Treasury, Foreign Exchange and Trade Finance - Research Paper Example

Treasury, foreign exchange and trade finance A. Purchasing Power Parity (PPP) is founded on the law of one price, meaning it assumes that different market forces will intervene and eliminate same situations in which the same commodity or good will is sold at a different price overseas or abroad. One explanation for this is that PPP takes into account the fluctuation or rate of changes in prices between the two economies involved in trading. Its strength is its capability to adjust with the inflation to set the prices at equilibrium. The ability to even out the prices despite of barriers in terms of location and inherent market factors creates smooth product exportation among countries. This ultimately favors one developing country over the next in accordance with the purchasing power of its population. PPP calculations are often used to measure poverty rates, for this it is the most realistic basis for economic comparison. The PPP method of forecasting the exchange rates is considered to be a better method over the other exchange rate forecasting methods as most of them undertake and reflect only traded goods. The PPP method considers the price of standard goods identical within two countries. The ‘standard’ goods can be anything related to consumer goods and services. PPP determined exchange rates are very useful in the situations where the official exchange rates are manipulated. They serve as the realistic base of currency comparisons in such scenarios. The purchasing power parity can be easily influenced by the short-term fluctuations in the prices of the countries. The short term prices of a particular country can easily be influenced by the fluctuations of the market or any demand or supply disruptions. These fluctuations may lead to inaccurate PPP leading to inaccurate forecasting of the currency values. Long term analysis of the currency values should only use the PPP to enable accurate outcomes. The accuracy of PPP also depends upon the accurate choice of goods used in the comparison index, if the choice of goods is wrong the outcomes would be misinterpreted. In the countries like the one in our case study, are newly liberalized countries experiencing rapid changes in their economic structures. The economies are heading towards privatizations and liberations. (Conover & Norrbin n.d). The idea that in absence of transaction costs, or input restrictions identical goods will have the same price in different markets is considered a weakness of PPP. It is next to impossible to eliminate such cost and will limit the ability to ship goods between countries if implemented. This creates a product’s vulnerability to price changes that will concurrently favor one over another. Another thing to take into consideration is that products in different countries are rarely identical. There will be differences in quality causing price difference in different markets (Brigham, Houston & Clark 2003). The basic premise that no two markets are the same posts a hindrance to the full implementation of PPP. Upon analysis of Purchasing Power Parity it could be seen that it is predisposed towards being intrinsically bias in its pricing. It is therefore upon careful deliberation upon implementation whether or not the system is worth executing and sustaining despite these disadvantages. There are a number of methods used to forecast the exchange rates other than PPP method. Due to the drawbacks of the PPP method two other approaches, namely the Fundamental and the Technical approach are the common ones. The fundamental approach looks at the various indices, inflation and the trade balances of the country to determine the currency values. The long term analysis is made in this respect. The next method, the technical analysis, uses the patterns of investments to determine the currency exchange rates. It basically follows the trading of the investors, their surveys and forecast is made on that basis. This method is more appropriate for short terms investments. (Exchange rates forecasts- methods and madness n.d). Interest rate parity can also be used in foreign exchange forecasting. This concept holds that investors or company owners should expect to earn the same return or security investments in all countries after adjusting for risk. This method recognizes that once an investor invests in a country other than its home country, he is essentially affected by two forces i.e. return or the investment itself and changes in the exchange rate (Brigham, Houston & Clark 2003). This is a logical principle as it already exposes the investor to the nature of his investment and the factors that will affect his business as it is conducted on a multinational scale. Gold