Exchange Rates and Foreign Exchange Exposure - Coursework Example

Exchange rates and Foreign Exchange Exposure xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Name Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Course Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Instructor Xxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxxx Date Contents Contents 2 1.0 Introduction 3 2.0 Exchange rates movement 4 3.0 Differentials in inflation 4 4.0 Differentials in interest rates 4 5.0 Current account deficits 5 6.0 Exchange rate exposure 5 7.0 Application of Theories 6 7.1 PPP Approach (Inflation and interest rates differentials) 7 7.2 The balance of payment approach 7 7.3 Mundell- Fleming’s model 8 7.4 Monetary theory of exchange rates (the monetary approach) 8 7.5 The portfolio balance theory 8 7.6 Dornbursh Model (overshooting) 9 7.7 Chartist Model 10 8.0 Overview of theories 10 9.0 Data and Findings 10 10.0 Conclusion 12 11.0References 13 1.0 Introduction Exchange rate is defined as the rate in which a country can exchange its currency for that of another. There are many factors that impact or determine exchange rates and they include free market systems and international trade which assist in creating and maintaining a balance of capital and a balance of trade. For instance, an exchange rate that is skewed may cause exports to be sold cheaper as compared to other countries. Exchange rates are quite significant to the economy of any given country. Stability of exchange rates demonstrates the strength of the nation. In addition, levels of imports and exports are determined by the extent of exchange rates of the country in question. Appreciation of a domestic currency over foreign currencies will ultimately cause reduction in the prices of imports in the domestic market. on the other hand, a country with a very strong currency is bound to lose its competitiveness in the local market as its commodities become too expensive and unaffordable. Exchange rates also serve as drivers to investment in the country. The rates may increase the value of the local currently hence attracting foreign investment (Vetter 2008). Over the past few decades, drastic changes have been observed in the global exchange rates movement. This has been greatly to the continuous cycle of financial crisis hitting the world over. Major world currencies have are gradually declining triggering counter actions by powerful economists. The report will detail major theoretical and practical issues underlying exchange rates movements and foreign exchange exposure. This will be well elaborated using real data and analyzing the findings thereof. 2.0 Exchange rates movement Like any other commodity in the market, exchange rates are based on demand and supply of the currency in question. Variations in the supply of a country’s domestic currency are determined by monitory and fiscal policies controlling its economical systems. On the hand, there are many factors that influence the demand of a currency; interest rates, differentials in inflation, government regulations among others (Vetter 2008). 3.0 Differentials in inflation Generally, a country that experiences consistently low rates of inflation has considerably high value currency. Such countries which include Japan, U.S., Germany, Canada and Switzerland have been able to achieve very strong currencies against other currencies. Contrary to this, countries with high rates of inflation suffer tremendous depreciation on their currencies in comparison to their trading partners in addition to heightened interest rates (Bergen 2003). 4.0 Differentials in interest rates Indeed, inflation, interest rates and exchange rates have a powerful correlation. Changes in interest rates, manipulated by central banks have major impacts on exchange rates, inflation as well as currency values. Lenders who offer high interest rates have the advantage of higher returns in comparison to those with low rates. Evidently, high interest rates have a direct effect in attracting foreign investors and capital as well rising exchange rates. However, if the interest rate of a country is much higher than in others, it may drive the value of the currency too down to recover it. In an opposite relationship, low interests rates have a tendency of decreasing exchange rates of the country (Vetter 2008). 5.0 Current account deficits Trade matters between a country and its partners in relation to payment for goods, services, dividends and interests are portrayed in the current account. A deficit, that is, a negative value in the current account reveals that the country is expending more in foreign trade than it is making profits. It is also a clear indication that it is borrowing capital from external sources to cover the deficit. This implies that fewer sales are made on exports hence few foreign currencies enter the country. The country therefore, has to buy foreign currencies for purchase of imports and such increase in demand for foreign currency lowers exchange rates such that domestic commodities become extremely cheap while foreign ones are very expensive to generate enough income for domestic use (Bergen 2003). 6.0 Exchange rate exposure Exchange rate exposure is defined as the relationship between exchange rates variations and excess returns. It is a measure of the sensitivity that arises in the value of the real domestic currency for operating income, assets or liabilities to unexpected changes in exchange rates. The value of operating income, assets and liabilities are exposed by effects of fluctuations in exchange rates. Foreign exchange exposure occurs only if the anticipated change is different from the actual change (Pantzalis, et al 2001). Exchange rates fluctuations are points of uncertainties and threats to large companies and especially multinational companies. Managers, workers, investors and even consumers of this companies regard exchange rate risk as a sensitive matter that should handled with much care. The manager is concerned with the issue of exposure as it is directly related to profitability while to the investor drastic changes in exchange rates might adversely affect portfolio