Exchange risk - Research Paper Example

Finance and accounting [Insert al Affiliation] Table of Contents Introduction 3 2.Country A (United s) 3 2 Possible foreign exchange risk 3 2.2.Economic implications of foreign exchange 4 2.3.Managed floating exchange rate 5 3.Country B (United Kingdom) 6 3.1.Possible foreign exchange risk 6 3.2.Economic implications 7 4.Country C (Argentina) 7 4.1.Foreign exchange risk 8 4.2.Economic implications 8 5.Purchasing power parity 9 5.1.How purchasing power parity is calculated 10 5.2.Why purchasing power parity is good 11 6.Interest rate parity 11 6.1.Assumptions of interest rate parity 12 6.2.Uncovered interest rate parity 13 6.3.Covered interest rate parity 13 6.4.Why interest rate parity is good 13 7.Conclusion 14 8.Bibliography 15 1. Introduction Multinational company is a firm that has its assets and other facilities in at least one other country other than the home country. Such companies have factories or offices in different countries and do have a centralized head office where they perform a global management. In economic world, such companies are faced with a number of impediments to their effective operations, income generation, and shareholders wealth maximization. The paper examines the following: possible foreign exchange risks that multinational companies’ face and the economic implications of such hazards. The paper additionally discusses the available strategies for mitigating such risks as the purchasing power parity and interest rate parity. 2. Country A (United States) The country has a number of multinational companies. Some of them include coca cola, Accenture, Intel, Kimberly-Clark and Marriott companies. These companies have their goods and services in United States and other countries such as Mexico, Venezuela, Colombia, Chile and United Kingdom. 2.1. Possible foreign exchange risk Foreign exchange risk is the risk that investments or rather an assets, goods and services dominated in foreign currency will lose the value as a result of unfavorable movements in the exchange rates between the foreign currency and domestic currency affecting the product or service in question (Isard, 2006). It also means the practice of buying and selling one currency for another. The process can occur in two ways that is in forward market where transactions are contractually scheduled to occur under certain terms and conditions at some time in future or spot rate where purchase and delivery take place in a span of two days. The risk affects the business of importing /exporting and investors who make international investment decisions. A practical example is when money is converted to another country to make an individual investment, and then an adverse change in the exchange rate will cause such an investment to be unfavorable when the investment is sold and converted back to domestic currency. The foreign exchange risks that are borne include interest rate risk, country risk, and exchange rate risk. Interest rate risk that result from the difference in interest rates between countries for example Intel borrows dollars where the foreign lending interest rate is 6% while local interest rate is 4%. This disparity arises due to inflation rates and differences in liquidity of financial markets and lending risks (Harvey & Jenkins, 2009). Country risk occurs mainly due to adverse political situations and economic trends hence effect to the exchange rates (Nagy, 2009). The exchange rate risk occurs when there are changes in the currency rates. The loss is incurred as a result of the change in the money value. 2.2. Economic implications of foreign exchange Foreign exchange rates have an impact on the economic society as discussed. Low exchange rates are a signal to the recession economic period and consequent political instability. Conversely, substantial rates of exchange are a sign of stable commercial conditions for a country. The exchange rates directly affect the international trade. For instance, low exchange rate support activities like tourism and exports in the economy (Howell & PRS Group, 2011). At this point, domestic goods become inexpensive for the foreign buyers. However, local customers prefer high exchange rates as they have an enormous purchasing power to pay out on imported goods. Additionally, foreign currency rates have an effect on investment funds that either move in or out of an economy. The countries that have fluctuating currency are less attractive to investors from overseas. This because all investors are assumed to be risk averse and, therefore, like returns and dislike losses. At this time, foreigners liquidate their real estates, stocks, and bonds just because such derivatives are losing purchasing power to rival investments in other countries. Foreign investors prefer making financial investments when they think that price in them will be conserved as international profits are ultimately converted back to their domestic currency. The foreign exchange rate leads to an economic growth: it is true that the higher the price of the net exports, the higher the nation Gross domestic product. The country’s GDP is given as C+I+G+(X-M) Where C = consumer spending, C= capital, I= investment by the businesses and households, G= government spending and (X-M) = net exports. Interest rates: a domestic currency exerts a drag on the economy hence achieving a tighter monetary policy that is higher interest rates. Extra tightening of the monetary policy, when the local currency is already unjustifiably strong may intensify the problem by drawing more hot money from investors who look for higher yielding investments available in an economy. 