standard is also offered in this case. In trying to fix the exchange rates, the value of domestic currency can be tied directly to gold. Under a gold standard, the international financial market reached equilibrium through the effect of gold flows on each money supply of countries (Miller 2004). B. The fixed or pegged exchange rate scenario where one currency of a country is not allowed to fluctuate and its value is fixed in terms of some other currency was such as implemented in Argentina. Under the Bretton Wood system all the currency values of all the countries under the Bretton Wood treaty were fixed in comparison to the U.S. dollars. The values of the currencies were comparable to the fixed value of gold. Many countries including Argentina followed this method of exchange rate regimes. “In a fixed exchange rate system, the PPP theory implies equality between inflation rates of the anchor country and the fixed exchange rate country.” (Carolina 2006). However, even under the fixed exchange rate regimes the difference in inflation rates do exist in different countries. The difference in the Inflationary rates weakens the PPP theory of determining the future currency values. It has been argued that the inflationary differences are short run differences and the PPP gives measures of the long run. Literature and empirical data prove that the inflationary differences in the countries are not short-run phenomena. The empirical analysis conducted by calculating the real exchange rates between the U.S.A and its trading partners, showed that the PPP theory had been incapable in determining the Future currency values accurately (Enders 1988 pp 504-508). It has been observed that the PPP have been persistently providing deviations from the actual exchange rates under the fixed regime of exchange rates. The theory behind this analysis can be explained by providing an intuition that the United States is a large nation as compared to its trading partners. Therefore adjustments were difficult as compared to other nations. Thus, the PPP method was unsatisfactory to determine the currency values under the Fixed or Pegged exchange rate regimes. This shows that the use of PPP in Argentina was not as appropriate and effective due to the wide discrepancy between the involved currencies under it. C. The period of 1995 to 1999 was marked with prolonged real appreciation of the U. S. Dollars. This appreciation was followed by its trading partners, resulting in depreciation of the currencies of weak countries like Brazil and Argentina. The United States is a very large country in comparison and this appreciation could not be handled properly by the smaller economies of Brazil and Argentina. There was massive borrowing within the groups of trading partners of U.S. The less developed countries of Brazil and Argentina did not even lag behind in this borrowing phase. In effect, these countries accumulated a huge debt burden and they did not have the concern to make repayments. They did not have the ability to repay their obligations via export earnings. As a result, the countries failed to make debt payments that were due on specified times. Currently, Argentina had already settled some of the interest at about $80 million but the total debt still stands at more than $800 million (Q&A: Argentinas economic crisis February 2003). The currencies of Brazil and Argentina were suffering huge capital outflow due to their defaulter’s position. This capital outflow, led to grave financial and currency crisis. “Currencies tumbled at varying rates in Russia in August 1998, Brazil in January 1999, Turkey in early 2001, and Argentina in December 2001” (Desai n.d p. 3). Brazil and Argentina were major trading partners in the years of 1999, so the countries were aggravating each other’s financial crisis by taking actions to improve one’s economy. In the year 1999, Brazil was facing financial crisis and it devalued its currency for market corrections. This led to hurting the exports of Argentina by a large amount. Argentina trying to maintain parity with the U.S dollars resulted in a huge overvaluation of its currency. On the other hand, its major trading partner Brazil was devaluing its currency. This further increased the real exchange rate of Argentina. Therefore Argentina suffered a substantial loss due to the loss of competitiveness in the international trade. “This overvaluation resulted in a significant terms of trade loss and consequently massive deterioration in the current account of the balance of payment which had to be financed by the accumulation of foreign debts” (Mulraine December 2004 p 11). The currency crisis in both these countries appeared due to the overvaluation of the exchange rates. As Brazil was devaluing its currency, the