International Financial Markets - Exchange Rates and Inflation - Literature review Example

International Financial Markets: Exchange Rates and Inflation Introduction International financial markets have grown tremendously over time. Many investors are utilizing the unparalleled technological advancement to get crucial information about the foreign stock and financial markets. Levene (2009, 6) asserts that information is extremely crucial because it enable foreign investors to make solid decisions without buying information about the stocks and financial markets. Many companies have unified their accounting standards and financial data for the potential investors to access such information. Thus, understanding of international financial markets is very crucial for any company wishing to invest in the global markets. A thorough research before investing in international markets is critically important for the success of the investment. Feng (2007, 35) points out that global markets around the world have suffered instability and stress due to weakening of the international economy. In essence when investing in an international market dominated by foreign currency investors, investors are subject to inflation that dominates foreign markets. Ryan (2007, 112-156) argues that stocks may depreciate against the investor’s currency over time. Therefore, it is extremely crucial for foreign investment to conduct initial fiscal research in order to implement adequate measures to cushion international markets from inflation. Ryan (2007, 102-136) asserts that United Kingdom is an international financial center that depends on the maintenance of cooperation with other financial markets and open economy. This implies that UK plays a central role as a finance hub for European countries and the globe. Thus, UK provides a favorable investment environment and acts as a prime source of financial expertise and liquidity in international markets. Levene (2009, 61) indicates that investors in financial markets benefits from diversifying in the international markets. The location of financial markets influences their performance because of volatility in exchange rates and inflation. Stock markets reflect forecasted and current state of the countries economies. Ryan (2007, 132) points out that United Kingdom is one the most preferred destination for the many investors diversifying their businesses. UK offers a vibrant business environment for investors to realize a substantial growth in a short time after investment. Several factors qualify and win the confidence of investors in UK financial markets. For instance, UK’s economy is an exceptional, innovative, multicultural, and entrepreneurial. The region embraces opportunities of the world market place and qualifies as a prime hub of international trade. UK has strong links with giant global traders such as Asia, United States, and commonwealth countries. In United Kingdom, investors plug directly into the center of global finance, professional and creative services, international talent, and media. The globalized nature of exceptional UK economy is evident in London. London is the heart of international trading and holds many companies such as Fortune 500 that participate in London Stock Exchange (Levene 2009, 61). The city offers a variety of business facilities and globally valued skills. In addition, UK does not have a specific law that controls or restricts foreign investment. The law treats foreign businesses as UK-owned companies. Moreover, investors can engage in any business in all sectors of economy with the exception of defense in United Kingdom. Thus, investors have invested in UK financial and stock markets to realize tremendous growth. Investors, with interest to UK markets require understanding pertinent issues of the investment. Such issues include exchange rates, inflation, estimate of spot and forward rates, and internal and external exchange rates. Levene (2009, 61) alludes that currency translation approaches are crucial to help investors evaluate whether changes in exchange rate will have direct or indirect effects on cash flows. Exchange rate affects foreign direct operation of foreign entity in a currency different from investors’ domestic currency. Therefore, it is important for investors to apply strategies such as forward forecasting and estimated stop exchange rate to cushion them from foreign exchange risk. This step is crucial because foreign exchange risk affects the cash flow of investments due to currency fluctuations. Levene (2009, 61-85) points out that there are three forms of currency risk such as transaction, translation, and economic exposures. Investors should make solid decisions with intention of minimizing the negatives effects of unpredictable exchange rates. Investors use hedging techniques as a precautionary mechanism against possible losses of their investment. Investors should consider foreign currency translation because they are critical to the performance of their investment. Foreign currency translation entails expressing amounts measured in foreign currencies to the reporting currency of domestic entity. The preparation of financial statement using principles of account different from domestic reporting entity compounds foreign currency translation. This implies that income statement accounts, which do not reflect historical cost of investment, should be translated at the spot rate evident at the time of expense and revenue