Determination of Exchange Rate - Coursework Example

? Determination of Exchange Rate History of Exchange Rates As d by Bagella et al (2006, p.1151), the choice of policiesof exchange rates was not so vexing sometimes back. In modern period, the selection of an exchange rate policy that suits a country is vital since though the selection of the policy is convenience based given application of international rules and regulations. Exchange rates policy dates back many years. As noted by Lau (n.d., p. 2), in 1867, the Trans-Atlantic cable was the only electronic link between Europe and North America. In this period, four fuzzy edges characterized the international monetary experience. The initial period was 1870 to 1914 where most countries adopted the gold standard where gold was used as domestic money. The above gold standard was a uniform exchange rate regime, though some countries constantly used silver while other countries gold inconvertible currencies (Ehrmann and Fratscher, 2004, p. 105). The start of the First World War interrupted this exchange rate era thereby bringing in the second phase that was 1914-1946. Under this second period, there were many changes as many countries saw great variations of currencies used among countries and the over time. Exchange controls were initiated with most countries utilizing the floating exchange rates (Escobar, 2012). It was noted that in the late 1920s, the efforts to restore the gold standards as were before the war began aborted (Deaton and Duprietz, 2011, p. 152). The exchange rate policy was dominated by the Breton Woods agreement that was signed in 1944 between 1946 and 1973. Through this pact, countries agreed to commit themselves to convertible currencies that could be converted to the current account and the fixed exchange rate (Chinn and Hiro, 2005, p. 301). The pact enhanced eschew of exchange controls and fixing the exchange rates due to the negative lessons that were experienced after the world war (Bagella, et al. 2006, p. 1152). Despite the increased application and use of the Breton Woods pact, Kenen (2000, p. 111) posits that the arrangement was strained since the 1960s and in 1973, fixation of exchange rates was officially abandoned by most countries in Europe and Japan thereby ushering in the next period of exchange rates that has been in application since 1973 to date where countries use floating exchange rates (Chinn & Hiro, 2005, p. 303). 2.2 Types of Exchange Rates 2.2.1 The Nominal Exchange Rate Regime The nominal exchange rate is the exchange rate of a given currency whose value is not averagely weighted in relation to the major currencies across the globe (Cooper, n.d.: 21). The weights of the currency are determined by the domestic country that places its currency in a given pool of global currencies that are measured by the balance of trade between these countries. The nominal effective exchange rate (NEER) is the relative value of a domestic currency as compared to major global currencies such as the U.S. Dollars, the UK Pound and the Japanese Yen among others. A high NEER implies that the domestic currency has a more value than the foreign currency while a lower NEER implies that the domestic currency has a less value as compared to the foreign currency. As noted by Eichengreen and Leblang (2003, p. 804), the nominal exchange rate refers to the exchange rate of a given currency in relation to the given foreign currency. 2.3 Real Exchange Rates Galindo (2006, p. 64) note that the real exchange rate can be distinguished from the nominal exchange rates since real exchange rates refers to the cost of foreign good relative to the cost of domestic products. It provides the required competitiveness in the market and it is necessary in explaining the behavior of trade and national income in a competitive global economy. The real exchange rate is usually volatile and it keeps varying based on various business environment factors (Ickes, 2004, p. 16). The big fluctuations in the real exchange rates could lead to improved welfare to an economy, though this is not always the case. The real exchange rate could be captured in this equation 1 below: Q = SP*/P where Q is the real exchange rate and S is the nominal exchange rate. P* is the price level in the foreign country while P is the price level in a domestic country (De Grauwe and Gunther, 2003, p. 296). The appreciation of a real exchange rate could indicate an increase of the price of a given bundle of goods in foreign price relative to the domestic price. The appreciation of the real exchange is an indicator that the real value of a foreign currency has depreciated thereby resulting in its reduced purchasing power. It is important to note that definition of the real exchange rate requires one to define the price levels. The GDP deflator or the CPI could be used to regulate the prices of commodities (Galindo, et al. 2006, p. 66). The changes of the real exchange rate could be caused by various factors (Milton and Schwartz, 1982, p. 211). To begin with, the changes could be cause by the change in the global relative demand for the foreign goods. This could be due to the shifts