Managing Dollar Exchange Rate - Assignment Example

International Financial Management International Financial Management Managing Dollar Exchange Rate Firms exposed to foreign currency exchange should adopt exchange rate risk as an integral part of their decisions. Foreign currency exchange risk facing a firm is the exposure to probable financial losses because of foreign currency devaluation against the domestic currency (Madura, 2009). Thus, a firm involved in international transactions should adopt exchange rate measures to mitigate the financial losses that are likely to arise if the foreign exchange rates between the cross-border country currency and home currency fluctuates. SN is likely to experience the foreign exchange risk due to it cross-border transactions. Fluctuation of the exchange rates between the different currencies the firm transacts through has the potential of exposing the firm to financial losses. The major exposure risk the firm is likely to experience is the transaction risk that distorts the cash flows realized. This is due to the recent behavior of the US dollar against major international currencies. The US dollar has of recent been depreciating against Euro and pound currency. Thus, the cost of the purchases the firm makes using dollar has the potential of increasing when it is converted to Euros or pounds in determining the profit earned. Consequently, it is critical for the firm to undertake measures to manage the exchange rate risks to mitigate probable financial losses in future. Managing the exchange risk facing a firm engaged in cross-border trade requires the management to determine the exposure risks been faced, hedging strategies capable of mitigating the risk and the existing instruments that can be used to cushion the exchange risks. This is done by adopting hedging strategies that help in reducing or eliminating currency risks. A number of hedging options are available in managing the exposure risks the firm faces under it cross-border trade. One of the hedging methods that can be used in managing the exchange risk facing the firm is forward contract. Forward contract allows a firm to exchange foreign currencies at an agreed exchange rate in future (Levi, 2009). Consequently, SN can undertake a forward contract that will guarantee the exchange rate that will be used in exchanging the foreign currencies in future date. The pre-fixed exchange rate that will be used in converting the foreign or domestic currency will counter the exchange rate fluctuation since the firm will be shielded by the agreement from such exposure. This arrangement will allow the firm to convert the Euros or Pounds it is possessing to dollar currency at a pre-agreed rate when making the purchases in dollars in future. Thus, the depreciating trend of the dollar against the Euro and Pound will not affect the cash flow in determining the profit accrued from the trade. This hedging option is critical in eliminating the transaction exchange risk the firm is likely to face in determining the cash flow from the cross-border currency transactions when exchange rates fluctuates negatively. Another hedging strategy the firm can employ to manage the currency exchange rate risk is an option hedge. The option hedge gives the holder a right but not an obligation to exchange a specific amount of foreign currencies to a lender to be exchanged at a predetermined rate up to a specified date (Madura, 2009). This is advantageous for SN firm since it will not be under obligation to exchange the domestic currencies to foreign currencies in making purchases. Thus, if the foreign currency depreciates significantly, the firm will be cushioned by the agreement from suffering financial losses. In addition, if the foreign currency (dollar) appreciates before the expiry of the agreed period, the firm can exchange the Euros or Pounds currencies at the spot rate to attain more dollars to acquire more purchases (Cheol, Eun, & Resnick, 2011). Under the option hedge, SN firm will be able to mitigate the depreciating dollar effect on the price of the purchases when they are converted to home currency. This is because the firm will be able to acquire the inventories in dollar by exchanging the home currency at the pre-determined rate within the agreed period. Thus, the potential distortion of the cost of the purchases will be eliminated through this strategy. This will protect the firm from financial losses it is currently experiencing. Similarly, future contract is another hedging practice that can be used by the firm in managing exchange rate risk. This is an agreement to make currency exchange at a fixed rate in future (Brigham & Houston, 2009). Thus, the firm can enter into an agreement with a financial institution on the exchange rate that will be applied in exchanging the domestic currency to dollar when making purchases that are denominated in dollar currency. This will protect the firm from effects of the depreciating dollar that has the potential of increasing the cost of the purchases when they are converted to pounds to determine the profit generated. Currency swaps is another critical mitigation strategy that SN Corporation can utilize in managing the exchange risk exposure. A currency swap is a substitute of cash flows or interest of domestic currency for that of foreign currency (Madura & Fox, 2011). Under this strategy, a principal amount is exchanged at the commencement and conclusion of the swap agreement. SN firm in making the purchases