International Finance and Management - Essay Example

International Finance and management Task Table of Contents Table of Contents 2 Executive Summary 3 Introduction 4 Risk in relation to changes in exchange rates 4 Causes and factors affecting foreign exchange rate risk 5 Methods of dealing with foreign exchange risk 7 The two methods 9 Reference List 10 Executive Summary International transactions are accompanied with various risks such as interest rate and exchange rate. The Constant fluctuation in the named items poses a huge risk for multinational companies. The factors influencing the volatility in the exchange rates are the interest rate, the rate of inflation, the forces of demand and supply, the levels of export and imports and the economic performance of a country. The exchange rate risks are classified into three categories, that is, the economic exposure, transactional exposure and translation exposure. The methods for managing the said exposures are forward contracts, money market contract, currency options, currency swaps, leading and lagging and choice of currency invoice. Lastly, a brief illustration on how to use the money market and forward contract is provided. Introduction Medco Ltd is a pharmaceutical company based in the U.K. the company deals in exports and imports of medicines throughout Europe. The nature of the company’s transaction presents a risk as a result of the fluctuation of the foreign exchange rates. The company is planning to invoice a customer in France for 500,000 euros, payable in six months. The company’s managing directors seek advice on whether to implement money market or forward contract hedging strategy. This essay presents the risks in relation to the changes in exchange rate, the causes and factors affecting foreign exchange rate risks, methods of dealing with the forex risks and a mathematical illustration to help the company’s managing directors decided between the two hedging strategies (money market and forward contract). Risk in relation to changes in exchange rates Foreign exchange is a market concept that means, converting currency of one country into that of another. Therefore, foreign exchange market is the market that hosts the currency conversion process (Baxter & Stockman 1989). The process of currency conversion depends on exchange rates. An exchange rate is the cost charged for converting the value of a country’s currency into the value of another. A spot exchange rate is the rate used in an instant currency conversion agreement between two or more parties (Dornbusch 1976). Spot exchange is carried out in a spot exchange market, which is part of the foreign exchange market. On the other hand, forward exchange rate is the rate agreed on today, to convert currencies at a future date specified in the agreement (Weithers 2011). The fluctuating exchange rate could present an unfavorable situation to a company if the local currency is rendered less valuable, (increased exchange rate), as compared to the value of the foreign currency. In that case, companies that face obligations to make payments to the foreign suppliers must spend more of the local currency for less of the foreign currency. This way, the local companies lose money due to the unfavorable exchange rate, thus, the cause of the risk (Dunnen 1985). Causes and factors affecting foreign exchange rate risk The foreign exchange rate fluctuation is caused and affected by some factors such as the rate of inflation, interest rate, demand, level of export and imports and the economic performance as measured by the GDP. First, the inflation- is a condition that involves a period of high commodity prices in a country. If the local products were more expensive than the foreign products, the local consumers would prefer the foreign products. This situation would lead to a high demand for foreign products, thus more export activities. The local country would pump more of its currency in the foreign exchange market in order to pay for the foreign products (Chowdhury & Sdogati 1993). A further increase in the supply of a local currency (increase in a foreign demand) leads to an automatic reduction of the local currency’s value. The cause of the reduction is the force of demand and supply. The reduction in the value of the local currency would lead to an increase in the exchange rate against between the local and the foreign denominations (Homaifar 2004). The increase in the exchange rate would be caused by the automatic devaluation of the local currency. Therefore, if the devaluation were projected to continue further into the future, the prices of currency, future contracts would be low (Siddaiah 2009). Second, the interest rates- the difference in the rate of interest between countries is one of the major causes of future price movements. If a country’s monetary authority decides to increase the money supply on an economy, the demand for the local goods would be higher than the supply, assuming that the production rate is constant. The increase in demand would lead to an increase in the prices of the local commodities. The effect would reduce the purchasing power of the local currency, thus the value would reduce (International Monetary Fund 1984). The purchasing power of a foreign currency would therefore be greater than that the local currency. These series of activities would eventually cause lower the price of the local currency. If the effect is projected to continue further into the future, the future currency prices would be lower too because the price of the underlying asset would be lower (Bilson & Marston 1984). Third, demand- just like commodity prices goes up when the demand is higher than the supply, currency prices are also affected in the same manner. If the demand for a particular currency in a future transaction is high, the price of that currency goes up. For instance, if the demand for US$ is higher for future transaction than any other denomination, the price of US$ against the other currencies would increase thus an increase in the future prices. A sharp fall in the demand for the same currency for the future would lower its price, thus the future price (Krueger 1983). Fourth, the level of exports and imports- a local country exports more products than the imports, it receives more foreign exchange. In the process, the foreign countries that consume the products will require the exporting country’s currency in order to make payments for the deliveries. The need to pay for deliveries will increase the demand for the local country’s currency. Due to the high demand, the price of the local country’s currency will increase against the foreign countries’ currencies. Therefore, the exchange, from the local country’s perspective will be low for the reason that the local currency has gained strength against the foreign currencies (Langley 2002). Conversely, if