International Finance: Hedging Strategies - Essay Example

1.0: Hedging Strategies 1.1: Hedging for export The information provided in the tables concludes that two different hedging strategies can be deployed in this case of earning funds from in an international currency. Arbitration Hedging: In this case the company can exploit the pricing in the international money market and the interest rates to increase its financial holding. The Foreign Exchange rates table reveals that the conversion of the US Dollar funds into pounds and depositing for a period of three months is a lucrative method to increase the amount held in pounds, which is the major trading currency for the company. The conversion of the US$ 12,000,000 to GB Pounds for the aggregate value of foreign exchange rate in June 2006 (@ £1 = $1.75) the value of the amount earned in pounds by the company is £6,857,143 approximately. The interest earned for the three-month period between June and October 2006 is estimated at about £1,902,857 (simple interest) totalling to £8760000 earnings to the company. Hedging using arbitrage has the desired effect mainly in cases of cross border finance and trading in more than one currency as the inefficiency in the pricing at the market is exploited by the method. In the case mentioned above, the fact that the interest rate is higher in case of the pound sterling as well as the relatively higher premium earned from the dollars justifies the advantages of this method. Another hedging strategy that is widely used with respect to the foreign currency transactions in order to maximize the profits is that of Offsetting forward contract to accomplish risk aversion on the loss of revenue through exchange. The process of offsetting forward contract predominantly involves the process of purchasing a specific foreign currency which will be of need to the company in future for investment or payment of bills due in another form of currency. This argument by Patrick Cusatis and Martin Thomas (2005)i that the offsetting forward contract is not only a successful hedging strategy but also provides the flexibility of deploying the currency conveniently instead of undergoing more than one conversion from one currency to another. The fact that the offsetting is not only a successful method of rotating the overseas income for payment overseas but also provides the flexibility for the organization to reduce the risk of loosing revenue. As the conversion of the US dollars expected to receive in the June 2006 in the case under discussion can also cater the payment for import in euros by October 2006, the conversion of the funds into euros straightaway is another option of hedging the funds. The amount earned in Euros through the above method for US$12,000,000 has a discount of approximately 80cents leaving the company with approximately 9,942,858 euros. This makes it cleat that the company meet only a part of the total 15,000,000 euros payment for imports through directly converting the US$ 12,000,000 into euros than Pound Sterling. Alongside the fact that the interest rate for Euros is considerably lower to that of pound sterling further makes it clear that the overall profit made by the organization in the offsetting of the US$ is not appreciable. Hence the hedging using arbitration strategy is recommended for the given case of Globalcom Plc. 1.2: October 2006 Hedge position From the given exchange rates for US Dollars and Euros in October 2006, the revenue of US$ 12,000,000 can cater the same value of £ 6,857,143. Alongside, the exchange rates with respect to the euros and the conversion of the US Dollars to euros is more or less the same as discussed in the previous section under offsetting forward contract which did not lucrative. This makes it clear that the appropriate hedge position for the given situation is for the company to convert the US Dollars earned into Pounds Sterling in June 2006 and use the same with the interest accumulated to cater part of the import payment of 15,000,000 euros. The information provided on the foreign exchange rates present and future market contract prices make it clear that the hedging of the currency in the Pounds Sterling is more reliable to give highest return compared to the hedging in US Dollars or in Euros. As the interest earned in the case of pound sterling is higher than other international currency counterparts under debate, it is recommended to hedge in pound sterling. 2.0: Theories influencing Foreign Exchange rates The foreign exchange rates in the international finance markets are influenced by many factors some of which are discussed in this section. The major factors influencing the foreign exchange rates are identified as a. News: Sanjay Paul (2005)ii argues that the news and media play a vital role in the determination of the foreign exchange rates in the modern world. This is not only because of the fact that the efficiency of the business sectors in a given country is affected by the media but also due to the fact that the stock markets and stock indices are all mainly dependant upon the media as an external influencing factor. This makes it clear that the news as an influencing factor not only has a direct control over the foreign exchange rates but also has an indirect effect on the exchange rates through influencing the stock markets and also inflation. Furthermore, the fact that the real world is characterised by unpredictable shocks and surprises that is being transmitted with minimum delay through the technology rich media today is the main element that influences the foreign exchange rates in the international finance markets. Alongside, the response of the general public to the news in the twenty-first century and the increasing competition in the global markets are the major elements that make new as an influencing element in the foreign exchange rates itself. Sanjay Paul (2005) further argues that the news not only presents the facts but also has the capability to give a definite face to a situation making the position of a country more vulnerable in the international markets. This is evident in the case of United States of America where the country’s weakness in preventing terrorist attacks has affected the NASDAQ as well as influenced the exchange rates of the US Dollar against many Middle Eastern currencies like the Kuwait Dinar. Alongside, the ability of news to influence the purchasing power parity as argued by Sanjay Paul (2005) further justifies the critical nature of the news in influencing the foreign exchange rates in he international markets. b. Market Efficiency: The market efficiency in terms of international finance is predominantly the ability of a country to nurture its efficiency in the international trading stage. Richard Pike and Bill Neale (2005)iii further argue that the corporate identity and corporate culture of a global organization and its role in the international markets representing its originating country is a dominant factor influencing the foreign exchange rates in the international markets. This not only justifies the argument that the GDP of a country and the performance efficiency of the