may need to borrow money in a UK financial institution to be repaid back at a specified interest rate. Since the borrowed fund will be denominated in UK pounds, the firm will enter into a swap contract to exchange the fund received to a current amount of dollars (Carbaugh, 2013). The amount will be used in purchasing the inventories. This strategy will help in managing the exchange risk since the interest rate charged against the dollar principal will generate higher amounts when converted to sterling pound due to depreciating dollar to settle the pound loan interest. Consequently, the firm will be able to borrow funds in UK to make purchases in dollar denominated currencies without facing undue financial disadvantages. Risks of Investing In a Developing Country The decision to expand to investment operations in a developing country should be evaluated to measure the potential risks of the opportunity. Even though a developing country is an attractive destination for the company due it growing economy, it poses a number of risks for foreign investors. Consequently, an in-depth evaluation has been undertaken to investigate the corporate risks that will be faced by extending the SN operations to a developing country. One of the investment risks of extending to developing countries is the political and legal risk. Political instability in the developing countries is the major risk that has the potential of derailing or sabotaging the realization of returns from an investment (Ehrmann, Fratzscher, & Rigobon, 2011). This is because the political tension and violence that is experienced in developing countries makes operations of an organization to be limited due to lootings and safety of the employees. Consequently, the potential growth of the firm and its survival in the country is hindered due to political instability. Eruption of a civil war or disruption has the potential of hindering a foreign company from continuing it operations that will cause a huge capital investment loss (Cheol, Eun, & Resnick, 2011). Similarly, the evolving ethical and legal framework in developing countries makes foreign companies vulnerable to corrupt government agents. Accessing vital licensing documents to start operation or acquire necessary inputs from corrupt government agents will force the firm to give bribes (Amiti & Weinstein, 2011). This has the potential of hurting the financial condition of the foreign investment since it will be forced to incur undue costs to operate that erodes the returns accumulated. Furthermore, uncertainty on the tax policy and laws of the developing country has the potential of causing financial losses. The ever changing corporate tax laws and policies in developing countries hinder foreign firms from making accurate cash flow forecasts. Thus, it is difficult to estimate the profitability of an investment in a developing country due to uncertain measurement of cash flows. Another major political and legal risk of investing in a developing country is the protectionist sentiments by the governments. The risk of the governments in developing countries in nationalizing or imposing punitive measures on multinational corporations to protect indigenous firms has the potential of causing foreign firms operating in developing countries from losing their capital investment (Cheol, Eun, & Resnick, 2011). This has been experienced in a number of foreign firms that have extended their operations in developing economies of Africa. Social and cultural risk is another type of risk that a foreign firm intending to extend it operation in a developing country is likely to face. Owing to the conservative population of the developing countries, social and cultural norms are highly preserved (Siegel, Licht, & Schwartz, 2011). Thus, a foreign firm extending it operation in the country risks from been isolated if the population feels it trading or products are against their culture and social structure. This implies that a foreign firm may engage in an advertisement that is appreciated in the home country but has a different meaning in the foreign country due to the conservative nature of the other country. Thus, activities of a foreign firm have the potential of prompting unrest in the foreign country when the management had no ill motive. Furthermore, employees of foreign firms investing in developing countries face the risk of social discrimination due to their different social behaviors and perception. This has the potential of hindering the firm from penetrating the market adequately to realize the optimal benefit of investing in the country (Brigham & Houston, 2009). Consequently, a foreign firm extending it operations in a developing country faces the potential of suffering financial losses due to cultural and social risks. Another risk of investing in a developing country is the operational and environmental risks of infrastructure failure and technology (Wincoop, 2012). Power supply and telecommunication services in the developing countries are highly unreliable due to frequent interruptions. These are critical amenities that a business organization will require to efficiently undertake it operation in realizing optimal return. Thus, the frequent disruption of the telecommunication and power supply hinders multinational corporations from operating at optimal capacity. This causes the firms to lose financially due to inefficient allocation of resources such as labor (Cheol, Eun, & Resnick, 2011). Similarly, environmental risk