Foreign Exchange Rate Exposure - Coursework Example

Running Header: Foreign Exchange Rate Exposure Student’s Name: Instructor’s Name: Course Code: Date of Submission: Foreign Exchange Rate Exposure In many instances, there are very many companies and corporations that are trading with foreign currency. There is a risk that is involved when international companies and organizations go through this route. This is what can be termed as foreign exchange rate exposure. The risk lies heavily on the international firm in instances where the foreign currency used during trading takes a certain turn. This turn may not be beneficial to the firm that is represented at the international level (Myers 1992). The turn could automatically have adverse effects on all the existing set ups in the organizations. This is one of the main reasons as to why it is encouraged that international companies have set mechanisms to deal with foreign exchange rate exposure. The general capacity of any firm or organization is represented by its ability to remain firmly rooted on the ground. This is as it strives to make the necessary profits that it is required to make. This paper aims to help in the understanding of foreign exchange rate exposure. It will dissect the effects, if any, of the exchange rate of international companies. This is in line with observations around the different theories and processes (Myers 1992). To be able to fully understand foreign rate exchange exposure, an analogy can be used. If a person is a major shareholder in the Toyota brand in Japan, the Japanese currency will dictate how the business goes. This means that if the Japanese Yen drops, so do the profits that are expected. If it is at an all time high, profits will be accrued from many of the transactions conducted. The general observations that relate to exchange exposure are of three distinct types. They include the economic, transactional and translation exposures. They all have varied effects on the standing and capacity of the global firms. Economic exposures relate to all the risks that are encountered as a result of trading in known and unknown markets from time to time (Wong 2003). International firms have to transact at each and every step of the way in their host countries. This gives rise to the transactional exposure. This requires the company to have the ability to maneuver its activities and transactions around the foreign currency. There are also huge accounting risks that are as a result of the general cost of accounting. This are involved with the physical presence of a company in foreign territory trying to operate in their terms. In summary, any international company has to ensure that it has systems in place. The systems should be able to deal with fluctuations on the foreign currency (Myers 1992). This is because this will have obvious effects on the company’s assets, liabilities and the overall general standing of the business. It would not be fair to say that local companies do not battle with many of the above mentioned issues. They obviously battle with operating, transactional and economic costs. All these are effectively and efficiently coordinated to ensure that the main objective of the local companies is realized. This is with due consideration to expansion, growth and profit making. This will lead to employee satisfaction and low staff turnover (Houston, 1987). The risks that are affiliated to the local companies in terms of exchange rate cannot be compared in any way to the international companies. This basically means that they are higher when they are compared to each other. There are very many theories that surround foreign rate exchange exposure. This theories all work in a way that actually looks into the issues of international companies and how they deal with the issue of foreign rate exchange. The theories include the International Fischer, Purchasing Power Parity (PPP) and the Unbiased Forward Rate theories. All these theories have a deep connection to the foreign exchange rate exposure. The PPP as is dictated by arbitragers insists on the maintained price of the goods and services bought in one country and sold in another. This basically means that there should be the controlling of the prices of the goods bought in one country and sold in the next. This is what constitutes good business practices between two countries and the companies that represent them. The aspect of foreign exchange rate exposure in the real sense retards this concept. This is because it is practically impossible to retain the price of the goods sold in one county in another country (Houston 1987). This is because of the fluctuating currencies that have time and time again affected how the goods will be sold. Inflation is the result of conducting business in such an environment (Levich 2002). A good example where the effects of the FERE (Foreign Exchange Rate Exposure) are being witnessed currently is in Kenya. This East African country has for the longest time traded with the United States. The dollar and the shilling have had good standings in many years of the transactions carried out. As much as the Kenyan shilling could not be compared to the American dollar, it was possible to conduct business. The weakening of the Kenyan shilling against the US dollar has been a nightmare for investors and consumers (Houston 1987). Many international companies have increased the prices of many goods and services that they are offering in the country. This is because they also aim to cushion their businesses. At the end of the day, the consumer is adversely affected by the fluctuating currency. This has given rise to the rates of inflation in the third world country. The prices of basic goods and services are choking majority of the citizens. Many of whom before the fluctuating currency, were living below the poverty line. This is one of the reasons as to why it can be observed that the general changes in exchange rates have adverse effects on the levels of inflation. If the rates change in a way that the citizens can afford basic commodities, inflation has been reduced. If the exchange rate demands an increase in the prices of basic goods and services, then inflation will be observed in many areas. The International Fischer Effect theory (IFE) means that any investor has the