transaction. Relative interest rates and prices of goods between two countries tend to influence patterns in exchange rates. Investors face translation exposure when diversifying their trade to countries away from home. This is a translation risk and captures items in the investors’ balance sheet. In essence, the products that entail physical exchange of money do not hedge translation exposure. Joseph (2000, 134) asserts that losses and profits from translation exposure appear only in books and do not affect cash flow in short term. However, in cases of liquidation, occurrence of cash flow profits and gains are apparent. Thus, it is not recommendable for investors to hedge translation exposure. Generally, investing in international markets, which generates cash outflows and inflows in foreign currency, is subject to foreign exchange risk. However, companies without foreign assets and liabilities are not immune to foreign exchange risk. Kavaliova (2007, 145) asserts that the volatility in foreign exchange rate affects the competitive position of businesses regardless of their location. This implies that investors should not fear expanding their businesses in foreign lands. Investors should put sound mechanisms in place to measure translation exposure. For instance, the investors can estimate the future anticipated earning from each subsidiary. In addition, the investors should apply sensitivity analysis to identify the probable effects exchange rate fluctuations. Kavaliova (2007, 145) perceives that hedging is an important tool that reduces agency of problem, protects investment from adverse information content of earning, and averts risk among contracting parties and managers. Hedging encompasses both internal and external methods. Wang (2009, 123) asserts that external techniques entail utilization of external contracts, swaps, options, and futures. Companies sell or purchase forward contracts to cushion them against exchange rate risk. The external techniques protect the investors from the potential exchange losses that occur because of failure of internal measures to protect investments. Forwards are custom-made contracts to sell or purchase foreign exchange in future at the specified current price. Therefore, it is advisable in anticipation of inflation for investors and companies to embrace forwards. Forwards are advantageous because their maturity is determinable individually and hedge the desired and anticipated position. Kavaliova (2007, 145) asserts that hedging with futures and forwards entails adopting of an opposite direction to the position an investment has on the spot market. For instances, exporters who anticipates to get money fear devaluation of foreign currency. Therefore, the exporters sell forwards to profit from potential devaluation. This enables the investors to compensate for possible losses. On the other hand, importers with foreign currency debt fear an appreciation of currency. It is advisable for such importers to purchase forwards and neutralize the risk of foreign exchange. Similarly, companies employ foreign currencies as an option to hedging in forward and money markets Kavaliova (2007, 145). It is advisable for investors to implement a zero-cost option strategy to manage risk of exchange rate. The external hedging can have beneficial effects on investment regardless on the rate of inflation. In addition, it enables investors to evaluate risks of their investment in international markets. Internal hedging is relatively less costly than the external hedging. Investors employ international hedging such as netting, pre-payment, leading and lagging, price adjustment, and long term structural changes. Netting entails investors to reduce volume of transactions with intention to cover exposures. This calls for management of cash from a central point. Thus, companies should collect foreign currency flows from subsidiaries in a central point so that an inflow offsets an outflow in the identical currency. For instance, consider General Motors with two subsidiaries in UK and US. The UK subsidiary owes the US subsidiary 50,000 Euro while the American subsidiary owes UK 100,000 Euro (Economics Group 2003, 5-7). Netting these two flows leaves the company with a payment of 50,000 Euro from the US to UK subsidiary. Therefore, there is a reduction of the total amount of transaction exposure. Leading and lagging is performed in all subsidiaries if companies anticipate appreciation of currency. In this regard, companies require speeding up payments and getting payment before appreciation of currency. Similarly, if there is anticipation of depreciation of currency companies delay payment. Nevertheless, companies should consider cost of decreasing or increasing liquidity. Economics Group (2003, 5-7) asserts swaps entail settlement to exchange a given currency for another at agreed prices and dates. Swaps are convenient because they allow easy hedging of intricate exposures. The choice of technique is critical to increment of variability in the flow of cash. Joseph (2000, 134) asserts businesses employ foreign currency lending, and cross currency interest swaps to mitigate cases of low investment through reduction of cost of external funds and dependence of firm of external sources of funding. Studies suggest that investment without hedging have greater opportunities for growth and tends to over-depend on external sources of funding. Therefore, there is a likelihood of investors in international