in the private demand towards the foreign goods. In order to restore equilibrium, the relative price for the foreign good must increase to domestic goods. Therefore, the real exchange rates must decrease and the foreign currency appreciate in real terms. Similarly, this could increase relative to foreign good (Ickes, 2004: 19). The other reason for the changes in the real exchange rate is the change in the relative output supply. Supposing that there is an increase in technology, which increases the efficiency of the output in the domestic economy relative to the foreign output, given enough stocks of capital and labor, the domestic output will increase (De Grauwe and Gunther, 2003, p. 308). Given that the global demand remains constant, there would be excess supply of the domestic commodities. This is because technology is a positive shock that impacts positively on the domestic economy. However, not all income generated is spent on the domestic products. Some of the income earned will be spent on foreign goods. Therefore, the increase in the demand for domestic products will be less than the supplied output. The restoration of the equilibrium requires that the relative prices for domestic commodities fall. Therefore, De Grauwe and Gunther (2003, p. 313) note that relative increase in productivity results in appreciation of the real exchange rate while the real value of the domestic currency will depreciate. Determinants of Real exchange rate Volatility a). Real Exchange Rates and Inflation Many authors including Dywer and Hafer (1999, p. 15) have noted Price increase as a factor that represents inflation. It may also be defined as the continuous loss of value of money. The increase in the prices should be continuous. In addition, a given commodity price should increase relative to other commodity prices. According to Makinen (2003, p. 73), inflation should continue for some time such as a week, a month or one year. Many countries have experienced drastic inflations in during different periods in history. One of the significant nations is the U.S., which has experienced high inflation over time especially since World War II (Kedia & Abon, 2003). Inflation can be caused by many factors with the most significant being the supply of money. For instance, the level of inflation in the U.S is closely linked to the increase in the money supply in the economy. Makinen (2003, p. 73) notes that an increase in the supply of money in an economy relative to the output in the economy could lead to inflationary pressure on prices of goods and services in the economy. It is believed that an increase in the supply of liquidity in the country could lead to increased amount of money used to purchase few available goods. Increased money supply therefore leads to increased demand for goods and services yet the amount of goods remains literally the same (Dywer and Hafer, 1999, p. 4). The Federal Reserve while in other countries, the central banks such as the European central bank (ECB), controls the level of liquidity in the U.S economy. As economists blame the Federal Reserve and central bank for inflation, the two provide different reasons for increased inflation in an economy (Eichengreen and Leblang, 2003, p. 812). It is believed that inflation in the U.S. is caused by other factors other than money supply such as activities that have a negative impact and upward pressure on prices. OPEC activities could also affect negatively the operations of firms in an economy leading to reduced productivity. Other activities that affect productivity negatively include fluctuations in the exchange rates such as a decline in the USD and crop failure (Milton and Schwartz, 1982, p. 346). These theories are mainly applied in the U.S. and UK economies (Galindo, et al. 2006, p. 73). For instance, the initial two causes of inflations as stated above are believed to be the causes of inflation in the U.S. especially after the II world war in which the Federal Reserve used to pump money in the economy to stimulate production and reduce unemployment while resulting to inflation. However, the last reason as explained above is entrenched among British economists who hold that inflation is not only caused by increased liquidity (Milton and Schwartz, 1982, p. 348). They attributed the inflation affecting UK over time to the money substitutes that cause inflation in the guise of credit. b) Interest Rates According to Desai et al. (2004), the differentials in the interest rates are sometimes used as a determinant of the real exchange rates due to the uncovered interest rate parity. There s high correlation between the interest rates, inflation and the exchange rates. While determined by the central bank and serving as a monetary policy instrument, interest rates influence inflation and exchange rates. The reason is that interest rates affect capital flows thereby leading to currency appreciation. c) Money Supply As noted by Scharfstein and Jeremy (2000), the real exchange rates are reactive to the monetary shocks in an economy that are similar to those put forward by the Dornbusch model. From this model, monetary shocks provide large