power to convert his currency. The conversion is aimed at reducing the effects of investing in a low interest area. The currency can be converted to high interest areas. Once this is done, the difference between the observed principles aims at cushioning the investor. The currency difference accrued from the exchange rate leads to a certain said profit margin. The margin aims to ensure that it is possible for the investor to offset his loss from the transactions. This means that the currency gained during conversion will protect his business. This is especially the case when the projected exchange rates have negative effects on the investors standing in the business (Gagnan 1998). The expectations theory propagates a set system that aims at ensuring that it is possible to come up with some mechanisms. The selected mechanisms ensure that it is possible to identify all the potential hazardous systems for investors. Once this is done, it is much easier to come up with systems that compliment the exchange rate that has been observed. The great thing about this system is that it does not limit on the observations of the exchange. All the observed theories are from an unbiased source. This means that they have the capacity to identify what needs to be done by each and every investor in any potentially dangerous situation. The processes of cushioning all the negative effects of the investment process allow forward expectations and their general reprieve. All the theories that have been analyzed show that there is a need to understand foreign exchange rate exposure. This is the only way that it will be possible to come up with feasible solutions for all the people who are investing internationally. This is because any type of investment has certain capabilities in the country where it is located. This includes infrastructure improvement, job creations and a sustainable economy for citizens in the country. The process of hedging is one of the methods that were created to rescue the effects of any potential financial losses. This was because it was practically impossible to realize all the risks that were involved in the process. This meant that in all instances, hedging aimed at creating a situation where investors in any type of business were protected at all costs. Hedging involves very many channels and avenues. All the channels and avenues are created to have the capacity to deal with any observed situation. As the fluctuation of the shilling cannot be ignored, hedging is one of the methods to deal with the issue. It can occur in many set means that have been identified by the parties involved (Williamson 2001). The risks that are involved during any transaction are halved. Their reduction is one of the things that make the option a very necessary one in all financial situations. Hedging occurs in very many different formats and processes. This creates a situation where it is possible to look at the different matters that arise differently. There are very many companies that are located in varied locations internationally. They idea of spreading their geographical locations ensures that the risk, either actual or potential is spread all over the areas. There are instances when the situation in one country is doing better off than the others (Houston 1987). The profits that accrue from the profits of one country can be used to stabilize the situation in another country. This means that if one company is located in Japan has recorded losses; the other one in the US can redeem the losses incurred (Levi 2007). This is one of the most common hedging methods that have been used over the years. The bailing out system has ensured that were profits are recorded; they are shielded from the harsh economic overturns. This is through investments and company expansions. It is proper for companies to draft financial contracts. This is because there are times and instances when the contracts have come in handy for companies and organizations. The financial contract is a legal binding agreement between involved parties as relates to all financial aspects in question. A good example that can be observed is when dealing with future prices of fuel. It is a well known fact that the prices of fuel are the most erratic in the world. This creates a situation where companies and organizations dealing with the commodity are constantly stressed out. The signing of a contract between the involved parties ensures that the risk of unreliable and expensive fuel costs has been dealt with. This is one of the strategies that Southwest Airlines used in 2004. The prices of fuel at that time were very high. This was because of the very many issues that the US was experiencing at that time. There was the issue of hurricane Katrina and the US invasion in Iraq (Dewenter 2002). The contract that the airline company had signed ensured that they saved a lot of money. They were able to afford the cost of fuel at that time. This was as compared to many other companies that were struggling to stay afloat. It is important to analyze the effects of the kind of exposure experienced. This means that the short and long term exposure issues have adverse effects on the choices made. Many stocks and shares related companies face both short and long term exposure issues. Once the issues have been analyzed, they create a situation where the right decision has to be made for the sake of the company. It is important to understand what needs to be done, and at what point it should be done. If a company has its shares threatened by any situation, it is important to map the way forward. This means that the company should take time to understand two critical issues. Should they sell all their stocks and shares at an expected loss? Should they hold onto their shares hoping that the current overturn system will result in increased profits in future? The point that is communicated here is that a company can have 1000 shares. If it sells them at $1 each, the profits will be $1000. If another company has 500 shares and sells them at $2 each, the profit margin will be the same. It is important to understand what needs to be done at each point. This will ensure that companies understand what they can do and how they should do it to save themselves in any financial crisis. Insurance is also a very strong