markets to hedge greater for their tremendous growth. Economics Group (2003, 5-7) perceives that many investments employ internal hedging techniques to realize returns from their businesses. The internal hedging techniques enable investment to eliminate the undesirable negative flows on cash. External techniques such as foreign currency borrowing and currency swaps capacitate investors to borrow through cheap ways. Kavaliova (2007, 45) asserts although hedging the risk of rate of exchange in the international markets is effective, there are apparent limitations. To start with, the number of foreign units such as euro to be converted to sterling pounds at investment may be unknown. If the amount of sterling pound received from liquidating the foreign supersedes the hedged amount, investors have not short or long position in the foreign currency. Thus, the return will be inauspiciously affected by depreciation. However, investors should hedge most of their exchange rate risk to despite imperfection in hedging techniques (Kavaliova 2007, 145). Second, investors may maintain the foreign stocks far from the initial planned horizon of investment. This implies that investors may be tempted to create a short position after termination of initial short position. Any attempt of investors to liquidate the foreign financial stocks before forward delivery date, the hedge will be extremely ineffective. Therefore, it is advisable for investors to invest in foreign money market predominated by the foreign currency to postpone conversion of sterling pound until forward delivery date. This action prevents the investors from utilizing the funds after exchange in other businesses until the delivery date. Moreover, the forward rates for currencies less traded may attract large discounts (Wang 2009, 123). Wang (2009, 123) asserts that forecasting exchange rates is an extremely useful tool for a variety of reasons. To start with, the forecast exchange rates help in decision-making on hedging. If the forecast implies that foreign exchange rate will be stable, an investor can decide not ton hedge. Second, forecast exchange rate assists investors in making financial decisions. In this regard, companies can decide on what currency to use in borrowing. In anticipation of inflation, firms do not borrow money because inflation increases the rate of repayment of loans. Third, forecasting helps to identify currency, which appreciates over time and with high interest. Lastly, forecasting exchange rate enables investors to make solid decisions on budgeting when opening new subsidiary (Joseph 2000, 134). The investors will approximate the future cash flows based on precise forecast of foreign exchange rate. Bibliography Brigham, E. and Houston, J., Fundamentals of Financial Management (Book Only) (New York: Cengage Learning, 2009) Economics Group, 2003, Corporate Risk Management: A Theoretical Appraisal. Available from: http://www.web.mdx.ac.uk/internet/schools/bs/departments/econ_stats/docs/dpap_econ_107.pdf [Accessed 24 Nov 2012]. Feng, X, 2007. Corporate Hedging of Currency Exchange Risk. Available from: http://essay.utwente.nl/58087/1/scriptie_X_Feng.pdf [Accessed 24 Nov 2012]. Joseph, N., 2000. The Choice of Hedging Techniques and the Characteristics of UK Industrial Firms, Journal of Multinational Financial Management Vol10, 2000, pp. 161-184. Kavaliova, M., Foreign Exchange Risk Management: Which Hedging Techniques Can Be Used by a Mid-size (New Jersey: Company Lighting Source Incorporated, 2007) Levene, T., Investing For Dummies, UK Edition (New Jersey: John Wiley & Sons, 2009) Ryan, B., Corporate Finance and Valuation, (New York: Cengage Learning EMEA, 2007) Wang, P., The Economics of Foreign Exchange and Global Finance (London: Springer, 2009) Appendix Board Pilot Project Euro Denominated Cash Flows Discounted at the Euro Base Real Rate (Investing in UK) Initial Investment Revenue Year 1 Revenue Year 1(3% inflation) Revenue Year 2 Revenue Year 2 (3% inflation) Revenue Year 3-4 Revenue Year 3-4 (3% inflation) 10m Euro 3m Euro 2.1m Euro 5m Euro 4.85m Euro 10m Euro 9.7m Euro 9.52m Sterling Pounds 2.86m Sterling Pounds 2m Sterling Pounds 4.76m Sterling Pounds 4.61m Sterling Pounds 9.52m Sterling Pounds 9.24m Sterling Pounds Real Sterling Denominated Cash Flows Discounted at the Domestic Real Rate Initial Investment Revenue Year 1 Revenue Year 1(1% inflation) Revenue Year 2 Revenue Year 2 (1% inflation) Revenue Year 3-4 Revenue Year 3-4 (1% inflation) 10m (Euros) 3m(Euros) 2.97m (Euros) 5m(Euros) 4.95m(Euros) 10m(Euros) 9.9(Euros) 9.52m Sterling Pound 2.86m Sterling Pounds 2.83m Sterling Pounds 4.76m Sterling Pounds 4.90m Sterling Pounds 9.52m Sterling Pounds 9.8m Sterling Pounds Euro Denominated Money Cash Flows Discounted at the Euro Base Money Rate Initial Investment Revenue Year 1 Revenue Year 1(1% inflation) Revenue Year 2 Revenue Year 2 (1% inflation) Revenue Year 3-4 Revenue Year 3-4 (1% inflation) 10m (Euros) 3m(Euros) 2.97m (Euros) 5m(Euros) 4.95m(Euros) 10m(Euros) 9.9(Euros) Sterling Money Cash Flows Discounted at the Sterling Money Rate Initial Investment Revenue Year 1 Revenue Year 1(3% inflation) Revenue Year 2 Revenue Year 2 (3% inflation) Revenue Year 3-4 Revenue Year 3-4 (3% inflation) 10m Euro 3m Euro 2.1m Euro 5m Euro 4.85m Euro 10m Euro 9.7m Euro 9.52m Sterling Pounds 2.86m Sterling Pounds 2m Sterling Pounds 4.76m Sterling Pounds 4.61m Sterling Pounds 9.52m Sterling Pounds 9.24m Sterling Pounds Read More