nation internally in the national markets and its share in the global markets are the key elements contributing to the market efficiency of the nation. Alongside, the fact that the increasing outsourcing in the west to the Far Eastern countries and the increased dependence on countries like China and India for human resource to leverage cost effective production justifies that the market efficiency is key element influencing the foreign exchange rates in the international stage. It should be noted that not only at the national level but also at the corporate level the need for market efficiency and market leadership is essential for the effectiveness in the market as argued by Philip Kotler and Kevin Lane Keller (2005)iv. Although the argument by the authors is in the light of marketing, they justify the fact that the market efficiency is the predominant element influencing the growth of a company in the target market. This makes it clear that the market efficiency is a key influencing factor to the exchange rates of the currencies in the international markets. In the light of the above arguments, the development of the IT services market in India is a classical example. The country is the target for the outsourcing of call centres and offshore software development for the western countries. The increase in the market efficiency with the country’s IT services sector holding over 50% of the global IT services market has increased its position in the international stage. This has not only influenced its exchange rates with the US Dollar decreasing in value against Indian Rupee but also the Pound Sterling facing a stiff exchange rate stability issue with the Indian rupee with the increase in the organizations moving Far East. The above example justifies that the market efficiency is a key-influencing element to the foreign exchange and exchange rates of currencies in the international finance markets. c. Psychological and Institutional Forces: John T. Harvey (2006)v argues that the principles of newclassism cannot entirely explain the factors influencing the foreign exchange rates and their determination in the international markets. This is mainly because of the fact that there are more non-rational factors that contribute to the volatility, instability and trade issues in the international stages. This is obviously because of the institutional forces and the psychological factors that fuel them in the global market. John T. Harvey (2005) argues that the psychological factors play a critical role in influencing the currency exchange rates in the global market both directly and indirectly. This is explained briefly as follows. The psychological factors associated with the customers in a given target market and demography is the key for the effectiveness in the market. This is not only because of the obvious fact that the psychological factors play a critical role in the success in a given market but also influences the more critical elements like the globalization and cross border finance. This makes it clear that the psychological factors are the driving elements for decision making in the international stage by a nation. Alongside, the institutional nature of many Middle Eastern and Far Eastern countries as well as the culture embossed European countries are influenced by the institutional factors in completing an exchange or closing a deal in the market. This makes it clear that the institutional factors that are driven by the psychological and cultural factors of a nation are one of the major influencing elements to the exchange rates of currencies in the international finance markets. The research by John T. Harvey (2005) further justifies that the explanation to the exchange rate determination in the in the psychological context yields superior results to those of the ones based on the traditional and neoclassical methods of determination. Hence it is clear that the psychological and institutional factors of a nation influence the exchange rate of currencies in the international stage. d. Purchasing Power: David H. Papell (2006)vi argues that the foreign exchange rates are not only influenced by the psychological and institutional factors but also with respect to the purchasing power of a nation in the international stage. The fact that the Panel Purchasing power is a critical element not only in the global stock markets but also in the case of purchasing energy resources like oil and gas in the global market. The long run Purchasing power Parity (PPP) is one of the key elements that influence the exchange rate of currencies in the international markets as argued by David H. Papell (2006). This is not only due to the fact that the PPP is a key element in the structural change which makes it clear that the PPP restricted structural change in the market is one of the key elements influencing the exchange rates in the international finance stage. The unit root tests conducted on the PPP to investigate the structural change by David H. Papell (2005) further makes it clear that the ‘real exchange rates’ are dependent upon the hypotheses set by the tests which are in turn influenced by the PPP on the structural change. The graph in Fig 1 below reveals that the t-statistics on α as the span of the data increases from 1973(1)–1988(1) to 1973(1)–1998(4). Where is the t-statistic on α. fig 1: PPP restricted Structural Change (Source: David H. Papell, 2006, The Panel Purchasing Power Parity Puzzle, Journal of Money, Credit & Banking e. Resources: The natural resources in a nation are another critical element influencing the exchange rates. This is because of the fact that the dominance of a nation in the global market increases with its potential to provide a scarce resource like Oil for instance, which is a key source of energy. The global trading stage mainly considers a nation as resourceful in terms of its self-sufficiency in energy and the store of precious metals and stones in the market. Gold being one of the elemental trading items in the international markets is also considered as the main element or resource that influences the exchange rates of a given currency. This is not only because of the ability to easily trade gold on a common platform rather than the currency of the country. Thus it is clear that the gold being the most important resource as well as the trading platform in the international market is indeed the primary or fundamental influencing element in the country’s economical situation in the global market. From the aforementioned it is clear that the resources of a country is another influencing element on the exchange rates in the international market. 3.0: Conclusion Thus to conclude this essay it is clear that the hedging strategies when effectively deployed can save losses in foreign exchange to a company trading with different currencies. It was also established that the foreign exchange rates in the international market is influenced by many rational and non rational factors thus establishing that scientific approach to the exchange rate calculation does not entirely provide a concrete methodology to determine the exchange rates. Read More