the local country imports more goods than it exports, the local country will need the exporter’s currency in order to make payments for the deliveries. The local country will, therefore, increase the supply of its currency in the foreign exchange market. A further increase in supply than demand will lower the price of the local currency, thus affects the exchange rate (Jongwanich 2006). Fifth, the economic performance- the economic performance of a country as measured by the gross domestic product influences the exchange rate. A country with a high gross domestic product experiences a high level of production. A country with a higher GDP has more products in the local market (Ho & Yuen 2003). A high supply of commodities causes a reduction in the commodity prices, thus a lower rate of inflation. Low inflation rate lowers the rate of interest. The value of the currency in countries with low inflation rate is higher as compared to the currency values of countries experiencing high rate of inflation (Itō 1996) Methods of dealing with foreign exchange risk The foreign exchange market provides a variety of services in the international finance arena. Among the available services are risk reduction strategy using the derivatives. The foreign exchange risks are classified into three categories, that is, economic exposure, transaction exposure and translation exposure (Whaley 2007). The economic exposure refers to the negative effects of exchange rate fluctuation on a company’s cash flow and earnings. This exposure majorly affects the value of a firm as measured by the present value of the cash flows. This type of risk can be hedged using the following methods: forward contracts and money market hedge. The forward market hedge, two or more parties agree to exchange currency at a pre-determined rate, but for a future transaction. The parties decide asset prices in two different markets (Butler 2012). That is, in the derivative market and the underlying asset market. Under normal situations it is believed that prices of underlying assets and those of their derivatives move in the opposite direction. Therefore, potential losses due to unfavorable movement in the currency prices can be offset by gains in the underlying assets (Siddaiah 2009). The money market hedge is a strategy that involves borrowing or lending to the money market. The borrowing strategy pertains an agreement involving a pre-determined exchange rate to be used in currency conversion. The pre-determined exchange rate is arrived at following a market analysis of the exchange rate movement. In this strategy, the pre-determined rate is to be applied regardless of the spot rate on contract maturity. Therefore, an unfavorable exchange rate movement would be mitigated by the application of the pre-determined rate. The borrower would pay less than he would have if the spot rate was used in currency conversion, thus mitigating losses (Machiraju 2002). Second, transaction exposure refers to the variability of s firms future cash flows from international trade-based transactions, borrowing and lending in foreign currencies. This type of risk can be managed using currency option and swaps. Currency option is a strategy that involves a right, but not an obligation to buy or sell a specified amount of currency at a pre-determined exchange rate for a future transaction. In a call option, the holder of the option (buyer) is entitled to premium payments to compensate for the unfavorable exchange rate movements until the maturity of the contract (Shamah 2004). When the contract matures, the option buyer has the right to decide whether to buy the option or not depending on the exchange rate. That is, the buyer can decline the option purchase if the spot rate reflects a devaluation of the currency of the option buyer. Currency swap is a strategy that involves the two parties exchanging either the principal or interest on loan, in one currency for another currency (Isard 1997). Third, the translation exposures are losses and gains arising when the financial statements of the a foreign subsidiary (expressed in foreign currency) are converted into the home currency. This type of risk can be managed using the currency of invoice and leading and lagging methods. Choice of currency invoice involves the local company invoicing the receipts in the local currency rather than foreign or vice versa, depending on the strength of the currencies between the involved countries. Leading and lagging strategy involves a firm leading (early payments/early receipts) in currency that is likely to appreciate/depreciate in value in the future or lagging (late payments/ receipts) in currency that is likely to depreciate / appreciate in the future. The two methods The money market method: borrow 500,000 € in France and receive a discounted value using the interest rate (cost of finance) = (500,000/1.01) = 495,050 €. Second, convert the euros to pound using the spot rate = (495,050/1.2834) = 385,733 £. Third, invest the amount in UK for six months = 385,733(1.04)^0.5 = 393,372 £. Fourth, convert into euros using the forward rate and make the payment = (393,372*1.2755) = 501,746 €. The forward market method: using the forward rate, 500,000 euros would be (500,000/1.2755) = 392,003 £. Therefore, Medco Ltd should consider using the money market hedge for the reason that the second method results in a loss of 1,369 £. Second, the future forward rate reflects a depreciation in the value of UK currency, thus presents a risk (Beenhakker 2001). Conclusion The following items have been discussed above: how the exchange rate risk comes about, the factors that influence the exchange rate risk, the methods used to manage the three types of exchange rate exposures and a decision on which exchange rate risk management method to be selected by Medco Ltd. Concerning Medco Ltd, money market hedge is more appropriate than the forward contract. Reference List Baxter, M., and A.C. Stockman 1989, “Business Cycles and the Exchange Rate System,” Journal of Monetary Economics, Vol. 23, pp. 377–400. Beenhakker, H. L 2001, The global economy and international financing. Westport, Conn. [u.a.], Quorum Books. Bilson, J. F. O., & MARSTON, R. C 1984, Exchange rate theory and practice. Chicago, University of Chicago Press. Butler, K. C 2012, Multinational finance: evaluating opportunities, costs, and risks of operations. Hoboken, NJ, Wiley. Chowdhury, A.R., and F. Sdogati 1993, “Purchasing Power Parity in the Major EMS Countries: The Role of Price and Exchange Rate Adjustment,” Journal of Macroeconomics, Vol. 15, pp. 25–45. Dornbusch, R 1976, “Expectations and Exchange Rate Dynamics,” Journal of Political Economy, Vol. 84, pp. 1161–76. Dunnen, E. D 1985, Instruments of money market and foreign exchange market policy in the Netherlands. 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