Argentinean Peso was unable to follow suit. There were huge deficits in the government budgets due to the decline in exports and unemployment rates were as high as 30%. In the beginning of the millennium, Argentina tried to devalue its currency. “The peso has now fallen about 70% against the dollar, making Argentine products much cheaper for those paying in foreign currencies” (Q&A: Argentinas economic crisis, February 2003). This helped in boosting exportation as home products were very cheap compared imported goods. However, this strategy hurt the people who had invested in Argentina by lowering down their profit levels. The real value of governmental debts increased and devaluation turned out to be expensive for the government. Devaluation also boosted inflation. These problems dragged Argentina and Brazil to another currency crisis in the year 2002. Several programs to privatize state businesses were promoted in this year to draw the country out of the crisis. “Having failed to plug capital outflows and stabilize their currencies, policy makers in the financially troubled economies, led them to a second crisis.” (Desai n.d p11). The lack of confidence in the economy of these countries led to a massive drain of reserves in the year 2002 which further aggravated the crisis. The outflows led to the rise in the short term interest rates, tightening the monetary policy and slowing down the economic growth. This economic turmoil was a result of failed economic stabilization programs enforced by the respective governments (Mulraine 2004 p. 1). 2. A. Sensitivity Analysis of USD WACC of 10% p.a. and Nominal Growth Rate in Perpetuity of 5% SCENARIO 1 2 3 Growth Rate (5%) USD WACC (10%) 6% Devaluation in year 1 11% Devaluation in year 2 16% Devaluation in year 3 Argentina 131 258 123 828.30 118 250.45 113 153.45 Brazil 206 829 219 238.74 186 332.43 178 300.86 Chile 59 663 56 285.85 53 750.45 51 433.62 Total if correlated 397 754 399 356.67 358 336.93 342 891.38 This is the summary of the sensitivity analysis of USD assuming WACC of 10 % p.a. and nominal growth rate in perpetuity of 5%.The table also summarizes the three scenarios. Discounted cash flow is computed by dividing the free cash flow by the sum of 1 and the percentage of discount rate or weighted average cost of capital (WACC). This can be expressed in mathematical equation as DCF=FCF/1+WACC. Let’s take the scenario 1 having 6% devaluation after year 1. For Argentina, FCF of $131 258/ 1+.06=$123 828.30, Brazil will be $206 829/1+.06= $219 238.74 and Chile will have $56 285.85 because of $59 663/1+.06. The same formula applies to second and third scenarios only replacing the WACC with .11 and .16, respectively. The figures under the first scenario assumes that after one year the FCF for each country will be discounted at a lesser rate of 6%, so Argentina will have FCF of $123 828.30, Brazil will have $219 238.74 and Chile will have $56 285.85. For scenario 2, a discount rate of 11% will be given to each country’s FCF, this results to Argentina having computed FCF of $118 250.45, Brazil having $186 332.43 and $53 750.45 for Chile. And for scenario 3 a 16% devaluation after year 3 will cause $113 153.45 for Argentina, $178 300.86 for Brazil and $51 433.62 for Chile. B. Weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted. To get the net present value (NPV) of a project, businesses often discount cash flow at WACC. By using the weighted average, the amount of interest a business has to pay for every dollar it finances can be computed. It is also used to determine the economic feasibility of opportunities for expanding and merging their activities. If countries are to trade with one another, a system to facilitate payments is needed. This is where the role of exchange rate is observed. The tie-in with a standard currency such as the USD can ensure that all currencies are being exchanged in a reasonable rate. The concept of arbitrage or the process of buying undervalued currencies and selling overvalued ones to make profits works on this condition. To answer the question on which sensitivity analysis is more useful in cross-border valuation cases, an examination of the advantages and disadvantages of every sensitivity analyses yield inevitability. The WACC of a firm is a very significant figure, both to stock market to do the stock valuation and for the management of the firm to do the capital budgeting. It’s quite difficult to understand how stock analysts determine “fair value,” but one can, through the use of discounted cash flow. In simple terms, DCF tries to determine the present value of a company by using the projections in the future. However, these valuations can fluctuate wildly depending on what you perceive about the company’s