2.3. Managed floating exchange rate The managed float rule is the current international financial environment whereby exchange rates change from day to day but the central bank endeavor to manipulate their countries’ exchange rates by buying and selling currencies. Country A has a well managed floating exchange rate that is a role of the central bank. Furthermore, the country has fixed exchange rate that is linked to a basket of currencies and fixed exchange rate that is backed by a currency board system. 3. Country B (United Kingdom) The country has several multinational companies that produce and export their goods and services to foreign countries for profit generation and the consequent increase in the shareholders wealth. Some of the multinational firms in this country include quintiles, Atento, Coca-cola, Roche Accenture, Marriot and Novo Nordisk companies. 3.1. Possible foreign exchange risk From economic perspective, foreign exchange is the trading process of using one currency for another. In the normal business operations of these companies, they face foreign exchange risk hence leading to the occurrence of losses on their products and services (Floyd, 2010). This mainly happens when there is an unfavorable movement in the foreign exchange rates. Some of the risks that are always anticipated include interest rate risk, country risk, and exchange rate risk. Interest rate risk is the possibility of multinational companies to pay more interest rate on the principal amount that had been advanced to then due to the increase in the interest rates (Nawalkha & Beliaeva, 2005). The causes of this increase in the interest rate can be inflation, political instability, and war. These effects consequently cause the companies in question to have a poor financial health and bankruptcy. Exchange rate risk: This risk that arises unexpectedly due to certain changes in the currency rates. In a scenario where one company in the domestic country lends money to another foreign company, the risk will arise due to the change in the currency of the funds that have been advanced to the foreign company. The risk will be borne because the time the funds were lent out and the time when the finance is being paid back, the exchange rates between the two countries would probably have changed. Country risk: this is the danger of investing in another country. The risk depends on the changes in the business environment that may unfavorably affect the profits or assets value of a particular country (Mayer, 2009). 3.2. Economic implications A drop in the real price of a currency makes the exports of the company cheap and the imports to be more expensive hence leading to the fall in the economic growth. In the case of an appreciation of the domestic currency, the exporting companies either keep the prices constant and lose the sales or make an adjustment of the foreign exchange prices to maintain market share (Friedman & Roosa, 2007). The unexpected currency fluctuations of a company future cash flows and market values affect the competitive position of such company in the market. The country has a managed floating rate that is monetary policy used by the central bank for buying and selling securities, fixed exchange rate that is linked to a basket of currencies to prevent adverse effects of unfavourable movements of currency prices and fixed exchange rate that is backed by a currency board system for currency stability for long-run. 4. Country C (Argentina) The country has a number of multinational companies such as Accenture, Coca-cola, Telefonica and Intel that sell their products and services overseas. 4.1. Foreign exchange risk The foreign exchange risk that the country faces includes the country, foreign exchange rates, and interest rates risks. Country risk arises when the companies that invest in foreign countries incur losses on their business operations due to political instability, war and other unfavorable economic conditions that exist in the foreign country. Interest rate risk arises when companies pay more interest that accrues on the principal amount that is borrowed by them. This causes such funds to be more expensive to be acquired as they lead to financial distress of such companies (Miller, 2014). Foreign exchange rates risk: the risk arises when there is an occurrence of unfavorable movement of the foreign exchange rates hence causing losses on the currencies when transferred into their domestic currency. 4.2. Economic implications An appreciation of the domestic currency causes the exports to be more expensive while the imports being cheaper hence creating a deficit in the balance of trade of a country. When the exports become more than the imports, the net exports increases and consequently leading to the rise in the Gross domestic product of a country. The country has a managed floating rate that is used by the central bank to buy and sell securities, fixed exchange rate that is linked to a basket of currencies and fixed exchange rate that is backed by a currency board system (Katz, 2007). 