fluctuations in the exchange rates, something called the overshooting effect. However, Ross (1986) argues that the nominal shocks have a neutral effect in the long run as compared to the short run. An increase in the supply of money could result in more depreciation of the exchange rate than its depreciation in the long run with the exchange said to be overshooting. The overshooting of the exchange rate is vital in understanding the reasons for the daily sharp movements of the exchange rates in the short term. d) The impact of growth in productivity on Real Exchange Rates According to Di Giovanni (2005, p. 289), a country that experiences rapid growth in productivity also experiences appreciation of the exchange rate. The basic element in all this discussion is the effect on wages. Let us define price level for the domestic economy as: The price law of one price implies that tradable goods can be expressed as: In order to maximize profits, the wages paid to workers must be equal to the marginal products of the country. This yields this equation: Therefore, or The implication of the above equation is that the ratio of foreign currency in the sector of tradable goods is equal to the ratio of marginal products in traded goods. Therefore, an increase in production results in the increase of tradable goods in the domestic country thereby leading to an increase in the wage rate of tradable goods (Ickes, 2004, p. 26). The connection of wages for tradables and non-tradable products in a given country requires us to equalize wages in order to attain equilibrium. Therefore, let and where an asterisk (*) denotes variables for the foreign country (Kaplan & Luigi, 1997). Applying conditions for maximization of profits for non-tradable goods yields this equation below. Or Considering productivity in non-tradable goods is the last step to relate growth with real exchange rates. It is assumed that increased production of non-tradable products is equal across all sectors. Therefore, let . Putting together all the above equations beginning with the real exchange rate will yield: Since , and , we substitute it into the equation of non-tradable products to obtain: From this last equation, it is clear that the real exchange rate depends on the ratio of marginal products of labor in the sector of tradable goods. Therefore, an increase in the marginal product of labor in the sector of tradable products in the foreign country relative to the domestic country leads to an appreciation of the real exchange rate (Hendricks, 1983). The growth rate of the real exchange rate can be obtained by taking logs of the above equation and differentiating it with respect to time (Edmond, 2008: 31). This yield: Therefore, high shares of non-tradable products imply that there will be a greater differential productivity growth on the change in the real exchange rate (Fried & Howitt, 1983). 2.1 Types of Exchange Rate Regimes As from the outgoing discussion, the exchange rate regimes are mainly three. We have the fixed exchange rate regime, the floating and the managed exchange regime. 2.1.1 Fixed Exchange Regime Kenen (2000, p. 122) argues that this regime was applied by most countries as indicated above in the third phase of exchange rates that occurred after the Second World War in 1946 and the 1973. The Breton Woods system as it was called enabled countries to peg their currencies on a given global major currency mainly the U.S. Dollar or a fixed amount of Gold (Brealey & Stewart, 1997). The pegged rate system broke down in 1973 as countries began adopting the flexible regime (Kenen, 2000, p. 122). The pegged system requires that the central bank, which the regulation of financial institutions in most countries to regulate the exchange rates. The central bank does this by announcing the fixed exchange rate for a country’s currency, which is given in terms of a major world currency such as the U.S. Dollar. According to Chinn and Hiro (2005, p. 306), most countries that maintain a pegged system believe that a fixed exchange rate is definite and stable, which therefore acts as an incentive to most investors who increase their investments and thereby facilitate trade and flow of investments among countries (Roberts, 2003). This reduces the fluctuations that are realized in relative commodity prices even as it increases certainty. To reduce the fluctuations and increase stability, most financial institutions across the globe have established ways through which organizations can hedge fluctuations in future exchange rates, although the pegged exchange rates still exist (Lau, n.d., p. 2). 