exchange rate is considered as an endogenous variable, the variation in an exchange rate is observed to be linked with alterations in the relative returns. These relative returns are in terms of difference in relative inflation, interest rate, as well as stock return (Rosenberg, 2003, pp. 110-114). (Source: Cengage Learning, n.d., p. 3) Figure 7: An integrative look at the International Parity Conditions Consistency of the Exchange Rate Movements of EUR/USD with the International Parity Conditions The ex ante purchasing power parity states that the anticipated variation in the spot exchange rate should be equivalent to the difference between the inflation rates of the two involved countries. Hence the difference between the inflation rates between US and the Euro Zone would give us an indication of the expected change in exchange rate of the two currencies. In the United States, an inflation rate of 2.7% was last reported in March 2012, while that of Euro Zone during the same time was also 2.7%. (Trading Economics (a), 2012; Trading Economics (b), 2012). The inflation rates prevalent in both the regions during March 2011 were also approximately around 2.7% (Global-Rates, 2012; US Inflation Calculator, 2012). Consequently, it was observed that the inflation differential between the US and the Euro Zone during the past one year was 0. As a result, according to the purchasing power parity condition the exchange rate change during the same period should also be zero. However, the change in the Euro value during the period from April 20, 2011 to April 20, 2012 was -0.1323, which is equivalent to a decline of 9.1% (European Central Bank, 2012). Thus, the parity condition does not hold true for the period of one year. The most recent reported benchmark rate of interest prevailing in the United States was 0.25%. The average interest rate in the United States for the period starting from1971 to 2010 was 6.45% (Trading Economics (c), 2012). On the other hand, the latest reported standard interest rate for the Euro Zone was 1%. For the duration from the year 1998 to 2010, the average rate of interest prevailing in the Euro Zone was 2.89% (Trading Economics (d), 2012). Figure 3: Average (2002-2012) Interest Rate in the Euro Zone (Source: Trading Economics (d), 2012) Figure 4: Average (2002-2012) Interest Rate in the United States (Source: Trading Economics (d), 2012). It can be observed from Figure 3 and Figure 4 that though the prevailing rate of interest of the Euro Zone is higher than the US, the average interest rate of US in the past years was considerably higher than that of the Euro Zone. According to the International Fischer’s parity, (Spot today – Spot after a year) / Spot after a year = (Interest Euro - Interest US)/ (1 +Interest US) Suppose, these calculations were to be made during the year 2011, then the spot rate after a year would be the prevalent spot rate of Euro/USD. Then the equation would have been, (Spot 2011 – Spot 2012) / Spot 2012 = (Interest Euro - Interest US)/ (1 +Interest US) The interest rate of US and the Euro Zone during the year 2011 was 0.25% and 1% respectively. Therefore, the right hand side of the equation results in 0.75%. The Spot rate of Euro as on April 20, 2011 was 1.4515 USD (European Central Bank, 2012). Hence the left hand side of the equation comes out to be, (USD1.4515/Euro - Spot 2012) / Spot 2012 = 0.75% Solving the equation, the Spot rate as on April 20, 2012 should have been, USD1.3502/Euro. Nevertheless, the current day spot rate on April 20, 2012 was observed to be USD1.3192/Euro (Source: X-Rates, 2012). Thus, the expected exchange rate could not have been accurately forecasted by means of the international parity conditions. Effectiveness of the International Parity Conditions at Forecasting The Purchasing Power Parity model holds true for the long term movement of the exchange rates. However, it had been demonstrated that in the short term, the exchange rates cannot be predicted accurately by means of the inflation rate or the interest rates. There are various reasons for this deviation in the forecasted and the actual bilateral exchange rate. These comprise of unsuitable price indices to compute the inflation rates, capital flows, interference of the government in the currency market and speculative actions in the foreign exchange market among others. The variation between the real market exchange rates and those derived on the basis of purchasing price parity is known as real appreciation or depreciation (Eiteman et al. 2007). It had been observed that with the relative rise in prices in the United States as against that of Euro Zone, the purchasing power of United States has declined. As a result, the value of the US dollar had declined owing to the nation’s loss in competitive position. References ADVFN, 2012. US Dollar vs Euro (USDEUR) Exchange Rate Charts. [Online] Available at: http://in.advfn.com/p.php?pid=qkchart&symbol=FX%5EUSDEUR [Accessed on April 20, 2012]. Cengage Laerning, No Date. International Parity Conditions. [Pdf] Available at: http://academic.cengage.com/resource_uploads/downloads/0324421605_95531.pdf [Accessed on April 20, 2012]. Eiteman, D. K. Et al. 2007. Mutinational Business Finance. Pearson Education India. European Central Bank, 2012. Euro Foreign Exchange Reference rates. [Online] Available at: http://www.ecb.int/stats/exchange/eurofxref/html/eurofxref-graph-usd.en.html [Accessed on April 21, 2012]. Jeffus, W.M., 2010. Exchange Rate. [Online] Available at: www.wendyjeffus.com/images/Exchange_Rate_Determination.doc [Accessed on April 20, 2012]. JYSKE Global Asset Management, 2010. Analysis on USD/EUR. [Pdf] Available at: http://jgam.com/files/files/jgam/EditorsCorner/Archive2010/Analysis%20on%20USD_EUR%2014%2006%202010.pdf [Accessed on April 20, 2012]. Rosenberg, M. R., 2003. Exchange-Rate Determination: Models and Strategies for Exchange Rate Forecasting. McGraw-Hill Professional. Trading Economics (a), 2012. Euro Area Inflation Rate. [Online] Available at: http://www.tradingeconomics.com/euro-area/inflation-cpi [Accessed on April 20, 2012]. Trading Economics (b), 2012. United States Inflation Rate. [Online] Available at: http://www.tradingeconomics.com/united-states/inflation-cpi [Accessed on April 20, 2012]. Trading Economics (c), 2012. United States Interest Rate. [Online] Available at: http://www.tradingeconomics.com/united-states/interest-rate[Accessed on April 20, 2012]. Trading Economics (d), 2012. Euro Area Interest Rate. [Online] Available at: http://www.tradingeconomics.com/euro-area/interest-rate [Accessed on April 20, 2012]. X-Rates, 2012. American Dollars to 1 EUR. [Online] Available at: http://www.x-rates.com/d/USD/EUR/graph120.html [Accessed on April 20, 2012]. Read More