5. Purchasing power parity Purchasing power parity is one of the economic theories that whose aim is to determine the adjustments needed to be made in rates of exchange between two currencies to make them be the same with purchasing power of each other’s currency (Manzur, 2008). The theory too, states that the amount of spent on a particular product should be the same in the two currencies when an account on exchange rate is made. This, therefore, shows that the rate of exchange between the two countries must be equal to the ratio of the respective price level of fixed goods and services bundles between the two nations. In an economic period of inflation where a country experiences increase in domestic price level, the exchange rate of the same country need to be depreciated in respect to other currency in order to return to purchasing power parity (Lee, 2006). The purchasing power parity is used in the majority of the countries worldwide to compare the different levels of income. The importance of purchasing power parity is the rule of the same price. In a situation where there is neither transaction nor transport costs, the markets will make equal to the good price in two countries when prices are articulated in the similar currency. For example, a particular home theater whose selling price is 800 Canadian Dollar in Vancouver should cost 400 US Dollars in Seattle when the exchange rate between the two countries is 2 CAD/USD. If the price of home theater in Vancouver were 750 CAD, then consumers in Seattle would prefer buying the device in Vancouver because it seems to be cheaper (Dornbusch, 2008). However, if this happens when the arbitrage process is carried out on large scale, United States customers that buy a Canadian product will bid up the value of the Canadian dollar, hence this will make Canadian Products more expensive than those of then. This process will continue until the time when the goods have the same price. In purchasing power parity, there are three caveats to the rule of one price. Firstly transport cost that is a barrier to the trade and other transaction costs. The second is that there must be goods and services in a competitive market for two countries. Thirdly, the rule of one price applies only to goods that are traded, immovable goods like plants and a number of services that are local and not traded between the two countries. In economic world, there are two versions of purchasing power parity that are used namely: absolute purchasing power parity and relative purchasing power parity. Absolute purchasing power parity refers to the equalization of price levels in many countries. On the other hand, relative purchasing power parity refers to changes rates of price levels i.e. inflation rates (Officer, 2011).This proposal states that the rate of appreciation of a currency should be equal to the difference in the rates of increase between the home country and the foreign country. For example, if US have an inflation rate of 2% and Canada has an inflation rate of 3%, the Canada dollar will have to depreciate against the US Dollar by 1% per year. The suggestion holds well empirically particularly when inflation variances are significant. 5.1. How purchasing power parity is calculated The PPP is calculated by comparing the price of the standard good that is identical between the two countries. Economists on a yearly basis do publish light-hearted version of purchasing power parity called Hamburger Index that compares prices of various standard products in the world (Ong, 2013). There are other sophisticated versions of purchasing power parity that look at large number of goods and services. One problem that is borne is that consumers in different countries consume various products and services hence making it difficult to make a comparison of purchasing power parity between the countries. 5.2. Why purchasing power parity is good Purchasing power parity helps the economist to determine the trends of exchange rate, in the long run. It is a tool that is used to make a comparison of economic performance and the positions of respective countries. This happens because the purchasing power parity is not subject to vices like fluctuations and normally changes over years. It is used in most of the developing countries to measure and compare the market conditions among different countries. 6. Interest rate parity It is one of the economic theories that postulate that interest rate differential between any two countries is equal to the difference amid the forward exchange rate and the spot exchange rate. The interest rate parity plays a significant role in foreign exchange markets that connect interest rates, the foreign exchange rates, and spot exchange rates. The theory argues that the distinction between risk-free interest rates that are offered for dissimilar types of currencies establish the rate at which these currencies can be transformed to each other in a forward transaction (Moosa & Bhatti 2010). The interest rate disparities amid two unlike currencies will be reproduced in the premium or rather discount at the forward exchange rate on foreign currency in case there is no arbitrage, the business of buying