2.1.3 Flexible Exchange Rate System Under the flexible exchange rate system the value of an existing currency of a given country is determined by the free hand in the market. The free hands talked about are the supply and demand quantities of the currencies in question (Bubula & Otker-Robe 2002 p. 17). This involves the many transactions undertaken by many banks in a given country or across the world and the activities of companies and other institutions that seek to buy or sell currency for their different purposes. Sometimes called the floating system, the demand and supply determine the level at which the currency will be exchanged in the global economy. A high demand for a currency given that all other factors are constant could result in increased value (appreciation) of the currency. On the contrary, reduced demand for a given currency could result in depreciation of the currency (Galindo, et al. 2006, p. 53). According to Darvas (2012, p. 69), a currency could also depreciate if the supply of the currency is more than the demand of the currency in the market. Contrary, the reduction of the supply of a currency could result in currency depreciation given that the demand could be greater than the supplied currency (Evans & Shawn, 1993). The equilibrium exchange rate under this system is obtained through the equity of the demanded and supplied currency in the market as well as the covered and the uncovered exchange rate parities. Most countries are utilizing the floating exchange rates especially since 1973 although some have pegged their currencies to major global currencies. As noted by Eichengreen and Leblang (2003, p. 799), most OECD countries have a flexible exchange rate system. The demand and supply of currencies is vital to the exchange rates theory and it is necessary to note that the changes in demand no longer affect the prices of the currency that is fixed. The price of a given currency may remain fixed only in the short run but not in the long run since many changes that may occur in the long run may affect the exchange rate (Deaton and Duprietz, 2011: 154). The difference between the fixed and the pegged exchange rate regimes is the existing tradeoff of continuous small changes and the small changes in the exchange rate for large changes that are discrete (Ickes, 2004, p. 12). Study Findings From the regression of the data, it was established that various factors affect the exchange rates. To begin with, findings from the regression of UK data shows that inflation explains 19.43% of volatility of the exchange rate, economic growth in terms of GDP explains 27.5% and the supply of money explains 16.16% of the volatility of exchange rates (Canas-Kriljenko & Habermeier, 2004). On the contrary, inflation has no significance on the exchange rate of Saudi Arabia given its low Multiple R of 0.0007. However, the exchange rate of Saudi Arabia is affected by the economic output of the country and the money supply in the country at the rate of 20.03% and 40.66%. The United Kingdom has a floating exchange rate regime in which the exchange rate of England is determined by the forces of demand and supply in UK (Bravo-Ortega & Di Giovanni, 2005). Table 1: Saudi Arabia Exchange rate vs. inflaltion SUMMARY OUTPUT Regression Statistics Multiple R 0.000774 R Square 5.99E-07 Adjusted R Square -0.03448 Standard Error 0.127047 Observations 31 ANOVA   df SS MS F Significance F Regression 1 2.81E-07 2.81E-07 1.74E-05 0.996702 Residual 29 0.468084 0.016141 Total 30 0.468084         Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 3.691891 0.025143 146.8375 3.35E-43 3.640469 3.743314 3.640469 3.743314 X Variable 1 3.44E-05 0.008245 0.004169 0.996702 -0.01683 0.016897 -0.01683 0.016897 SUMMARY OUTPUT Regression Statistics Multiple R 0.194313803 R Square 0.037757854 Adjusted R Square 0.004577091 Standard Error 0.073077975 Observations 31 ANOVA   df SS MS F Significance F Regression 1 0.006077 0.006077 1.137944 0.294888 Residual 29 0.154871 0.00534 Total 30 0.160948         Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% Intercept 0.622727934 0.018573 33.52846 9.54E-25 0.584742 0.660714 0.584742 0.660714 X Variable 1 -0.007230715 0.006778 -1.06674 0.294888 -0.02109 0.006632 -0.02109 0.006632 Table 2: UK Exchange rate against inflation On the contrary, Saudi Arabia has a fixed exchange rate regime that has led the country to have a fixed exchange for a long time (Caporale & Amor, 2009). Therefore, other factors are less likely to affect the volatility of the country’s exchange rate despite their variation as indicated by the findings. In summary, all factors that include the GDP, inflation, the supply of money and the regime of the inflation affect the exchange rate of a country. However, the other factors may have less impact on the volatility of the exchange rate given the utilization of a fixed exchange rate regime (Crowder & Wohar 1999). Capital Budgeting Firms aim at maximizing profits through minimization of costs so that they attain objectives of growth and expansion. Profitability enables organization to accumulate capital for expansion in lucrative projects (Finance, 2012). Once the domestic market is saturated, firms usually venture into other international markets by investing in lucrative projects. According to Baxter and Stockman (1988), after an organization identifies a prospective investment opportunity, it employs capital budgeting tools in order to establish the viability of the project. Capital budgeting techniques are significant to multinationals as they help the firms accomplish different tasks. Many firms are limited to borrowing funds in order to pursue their prospects despite issuing unlimited stock to its