values. …argues that sensitivity of exchange risk to a large extent depends on the nature of firm’s activities for instance its exports and imports, competitors currency denominations, involvement in foreign operations as well as competitiveness of output and input markets. There are two basic models for measuring a firm’s exchange rate exposure: market value analysis and actual cash flow. The market value analysis makes the assumption that the market value of a firm is the present value of the firm which portrays its future cash flow. The actual cash analysis focuses on exchange rates effects and actual cash flows and these are used in assessing financial decision when making critical decision pertaining to the business. Past research has revealed a positive relationship between exchange rate sensitivity and firm’s foreign operations. In this case, foreign assets, sales and operating profits are regarded as foreign operations. According to Miller and Reuer (1998) explore some of the effects of foreign direct investment (FDI) on foreign exchange rate movement. According to these researchers, active participation in the international market through direct foreign investment protects the firm against economic exposure. Economic exposure measures the level of sensitivity of the firm towards fluctuations in foreign exchange rates. Many companies across the world have resorted to using multiple exchange rates in order to determine the extent of this exposure (Pantzalis, et al 2001). 7.0 Application of Theories In the analysis of exchange rate movements and foreign exchange exposure, it is very important to largely apply some theories involved in the analysis. According to Griffin and Stulz (2001), theories are known to model the relationship between exchange rates and foreign exchange exposure therefore avoiding the assumption that exchange rates are constant and linear to the impact created by the three foreign exchange exposures namely; economic, translation and transaction exposures. This paper will uses seven theories in analysis exchange rate in relation to foreign exchange exposure. These seven theories are; PPP approach which is the interest rates and inflation differentials, the balance of payment approach, Mundell- Flemings model, monetary theory of exchange rate also known as monetary approach, the portfolio balance theory, the Dornebusch model and Chartism 7.1 PPP Approach (Inflation and interest rates differentials) Griffin and Stulz (2001) maintain that, PPP theory commonly link the exchanges displayed in exchange rates to those in distinct relative price indices in two countries. Although this theory is viewed as a poor predictor of exchange rates it is very essential in analysis both exchange rates and foreign exchange exposure. Since when the theory is largely developed from an equilibrium base year as well as being used as a long term forecasting device it creates a background necessary in the analysis of exchange rate as well as foreign exchange exposure. 7.2 The balance of payment approach This theory widely assumes on an increase in national income. This is due to an increase in pressure for various imports to rise. This theory is necessary in the analysis of exchange rates movement and foreign rates exposure in that it is used in create an effect that largely dampens demand for import as well as forcing resources into export which in turn strengthening exchange rate exposure as well as foreign exchange exposure. For instance, assuming that the national income increases, the current account is known to decrease. For official reserve to be avoided it is necessary to improve capital account by way of higher income so as to safeguard exchange rates as well as foreign exchange exposure. By so doing it is quite evident that the current account will automatically swing back to a certain improved position (Griffin and Stulz 2001). 7.3 Mundell- Fleming’s model According to Williamson (2001), the Modell-Flemings approach is similar to balance of payment theory only that this approach assumes national income largely increases with an accompanying current account decrease. It is an important theory to apply when analyzing exchange rate movement and foreign exposure in that it ensures that if overall balance of payments equilibrium is maintained then it is necessary to raise domestic interests’ rates so as to improve capital inflow which in turn compensate for the deterioration of the current account. The theory is important in the this analysis in that it ensure that increase in interest rates dampens domestic demand which as a result creates an effect reducing import and improving current account in both exchange rate and foreign exposure. 7.4 Monetary theory of exchange rates (the monetary approach) This theory creates an environment whereby improvement to national income widely results in increased transaction in the demand for money. Increased money supply widely tends to push up interest rates and inflation which in turn worsen the exchange rate. This theory is important in this analysis in that it acts as the driving force in relative money supply between exchange rate movements and foreign rate exposure (Williamson 2001). 7.5 The portfolio balance theory The portfolio balance theory give a suggestion in which the exchange rate is considered as a function of relative supply of both foreign and domestic bonds. For instance, the theory tend to assume that supply of bonds in a country increase, bond prices gradually fall while in the same time bond yield to maturity increases. Further, when all other things being constantly equal, money will definitely flow into a country which in return will force up the exchange rate. 7.6 Dornbursh Model (overshooting) According to Williamson (2001), this model refer to the kind of behavior in which the exchange rate and foreign rate exposure swings beyond it long term equilibrium level before it come back to it. This theory is important in the analysis of exchange rate and foreign rate exposure in that for money supply to shoot up; there is need for exchange rate to depreciate. It assists in relating both interest and income rate into a given economy. The graph below describes the relation described by this theory with focus on exchange rate and foreign rate exposure M-money supply P-price I-interest E-exchange rate 7.7 Chartist Model This theory closely works fairly with Forex market in understanding exchange rate and foreign exchange exposure. This is because it works in connecting many market players where they use triangle pattern, neckline, breakouts and trend lines in analyzing both exchange rate as well as foreign exchange exposure (Allayannis et al 2001). 