hedging policy. This is because depending on the agreed upon platform, there are many companies that have been compensated for their losses in the international market (Brown 2004). Nike has over the years ensured that it has actively insured their stocks in all the international markets that it has managed to penetrate. This is because of the active need to have the systems to deal with any situation that may result in a loss for the company. This is one of the many reasons as to why Nike has been observed as a very profitable and ever expanding company (Brown 2004). It is true that foreign exchange rate exposure matters for international companies. This is because it is a huge and determining factor in the profits made, level of growth and expansion. It is also the determining factor in negative aspects for example plummeting of some companies from the international markets and the layoffs of very many employees. It is crucial o ensure that each and every company has active systems in place to deal with the issues of foreign exchange rate exposure. This is with the aim of ensuring that it has actively covered all actual and potential problems that may be experienced. The ability to come forth and create the active systems involves all the stakeholders in the company and in the host country. The failure of any organization in any country is a loss to all the parties involved. The international company will lose out on an active market that enjoyed its goods and services. The country will also lose out on all the economic advantages that were felt by the operation of the company. This will amount to many financial mistakes by well known companies that had the capacity to do more. References Allayannis, G & Ofek, E 2001, ‘Exchange Rates Exposure, Hedging, and the use of Foreign Currency Derivatives’, Journal of International Money and Finance vol. 20, pp. 273-296. Benninga, S 1985, ‘Optimal International Hedging in Commodity and Currency Forward Markets’, Journal of International Money and Finance vol. 4, no. 4, pp. 537-552. Brown, G, Crabb, P & Haushalter, D 2006, Are Firms Successful at Selective Hedging? : A Working Paper, University of North Carolina, Carolina. Dewenter, K, Higgins, R., & Simin, T 2002, Is there a Contemporaneous Relation between Exchange Rates and Stock prices? Evidence from Decisions to Allow the Mexican Peso and Thai Baht to float, working paper, University of Washington, Washington. Gagnon, L, Lypny, GJ & McCurdy, TH, ‘Hedging foreign currency portfolios’, Journal of Empirical Finance, vol. 5, no. 3, pp. 197-220. Glen, J 2006, ‘Currency Hedging for International Portfolios’, Journal of Finance, vol. 48, no. 5, pp. 1865. Houston, JE, Ames, GWC & Burney, RB 1987, ‘Hedging Portfolios for European Feed Processors and Compounders Including Foreign Exchange Risk’, Proceedings of the NCR134 Conference on Applied Commodity Price Analysis Forecasting and Market Risk Management. Johnson, SA 1992, ‘Measuring the Foreign Exchange Exposure of Offshore Assembly Operations’,  Journal of Borderlands Studies, vol. 7, no. 1, pp. 49-68. Jorion, P 2004, Financial Risk Manager Handbook. New York: John Wiley and Sons. Levi, M & Amihud, Y 2007, Exchange Rates and the Valuation of Firms, Bantam Books, Chicago. Levich, E 2001, Exchange Rates and Corporate Performance, Irwin Publishers, New York. Marston, R 2001, ‘The effects of industrial structure on economic exposure’, Journal of International Money and Finance, vol. 20, pp. 149-164. Muller, A & Verschoor, WFC 2006, ‘European foreign exchange risk exposure.”European Financial Management, vol. 12, no. 2, pp. 195-220. Myers, SC & Stern, J 1992, The Search for Optimal Capital Structure: The Revolution in Corporate Finance, Blackwell Publishers, Cambridge. Williamson, R. Exchange rate exposure and competition: Evidence from the automotive Industry. Journal of Financial Economics 59, 441-475, 2001. Wong, TC, Wong, J & Leung, P 2009, ‘The foreign exchange exposure of Chinese banks’, China Economic Review, vol. 20, no. 2, pp. 174-182. Appendix 1 The Foreign Exposure Rate of Nike operating in Japan Expected Maturity Date     Year Ended May 31,     2010     2011     2012     2013     2014     Thereafter     Total     Fair Value     (In millions, except interest rates) Foreign Exchange Risk                 Japanese Yen Functional Currency                 Long Term Japanese yen debt — Fixed rate                 Principal payments   $ 6.9      $ 6.9      $ 167.1      $ 6.9      $ 6.9      $ 44.7      $ 239.4      $ 235.9 Average interest rate     2.4 %      2.4 %      3.4 %      2.4 %      2.4 %      2.4 %      2.5 %    Interest Rate Risk                 Japanese Yen Functional Currency                 Long-term Japanese yen debt — Fixed rate                 Principal payments   $ 6.9      $ 6.9      $ 167.1      $ 6.9      $ 6.9      $ 44.7      $ 239.4      $ 235.9 Average interest rate     2.4 %      2.4 %      3.4 %      2.4 %      2.4 %      2.4 %      2.5 %    U.S. Dollar Functional Currency                 Long-term U.S. dollar debt — Fixed rate swapped to Floating rate                 Principal payments   $ 25.0      $ —      $ —      $ 40.0      $ —      $ 100.0      $ 165.0      $ 169.0 Average interest rate     3.1 %      —        —        3.1 %      —        1.6 %      2.2 %    Long-term U.S. dollar debt — Fixed rate                 Principal payments   $ —      $ —      $ —      $ —      $ —      $ 50.0      $ 50.0      $ 51.5 Average interest rate     —        —        —        —        —        4.7 %      4.7 %    Appendix 2 The table below shows Toyota brand in three business segments for each of the past three years in the fiscal observations of Toyota. This is reference to the design, manufacture, assemble and sales of the products of the brand in many of its international companies. This is in reference to the ability to stand firm in the international markets and environment. Yen in millions Year Ended March 31, Automotive . . . . . . . . . . . . . . . . . . . . . . . . . . . . ………In 2008 the revenue was recorded at ¥24,160,254 (2009)¥18,550,501(2010) ¥17,187,308 Financial Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2008)1,468,730 (2009)1,355,850 (2010)1,226,244 All Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (2008)660,256 (2009)623,219 (2010)537,421 Read More