factors of technology, infrastructure and access, and agents hurt the operations of foreign firm operating in developing countries. Technology advancement in developing economies is limited compared to developed economies. Thus, the ability of the firms in minimizing the cost of operation by employing advanced technologies is highly constrained. Similarly, the infrastructure development and access to the available infrastructure in developing countries is highly constrained (Levi, 2009). Thus, transporting goods and raw materials to the market is costly. Similarly, availability of skilled and experienced labor for managerial functions in developing country is a major problem for multinational corporations. Lack of capable labor in developing countries forces multinational firms to source it managerial staff from home countries that is expensive to maintain (Moyer, 2012). This hinders multinational firms from realizing potential returns of the capital invested. Forecasting Exchange Rate Movement The movement of the dollar and Euro in the recent times should not be merely used in determining the future value of both currencies. Forecasting the exchange rates of the two currencies is critical since it helps in evaluating the cash flows SN firm will experience in it future transactions. This is critical for the organization in evaluating the risks and benefits of transacting it operations using two different currencies in future. Forecasting the exchange rate of the two currencies should be undertaken using three major approaches namely fundamental approach, market sentiment assessment and technical approach. However, it is difficult to determine the precise and accurate approach to determine the exchange rates movements in future. This is because exchange rate movements in the foreign exchange market depend on simultaneous relations of diverse factors (Ajami, 2009). Thus, it is difficult to predict or quantify how the various factors manipulate each other and the way they manipulate movement of exchange rates. Fundamental forecasting approach predicts the future exchange rates through evaluation of main macroeconomic variables influence on exchange markets. Fundamental approach of forecasting exchange rate employs an extensive collection of data called essential economic variables that are capable of determining the exchange rate (Khan & Jain, 2010). These economic variables are derived from economic models. The variables that are commonly included in the fundamental approach include trade balance, GNP, productivity indexes, unemployment, inflation rates, and interest rates. Consequently, fundamental approach of forecasting exchange rates is founded on the structural models. The structural models are modified to cater for the statistical distinctiveness of the collected data. It is the structural model that is used in generating the equilibrium exchange rate under the fundamental forecasting approach. The variables collected are quantified by employing inclusive models that allow relationships of different factors through use of statistical techniques like regression analysis (Carbaugh, 2013). However, this approach faces the weakness to measure events capable of influencing exchange rate and the space between happening of the events and influence on exchange rates. This is because it is difficult to get the most recent data in making quantitative estimates precisely. Furthermore, the analysis fails to consider other non-tangible and noneconomic factors like investors’ fear, market speculation, political events and market sentiments that carry vast pressure on exchange rates (Bekaert & Hodrick, 2011). Technical forecasting approach on the other hand, employs past data on exchange rates in developing charts and quantitative models to forecast exchange rates in future. Thus, historical patterns of exchange rate progress are used in attempt to come up with a future pattern under technical forecasting approach (Siddaiah, 2009). Consequently, technical forecasting approach highly depends on perception and personal view than critical economic analysis. However, some technical approaches accommodate economic techniques in forecasting exchange rates. Thus, different levels of influence on the different variables utilized are assigned in determining the upcoming exchange rates movement. Market sentiment assessment assesses the spot and forward rate of the currencies reflected in predicting the movement of exchange rates. Under this approach, exchange rate will move up than expected level when the forward and spot rates are predicted to appreciate since speculators will put buying pressure (Moyer, 2012). Consequently, the prevailing forward and spot rates are generalized as actual realized future currency movement expectations. Accordingly, the various forecasting techniques of exchange rates show no approach is optimally superior to the rest. The optimal strategy the firm should use to predict the future movement of the exchange rates by integrating the various approaches. A broad-based and comprehensive view should be adopted in tracking the movement of the two currencies in order to employ the optimal hedging practice. This will help the organization in cushioning itself from foreign exchange risks in future operations. Reference Ajami, R. A. (2009). International business: Theory and practice. Armonk, N.Y: M.E. Sharpe. Amiti, M., & Weinstein, D. E. (2011). Exports and Financial Shocks. 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