Treasury and Risk Management - Assignment Example

Treasury and Risk Management By Lecturer’s and QUESTION Foreign exchange risk and economic implications Foreign exchange risk refers to the risk of fluctuation with regards to an investment value mainly due to adjustments in the currency exchange rates. This form of risk mostly affects export and import businesses, as well as the investors making investments at the international level (HILDEBRAND, 1993). For instance, if money should be converted into another form of currency so as to make certain investments, any form of changes in terms of currency exchange rate can cause such an investment worth to either increase or decrease especially when it is sold and exchanged back to the initial currency. This form of funds can be termed as being subsidiary and the other fact remains that, multinational corporations are the major investments that are often affected by such foreign exchange risks and economic implications. Multinational corporations are firms that operate in more than one country. It is an enterprise that operates globally with several branches in different countries. The control of the activities and operations of these firms is done at the home country with subsidiary managers given fewer powers to make important decisions. Managers in Multinational Corporations get accessed to global knowledge and skills through training that are important for them in the process of carrying out their global duties. They are well trained in order to compete well in the global environment. These firms lead to transfer of knowledge and technology in several countries in the world especially a case where labour is recruited from the global environment (ENGEL, 2011). a) Foreign exchange risk and economic implications of a managed floating exchange rate system: A floating exchange rate refers to the countrys exchange rate system whereby its nature of currency is largely set by foreign-exchange institutions through demand and for that specific currency being more comparative to others. Thus, such kinds of exchange rates often transforms freely with the main determinants being the aspect of FOREX trading (BARTH & WONG, 1994).  There is often an overall claim regarding the aspect of floating exchange rates being more preferable to the fixed exchange rates. This is based on the fact that, floating exchange rates normally makes some automatic adjustments, hence enabling a given country or nation to dampen the effects of  foreign business cycles and shocks, and the aspect of pre-empting the greater possibility of resulting into a crisis regarding balance of payments (KLEIN & SHAMBAUGH, 2010). On the other hand they work towards engendering unpredictability due to their dynamism. The main argument for such a system is the element of allowing room for the importance of some of the monetary policies for other functions. Under a fixed rate, there is often a commitment of monetary policy towards a single objective of exchange rate maintenance at its proclaimed level. Yet again, exchange rate is majorly taken as the only macroeconomic variable amongst other that can be influenced with the monetary policy. This floating exchange rate system gives room for the monetary policy-makers to make free pursuance of other goals objectives that includes prices or employment stabilization. The free floating exchange rate system can be at a higher risk with regards to the international foreign exchange standing since it often experiences volatility increment. This perspective can result into serious nuisance, especially when it comes to emerging economies. A good example can be on the Multinational corporations found in Nigeria. The economic stability or the entire financial sector of this country is usually hampered with various conditions. Some of these conditions can be taken to include; high liability dollarization, financial fragility, as well as impacts of strong balance sheets. Denomination of liabilities in foreign currencies with assets being in local currency mostly leads to the unexpected exchange rate depreciations, bank deterioration and the aspect of commercial balance sheets, hence threatening the local financial system’s stability (DUTTAGUPTA & FERNANDEZ, et. al., 2005). Based on this, emerging countries with Nigeria being a good example, appears to be facing greater floating fear since they have smaller variations with regards to nominal exchange rates. So, they tend to face bigger interest rate, shocks, as well as reserve movements. This is hence the main consequence towards the exchange rate reactions of frequent free floating countries such as Nigeria. On the other hand, floating exchange rates tend to pose some notable threats. This exchange rate is not that stable compared to the fixed. When a currency is in that position or is revolving around that system, there are high chances of rapid depreciation or appreciation of value. This often works towards harming the countrys exports and imports. If the value of the currency increases drastically, the exports may become costly hence harming the employment rates of a given country (KATZ, 1975). In line with this, when the value of currency decreases drastically, the country may not be in a position of affording some of the crucial imports. This is often the reason why central bank intervenes so as to minimize harmful effects resulting from radical fluctuation. b) Foreign exchange risk and economic implications of a fixed exchange