shareholders (Trahan & Lawrence, 1995). In some cases, firms have different projects that the firm has to choose only one. In such cases, the firm has to utilize capital budgeting techniques in order to determine the project viability (Fama & Gibbons, 1982). The most common tools employed by multinational firms include budgeting tools and tools that determine the viability of the projects such as NPV, IRR and the payback period among many. There has been increased debate whether the capital budgeting methods employed by firms are similar across big and small firms, different industries and countries. According to Aghion et al. (2006), though the techniques were developed for large multinational corporations, even small firms can utilize them. In cases where a small organization is considering investing in a given product line, it is difficult to estimate future cash flows directly based on the company’s past performance. In addition, the small firm operate son a small scale and it may not be cost effective for the firm to quantify the future demand of the new product and cash flows. For this reasons, capital budgeting techniques can be applied by both small and large corporations (Bleaney & Greenaway 2001). Capital budgeting techniques as used by different companies operating in different countries may have some differences from one country to another based on the level of technology and development of the countries. In a study conducted by Hermes et al. (2007) to establish different techniques used by different multinationals in China and Netherlands, 250 Dutch firms and 300 Chinese firms were surveyed. From their findings, it was established that managers of multinational firms in Netherlands utilized more sophisticated budgeting techniques when compared to their Chinese counterparts even though the difference is smaller than expected basing on the level of development of the two countries (Buckley l996, p. 106). A similar study was conducted by Leon Farah (2008) on budgeting techniques employed by Indonesian multinational companies. The study established that although the methods used are similar, the methods that different managers apply could be different and are determined by various factors (Marrewijk, 2012). To begin with is the education level of the manager whereby a highly educated manager will choose a highly sophisticated capital budgeting technique as compared to low educated manager. Similarly, small firms may choose less sophisticated technique as compared to a large corporation. Other factors are the type of industry and the annual capital investment set aside by the company (Broda, 2002). In another survey conducted by Ryan (2002), capital budgeting techniques were examined among the Fortune 1000 companies with the objective being establishing whether the methods differ. The study established that discounted techniques of capital budgeting are preferred by most multinational companies when compared to non-discounted techniques. The reasons for this could be increased use of sophisticated technology and inexpensive computer technology (Rajan & Luigi, 2003). The study also established that the present value is the most commonly utilized technique followed by the IRR. In addition, multinationals that have a large capital outlays usually prefer utilization of the NPV and IRR as compared to other techniques. Lastly, it is evident that the methods are applied by al multinationals regardless of the region of operation (Scott & William 1984). Challenges of capital Budgeting to Multinationals a) Parent vs. Project Cash Flows While evaluating the vitality of a given project, many multinationals are faced by the challenge of determining the cash flows to use. The cash flows in question are those that accrues to the parent company or those available for the project or utilization of both (Sharma, 2012). The competitiveness of an organization in its international subsidiaries is determined by the parent company cash flows. However, the parent firm is usually keen to establish the subsidiary project from the point of view of the net cash flows available to it since it depends on the earnings per share dividends (Summers, 1983). Multinationals can tackle this issue by simplifying the project evaluation through computation of cash flows from the project, evaluating the project with respect to the parent company. In addition, it is important for the firm to establish the incremental project flows in order to determine the true profitability of the project (Buljevich & Park, 1999). b) How to adjust for increased Political and Economic Risks Political and economic stability are fundamental factors for the success of multinationals. Political and economic risks affect the business. However, they can be factored into the project by shortening the payback period, increasing the required rate of return and adjusting the cash flows. These factors affect the exchange rate. However, the firm may convert nominal foreign cash flows into the domestic currency and discount domestic currency based on the domestic rate of return. Similarly, Coakley et al. 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