operation. If you will use the FCF forecasts, discount rates and perpetuity growth rates which are all of wide of the mark, the fair value that would be generated won’t be that accurate. This analysis works best when there is a significant degree of confidence about cash flows in the future. The investor’s ability to establish good forward-looking projections is very critical. Another problem here is its suitability to short-term investment as it focuses on long-term values. Exchange rate has the ability to specify the number of units of a given currency that can be exchanged for one unit of another currency. It is considered as a universal conversion on the world’s foreign currency exchanges. This system eliminates the confusion when comparing quotations from one trading partner to another. Conversely, this can also increase the uncertainty of the cash flows for a multinational corporation. This uncertainty known as the exchange rate risk is a major factor to be considered in multinational capital budgeting. This is also why some smaller countries have chosen to peg their currencies to one or more major currencies. If the country uses pegged exchange rates, a fixed exchange rate is established with that of a major currency and then the values of pegged currencies move together over time. We also have to consider that not all currencies are convertible. If this is the case then there will be limited central bank influence and the issuing government loses control over the value of its currency. A major problem in international trade is the lack of currency convertibility. In analysis of the cross-border valuation cases, the use of the WACC is more useful. As it shows us the average of the costs of sources of financing, and each is weighted by its respective use in the given situation. Risks involved in multinational capital budgeting can’t be and should not be quantified in country risk premium and just be an adjustment to the WACC. Each risk has its own implications in the forecast of cash flows, so each risk must be reflected and use the parent’s WACC to discount the cash flows. For example is the political risk, a potential action by the host government that can result to reduction of the value of a company’s investment. This can be seen as the implementation of higher taxes, tighter repatriation or currency control or restrictions on prices charged. It varies from country to country and seldom negotiable. Multinational corporations must address political risk extensively (Brigham, Houston & Clark 2003). A higher risk could also arise because of the exchange rate risk. This relates to the value of the basic cash flow computed in the parent company’s home currency. The establishment of a standard basis for conversion ensures that all currencies are computed in a consistent manner. If this consistency is not observed, the process of arbitrage could do the work to bring in equilibrium. It is sometimes possible to protect the company’s capital against fluctuations of exchange rate. An exchange rate risk premium can be subtracted when computing the projects cash flow. Bibliography Brigham, E.F. Houston, J.F. & Clark, D.C., 2003. Fundamentals of financial management. Ohio: Thomson South-Western. Carolina L.M. (August 18, 2006). PPP Theory in a Fixed Exchange Rate System. BNA Working Paper. BNA.WP/06/2. Conover M. C. & Norrbin C. S. (n.d). How much is purchasing power parity worth?. Questia. Available at: http://www.questia.com/googleScholar.qst;jsessionid=MPsYWjwpFvvQ1Pry8LXcyM2mMNjMk02DQMkvQTK1WpyXqb7VcFvv!-1212072275!-1754635462?docId=5001346941 (Accessed on June 9, 2010) Desai P. (n.d). Financial Crisis, Contagion, and Containment: From Asia to Argentina. Princeton University Press. United Kingdom. Enders W. (August 1988). Arima and Cointegration Tests of PPP under Fixed and Flexible Exchange Rate Regimes. The Review of Economics and Statistics. 70 (3). pp 504-508. Exchange rates forecast- methods and madness (n.d). Exchange Rate Forecast. Available at: http://www.exchangerateforecast.com/exchange-rate-forecast/exchange-rates-forecasts-%E2%80%93-methods-and-madness/ (Accessed on June 9, 2010) Miller, Roger L., 2004. Economics today the micro view. 12th ed. Boston: Pearson Education, Inc. Mulraine B. L. M. (December 2004). An Analysis of the 2002 Argentine Currency Crisis. Available at: http://www.chass.utoronto.ca/~mulraine/arg.pdf (Accessed on June 9, 2010) Purchasing Power Parity - Forex PPP: What is Purchasing Power Parity?, (n.d). studyforex.com. Available at: http://www.studyforex.com/purchasing-power-parity.html (Accessed on June 9, 2010) Q&A: Argentinas economic crisis. (February 2003). Business. BBC News. Available at: http://news.bbc.co.uk/2/hi/business/1721061.stm (Accessed on June 9, 2010) Read More