8.0 Overview of theories After understanding the above outlined theories it is important to understand efficient market hypothesis so as to have a great analysis of both foreign rate exposure and exchange rate. Allayannis et al (2001) maintain that, the two criteria which describe these hypotheses are; players are considered to be profit maximizes and always to understand that prices move more rapidly so as to reflect new information. Further, it is necessary that in analysis of both foreign rate exposure and exchange rate prices achieved should never be viewed as perfect but rather they should be viewed as unbiased. 9.0 Data and Findings Exchange rate movements have been a continuous concern for analyst, investor, shareholders, managers and investors. Data analysis has been done in various finance institutions. Exchange exposure of various firms is measured by the stock returns sensitivity to exchange rate of movements. One may still quantify this exposure as the cash flows sensitivity to movements of exchange rates. The analysis given below is the exchange rate from Turkey between 2001 and 2003. The firms used to give the collect were only 137 firms as they no missing data and had international transactions (Dominguez & Tesar 2001). The analysis was done to consider which factors affected the exchange rate movements and the impact of exposure of a firm to the rate of exchange rate movements. The hypothesis used was that a large firm had lower exposure beta. Larger firms are expected to have sufficient resources, that is, knowledge and personnel that will assist the firm to hedge the risks in the international transactions that leads to lower exposure. Other factors included were firm maturity, firm size and level of the international transactions. Firm maturity is the total number of years that the firm has been operating. Hence, it is so expected that an older firm has excellent managed compared to fresh firms. In this case, maturity could also indicate a lower exposure level. In international transactions, the firms that have high level of international activities are expected to have greater exposure. Therefore, international activity should to a lower or higher exchange rate exposure. Firms may use the export revenue to cover their import cost, and this may become one way to reduce the exposure to exchange rate. The table below shows the relationship of firm characteristics and exchange rate exposure. Pic and Pis are the percentage of all import cost in the total cost and percentage of the export revenue in all sales, Mat shows firm maturity, hedge variables are the value of imports / value of exports. Lagrange Multiplier test (LM) indicates that GLS is favored over OLS. The findings from the table were that the size of the firm has a non-affirmative relationship with exchange rate exposure. As the share of export revenue rises, it lowers the exposure beta. Both share of export revenue and firm size show those larger firms that have dependence on the international sales lower their exposure. The table, however, does not show any impact of firm maturity on exchange rate exposure (Solakoglu, 2005). The findings also indicated that firms can also have resources and incentives to eliminate or lower their exposure. The level of international activity is found to vital for a firm that may be characterized as net exporters, as measured by the share of export revenue in the total revenue and total cost of import expenditures (Dominguez & Tesar 2001). The exposure level was found to be higher in firms that are characterized mainly as net importers. The findings also indicate the differences in the industry structures that importers and exporters face. 10.0 Conclusion Clearly, analysis of both exchange rate movement and foreign rate exposure is a very important function in reducing high interest rate while in the same time increasing income rates. In order to mange risks associated to exchange rate movement and foreign rate exposure there is need for organization to come up with viable strategies to avoid falling into vulnerability. There is need to pay close attention to both exchange rate movements and foreign rate exposures with great attention to traditional type of exchange well as well as the modern exchange rate movement. 11.0References Allayannis, G., J. Ihrig, and J. Weston, 2001, Exchange-Rate Exposure: Financial vs. Operating Bergen, J., 2003, 6 factors that influence exchange rates. Retrieved on 23rd December 2011 from http://www.investopedia.com/articles/basics/04/050704.asp#axzz1hL04jqD5. Dominguez, K, Tesar, L, 2001, Trade and Exposure, America Economic Review Papers and Proceedings. Griffin, J. and R. Stulz, 2001, International competition and exchange rate shocks: A crosscountry industry analysis of stock returns, Review of Financial Studies 14, p. 215-241 Miller, D. and Reuer, J.,1998, “Firm Strategy and Economic Exposure to Foreign Exchange Rate Movements, Journal of International Business Studies, volume29, Issue 2, p. 493-514. Pantzalis, C., Simkins, J., and Laux, A., 2001, Operational Hedges and the Foreign Exchange Exposure of U.S. Multinational Corporations, Journal of International Business Studies, volume 32, Issue 4, p. 793-812. Solakoglu, M, 2005, Exchange rate volatility and real exports: A sensitivity analysis,” Journal of Economic and Social Resaerch , Vo.7. Strategies, American Economic Review 91, 391-395 Vetter, M., 2008, Exchange rate movements and their explanation, München GRIN Verlag GmbH. Williamson, R., 2001, Exchange rate exposure and competition: Evidence from the automotive industry, Journal of Financial Economics 59, 441-475 Read More