Economics of exchange rates - Essay Example

Case Questions Case Questions The trends for the foreign exchange indicate that XJP lost 60 million Renminbi in 2003 and other 70 million in 2004 (Moffett, Stonehill & Eiteman, 2008, p. 253). Foreign exchange gains and losses have a significant impact for XJP’s corporate performance, since it fully depends on how the foreign currencies behave towards each other to make its profits or suffer losses. Operating under such a business scenario is too risky for any business. This is because, regardless of how much sales a business makes, and regardless of how much a business tries to minimize its costs and expenditures, it will always find itself on the receiving end, where its performance is not dependent on its efficiency or effectiveness but rather on the behavior of the foreign exchange markets (Sarno & Taylor, 2005, p. 83). XJP receives virtually all its supplies directly from J&J Ltd, which, in turn, invoices all the costs and expenditures in Euros. On the contrary, XJP makes its sales in Chinese Renminbi. Therefore, it has to convert the income made from the sales from the Chinese currency into the Euros so that it can submit its payment to J&J Ltd. This means that the amount XJP pays to J&J is not solely dependent on the value of the supplies it receives from this company, but also on the rate at which the Chinese currency exchanges for the Euro. This system is too risky for a business, since when Euro gains value over the Renminbi, the difference in that gain becomes an extra cost for the XJP to meet (Coyle, 2000, p. 40). The situation becomes worse, if the rate of exchange keeps fluctuating from time to time, since the business cannot make any strategies for profit or even plan to grow its profits. Therefore, the foreign exchange gains or losses primarily determine the performance of XJP, contrary to the normal business situation, where the performance of any business is determined by the sales and revenues it generates in relation to the costs it incurs in its operations (Kenen, 1994, p. 663). Where there is a financial gain for the local currency (Chinese Renminbi), which would occur in a situation where the exchange rate for the Euro drops, then XJP is in a better position to improve its performance and profits, since it will cover its expenditures at a lower cost. However, if the foreign currency gains over the local currency, XJP will be forced to pay the cost of supplies at higher costs. This will in turn reduce its profit margin (Moffett, Stonehill & Eiteman, 2008, p. 254). Therefore, system through which XJP and J&J structure and manage their currency exposure is not suitable for the business, since it influences their performance and growth negatively. This is because, even when they apply suitable strategies to grow their business and increase their profitability, it is not possible to achieve their targets, since the target will always depend on the exchange rates (Sarno & Taylor, 2005, p. 90). Therefore, the most suitable way for them to structure their business is employ a system that allows XJP to purchase and pay for its supplies using the local currency. This will serve to remove the uncertainty involved in the operation of the foreign currency markets, making it possible for the business to Strategize on improving its profitability and consequently achieving the desired growth (Coyle, 2000, p. 41). Case Question 2: The situation in which XJP finds itself is very different from that of other foreign subsidiaries owned by J&J worldwide. This is because, while the other foreign subsidiaries are decentralized, allowing them to take responsibility of their own structure from top to bottom, the case is different for XJP. The organizational structure of XJP is characterized by a lot of control from its parent company. Thus, XJP is not capable for planning and procuring its own supplies, inclusive of the raw material, but instead depends on J&J to supply it accordingly (Moffett, Stonehill & Eiteman, 2008, p. 255). This arrangement might be beneficial for enhancing effective management of the subsidiary company by the parent company. However, such an organizational structure is detrimental, since it hinders the parent company from undertaking its own independent operations, which could be economical (Evans, 2011, p. 65). Where the other foreign subsidiary companies are allowed to run their operations through a decentralized organizational structure, they are in a good position to purchase for their supplies and materials locally and pay for them using the local currency. This goes a long way in mitigating the risks of dealing with payments in foreign currency, where the business is exposed to the risks of exchange rate fluctuations, and left at the mercy of the foreign markets operations (Sarno & Taylor, 2005, p. 88). Therefore, the situation of XJP is different, since its performance is fully dependent on the operations of the foreign markets and the fluctuations of the foreign currency exchange rates. This prevents it from planning for its profits growth effectively. Case Question 3: The relationship between these forms of exchange rates and the expectations for the Chinese subsidiary’s financial results by the US parent company is that all the exchange rates should tally or just vary to a lesser extent. This is because, the US parent company expects that the forward exchange rate and the budgeted exchange rate, which are future values, to equal the spot exchange rate of a future particular time, to avoid higher financial disparities. Therefore, the parent company expects that the forecasts and predictions applied to determine the future rates will be accurate and have a high degree of precision. Spot exchange refers to the exchange rate at which two parties involved in an exchange system agrees to trade their currencies, at a particular time (Coyle, 2000, p. 49). Spot exchange rate does not differ very much from the current market rate, since it refers to the exchange rate applicable to real-time transactions, which does not have a bearing on the future (Coyle, 2000, p. 51). On the other hand, a forward exchange rate refers to a future rate applicable for undertaking currency transactions, agreed by parties involved, in advance (Sarno & Taylor, 2005, p. 85). This means that a forward exchange rate fixes a future rate at which two currencies will be exchanged by the parties involved, based on the current rates and the future predictions (Evans, 2011, p. 64). Budgeted spot exchange rate refers to the predicted exchange rate that will be applicable for exchanging two currencies at a certain future date (Sarno & Taylor, 2005, p. 86). Contrary to the spot and the forward exchange rates which are fixed though a contractual agreement between two parties, budgeted spot exchange rate is the initiative of a single entity, planning for the possible exchange rate that will be applicable between two currencies, based on the current rate and the observed trends (Coyle, 2000, p. 52). References Coyle, B. (2000). Foreign exchange markets. Kent, England, Financial World Pub. Evans, M. D. D. (2011). Exchange-rate dynamics. Princeton, Princeton University Press. Moffett, M. H., Stonehill, A. I., & Eiteman, D. K. (2008). Fundamentals of multinational finance. Boston, Pearson Addison Wesley. Sarno, l., & Taylor, M. P. (2005). The economics of exchange rates. Cambridge University Press. Read More