rate linked to a basket of currencies: A fixed or a pegged exchange rate refers to the exchange rate regime whereby the value of the currency is usually fixed either against another single currency’s value to a currencies’ basket or to the other value capacities (COSTAS KARFAKIS & DEMETRIOS MOSCHOS, 2004). There are risks and benefits towards a pre-set exchange rate usage. It is generally used for stabilizing the currency value through direct value fixation between a pre-set proportion to a different stable and an internationally established currency. Doing so often ensures that the exchange rate that thrives between the prevailing currency and its peg does not experience any transformation based on the prevailing market conditions. This hence makes investments and trade between these currency areas to be easier and a little bit more predictable. It is mostly useful for developing economies such as Turkey, whereby external trades forms a huge segment of the GDP. This exchange-rate structure can on the other hand be used as an ultimate means of controlling the currency’s behaviour, for instance through limitation of inflation rates. In doing so however, the fixed currency is thus controlled using its value of reference. So, when the value of reference falls or rises, it follows that the values of pegged currencies also fall and rise proportionally to other commodities and currencies with which such pegged currency is traded. Simply, a pegged or fixed currency usually depends on its value of reference in the verge of dictating how its worth can be regularly defined (BARTH & WONG, 1994).  With relation to the multinational corporation within Turkey, fixed exchange rates can be criticized to a greater extent based on its foreign exchange risks. There is a claim that they do not serve towards the adjustment of the trade balance. When there is an occurrence of a trade deficit within a floating exchange rate set-up, increased demand with regards to foreign currency will heighten the foreign currency price at the expense of domestic currency (HASSAN BOUGRINE & MARIO SECCARECCIA., 2004). In turn, this makes foreign goods’ prices to be less attractive towards domestic market pushing down the entire trade deficit. Under fixed or pegged exchange rates, such an automatic rebalancing cannot be expected to occur by any possible means. On the other hand, Governments including that of Turkey have to make huge resource investment in the verge of getting the pile up of foreign reserves so as to defend the fixed or pegged exchange rate. Moreover, when a government has got a fixed instead of dynamic rate of exchange, it cannot be in a good position of using either fiscal or monetary policies freely. For instance, use of reflationary tools to set up a rolling economy, the entire government risks falling into massive trade deficits. This may occur as the household purchasing power increases alongside inflation; hence making imports somewhat cheaper (AL YAHYAEI, 2011).  c) Foreign exchange risk and economic implications of a fixed exchange rate backed by a currency board system: A currency board refers to a fiscal authority that is needed for maintenance of fixed exchange rates with that of foreign currencies. This policy goal requires conventional central bank objectives to be subordinated towards the exchange rate target (HO, KENNETH TAT, 1998).  Adoption of a fixed rate of exchange as a main target can be marred with a number of consequences. The flat money model will no longer be issued by the currency board but instead it will only issue a unit of the local currency with regards to each foreign currency unit it has within its vault (CHAMP & FREEMAN, 2001). The ‘s surplus of such a country is hence reflected by much higher deposits that are held by the local banks at the central bank, and the initial deposits made by the exporting firms within local banks. So, growth of supply with regards to domestic money can hence be coupled to additional bank deposits at central bank. This system’s virtue is that; the issue of currency stability does not apply. The drawbacks relies on the basis that a country has little ability of setting up monetary policies with accordance to domestic considerations, and the fact that fixed rates of exchange can also fix a countrys trading terms, irrespective of the economic variations with its trading partners. A good example of a country that has attracted a number of multinational corporations is Estonia. Estonia had a currency board that was fixed to Deutsche Mark between 1992 and 1999 before it switched its fix towards Euro. The peg to Euro was hence upheld till January 2011. This policy is however seen as a stronghold of this countrys consequent economic success (CHACKO, 2006).  