currency or shares in one financial institution and selling in another financial market at a profit. Given the equilibrium in foreign exchange market, the interest rate parity states that expected return on home assets will be equal to the exchange rate that is adjusted for foreign currency assets. It should be noted that investors would not earn arbitrage profits by borrowing in a foreign country that has a low-interest rate, hence exchanging for the foreign currency while investing in a country with high-interest rate. This is due to the losses or gains that are made after exchanging domestic currency at maturity. There are two forms that interest rate parity takes which are: covered interest parity and uncovered interest rate parity. Covered interest rate parity is where forward contract has been used to cover up exchange rate risk whereas uncovered is the situation where exposure to foreign exchange risk is unconstrained (Bhasin, 2006). Every form of parity condition exhibits a distinctive relationship with inferences for the forecasting of the prospect exchange rates that is the spot rate and the future rates. Economists found empirical evidence that covered interest rate parity. However, the evidence was affected by effects of taxation, costs, and liquidity differences. In a circumstance where both covered and uncovered interest rate parity clutch, they expose a relationship that suggests that the forward rate is an unbiased predictor of the future spot rate. The relationship can be used to test if uncovered interest rate parity holds, the test raised consequences. Where uncovered interest rate parity and the purchasing power parity hold jointly, they clarify an association by the name real interest rate parity, suggesting that expected real interest rates represent the expected adjustments in real exchange rates. The relationship holds for a long time and strongly among emerging market countries. 6.1. Assumptions of interest rate parity The interest rate parity has a number of axioms: the capital is mobile, and investors can quickly exchange their domestic assets and foreign assets. Additionally, the assets do have ideal substitutability following their riskiness and liquidity similarities. Given that capital is mobile and can be substituted correctly, the investors are expected hold assets that offer greater returns either foreign or domestic assets (Sarno & Taylor, 2009). Investors hold both national and foreign assets, and therefore it is true that there is no difference that exists between returns on foreign and local assets. This means that an investor on either side of national or foreign will expect to earn equivalent returns from any investment decision. 6.2. Uncovered interest rate parity It is when no-arbitrage condition is fulfilled lacking the use of the forward contract to prevent the occurrence of exchange rate risk. The investors who are neutral about the available risks will be indifferent to the interest rates that are available between the two countries. This because the rate of exchange between the respective countries need to be adjusted accordingly so that the return on dollar that are deposited is equal to the euro deposits dollar returns hence eliminating the possibility for exposed interest arbitrage proceeds. It helps to explain how spot exchange rate is determined. 6.3. Covered interest rate parity It is when no-arbitrage condition is fulfilled with the use of the forward contract to prevent the occurrence of exchange rate risk. Neutral investors will be indifferent of the available interest rates available between the two countries (Bhasin, 2006). This is because forward exchange rate sustains the equilibrium such that dollar return on dollar deposit and that of foreign deposit are equal hence getting rid of probably covered interest arbitrage earnings. 6.4. Why interest rate parity is good It is the best way to determine exchange rate values and explain how they fluctuate in the market. It helps in reduction of exchange rate risks through forward contracts by hedging hence giving confidence the parties to the contract to transact efficiently. It helps the investors to make sound investment decisions before they make a point of investing in either domestic or foreign countries. 7. Conclusion In a nutshell, it is clear that most of the multinational companies face a number of risks that affects their normal business operations. They are adversely affected by the foreign exchange risks leading to them operating at a loss hence bankruptcy. However, the managers of multinational companies in question must formulate strategies that will help to curb such risks and to attract investors consequently for investment purposes. The managers are advised to employ Purchasing power parity, and interest rate parity is the most efficient methods that can be used to mitigate such risks. 8. Bibliography Bhasin, V. K. (2006). Dynamic inter-links among the exchange rate, price level, and terms of trade in a managed floating exchange rate system: The case of Ghana. Nairobi: African Economic Research Consortium. Dornbusch, R. (2008). Exchange rates and inflation. Cambridge, MA: MIT Press. Floyd, J. E. (2010). Interest rates, exchange rates and world monetary policy. 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