From all these discussions, it can be concluded that foreign exchange risk is indeed a fluctuation with regards to an investment value mainly due to adjustments in the currency exchange rates. That this forms of risks mostly affects export and import businesses, as well as the investors making investments at the international level. QUESTION 2 Purchasing Power Parity Purchasing power parity refers to a concept expresses the initiative that a package of goods and products in one country have to bear equal cost in another country especially after taking into account the aspect of exchange rates (LEE, 1976). For instance, supposing that with the existing relative exchange rates and prices, purchase of a bunch of goods in Canada can be done using few US dollars than in the US itself. Hence, there will be a high possibility that the US consumers would opt to buy such goods in Canada. Even if such strategy might not be that possible based on a transportation cost perspective, some of the business ventures will have the incentive of buying those goods in Canada at such cheaper prices so as to remarket them back in US. Such kind of actions would hence cause the Canadian dollars to be bought in exchange for the U.S. dollars (YAN, 2002). This will then result into massive depreciation of the U.S. dollar as compared to the Canadian dollar. The currency would hence be expected to continue depreciating until the point whereby those goods bears the same costs within both countries (TAYLOR & TAYLOR, 2004).  Purchasing power parity (PPP) has since been viewed as an element of some financial or economic concepts that is often used for determination of the relative worth of various currencies. Theories that brings into play the aspect of purchasing power parity often assume that in various circumstances such as the long-run tendency, it would exactly cost the same amount of maybe US dollars to purchase Euros (MANZUR, 2008). This is often before it proceeds towards buying a market bunch of goods and products as it would be costly to use such dollars for direct purchase of those goods. The purchasing power parity concept allows for the estimation of what the two currencies’ exchange rates would be such that the entire exchange can be at par with their outstanding purchasing power.  Using the Purchasing Power Parity rate for theoretical conversions of currency, a given quantity of a single currency has equivalent purchasing power regardless of whether it is directly used for purchasing goods market basket or for conversion to other currencies based on the prevailing PPP rate (KATSELI, 1979).  PPP exchange rates assist in minimizing some of the misleading international evaluations that can occur with the application of prevailing market exchange rates. For instance, supposing that two distinct countries produce similar physical quantities of goods for two preceding years, there shall occur a slight difference in one way or the other. Since there is a substantial fluctuation of market exchange rates a country’s GDP can be measured and its currency converted to other countrys mode of exchange by use of the prevailing exchange rates. Here, one country may be inferred as having higher GDP compared to the other within a single year, but much lesser in the other. Hence, these presumptions would definitely fail to reflect on the reality based on their relative production levels. But in a situation whereby a countrys GDP is entirely converted into the other Purchasing Power Parity exchange rates, false inference cannot be expected to occur (OFFICER, 1982).  The purchasing power parity rates of exchange serve two major functions. They can be used for making evaluations between various countries simply because they are fairly constant on both daily and weekly basis and can only adjust modestly on annual basis if at all. Secondly, exchange rates tend to shift in the universal direction with regards to PPP rates of exchange over a number of years, and hence some values towards knowing the direction in which the exchange rate seems to be in a more possibility of shifting into within the long run can be ascertained. Purchasing Power Parity exchange-rate mode of calculation can at times be controversial simply because of complexities of discovering comparable package of goods for the ultimate task of comparing the purchasing control across countries. The estimation of PPP is often intricate by the reality that most countries do not simply diverge in consistent price levels; but rather, the food prices difference might be even greater than the housing prices difference. People in various countries usually consume varying categories and quantities of goods. It is therefore deemed necessary to make comparison between the cost of goods and services baskets using the price index model. This task is somehow difficult because the purchasing patterns as well as the availability of goods for making such purchases tend to differ across various countries. Thus, it is essential to make some adjustments based on the quantity differences regarding the products and services. In addition, the representative of goods’ basket of a single economy tends to vary from the others (BERGIN, GLICK, R., et. al., 2009). For instance; the statistics shows that Americans consume more bread, while Chinese consume more rice. So, a PPP that is computed by use of the US consumption as a main basis will tend to differ from the one that is calculated using the Chinese basis. Additional statistical complexities come up with the multilateral evaluations especially when two or more countries are equally evaluated. Various modes of averaging the bilateral Purchasing Power Parities can offer a more steady multilateral evaluation, but at the expense of distorting the bilateral ones. However, PPPs are usually vigorous in the countenance of the numerous nuisances that might arise while using the market exchange rates for making cognitive comparisons. For instance, in the year 2005 the gasoline gallon within Saudi Arabia was priced at USD 0.91, while in Norway the same product was priced at USD 6.27 (ONG, 2003). The significant price difference would not actually contribute to the accuracy based on PPP analysis, in spite of all variables that can contribute towards the significant price difference. Interest rate parity  Interest rate parity refers to a no-arbitrage situation that represents a stable state whereby the investors are indifferent to the available interest rates based on the bank deposits between two distinct countries (MEREDITH & CHINN, 1998). The reality that this situation does not constantly hold gives room for potential chances of earning riskless returns from the covered interest arbitrage. The two assumptions that are central to the interest rate equivalence are perfect substitutability of both foreign and domestic assets, and the aspect of capital mobility. Given the market stability of foreign exchange, interest rate equivalence situation shows that the anticipated returns on the domestic assets equal the rate of exchange. Investors can then fail to earn the arbitrage profits through the act of borrowing within a country that is having a lower rate of interest, that is making foreign currency exchange, and making investments in foreign countries with higher rates of interest, due to losses or gains incurred from their domestic currency exchange at maturity (BEKAERT & WEI, et. al, 2002). So, Interest rate parity is generally taken to mean the sole idea that funds or money must earn equal return rates especially after cognitive risk adjustments. For example, suppose an investor has a possibility of earning an interest rate of 6% with every single deposit of a US dollar in the US bank, or maybe can earn a 4% interest based on the deposit of a British pound within a London-based bank; he/ she has to make the most appropriate decisions with the main basis on the interest rates. This is due to the fact that by keeping money in dollars, an investor can be in a better position of earning higher interests and hence, one may expect the flow of all his/her investment funds to the U.S. banks. Exchange rates expectations however have to come into consideration in one way or the other. Supposing the investor is expecting the appreciation of British pound at a constant rate of around 2% compared to the US dollar; such an investor would hence be in a good position either way since both will be expected to finally earn a 6% interest rate (MEIER, 1999).  Interest rate parity thus takes on some of the distinctive forms that includes; the covered and the uncovered interest rate parity. The uncovered interest rate parity has to do with the parity situation whereby exposure to the foreign exchange risk is often uninhibited, while the covered refers to the situation whereby a forward contract is used to cover the risks regarding the exchange rates (DAS GUPTA, 1994). Each kind of the parity situation indicates an exclusive correlation with the implications for future forecasting of exchange rates. Economists have since found some of the empirical evidence that is generally held by the covered interest rate parity, though it does not bear some precision mainly due to the impacts of various costs, taxation, risks, and the ultimate variations in liquidity (FLOOD & ROSE, 2001). When both uncovered and covered interest rate parity holds such a precision, they tend to expose a form of relationship that suggests that forward rate happens to be an unbiased forecaster of future spot rates. This kind of relationship can hence be employed in testing whether the uncovered interest rate parity also holds the same, for which mixed results were found. It simply bring out the fact that; when the purchasing power parity  and the uncovered interest rate parity clutch together, they tend to illuminate a form of relationship known as the real or actual interest rate parity (HOWARD & JOHNSON, 1983). This kind of parity suggests that the projected real interest rates signify the projected adjustments within the real exchange rate. This form of correlation usually holds strongly over much longer terms and conditions and amongst rising market countries. Reference List: AL YAHYAEI, Q. I. (2011). The relevancy of the US dollar peg to the economies of the Gulf Cooperation Council countries (GCC). University of Glasgow. http://theses.gla.ac.uk/2643/. BARTH, R. C., & WONG, C.-H. (1994). Approaches to exchange rate policy choices for developing and transition economies. http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=449410. BEKAERT, G., WEI, M., & XING, Y. (2002). Uncovered interest rate parity and the term structure. Cambridge, MA. National Bureau of Economic Research. BERGIN, P. R., GLICK, R., & WU, J.-L. (2009). The micro-macro disconnect of purchasing power parity. Cambridge, MA, National Bureau of Economic Research. http://papers.nber.org/papers/w15624. CHACKO, G. (2006). Financial instruments and markets: a casebook. Hoboken, NJ, J. Wiley & Sons. CHAMP, B., & FREEMAN, S. (2001). Modelling monetary economies. Cambridge [England], Cambridge University Press. http://site.ebrary.com/id/10005017. COSTAS KARFAKIS, & DEMETRIOS MOSCHOS. (2004). Predicting Currency Crises: Evidence from Two Transition Economies. Emerging Markets Finance and Trade. 40, 95-103. DAS GUPTA, D., & DAS GUPTA, B. (1994). Interest rates in open economies: real interest rate parity, exchange rates and country risk in industrial and developing countries. Washington, D.C., World Bank, East Asia and Pacific Region, DUTTAGUPTA, R., FERNANDEZ, G., & KARACADAG, C. 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Ottawa, Statistics Canada, Micro-Economic Analysis Division. Read More