UK Foreign Exchange Rates - Example

Running Head: UK FOREIGN EXCHANGE RATES UK Foreign Exchange Rates [The Author’s Name] [The Name of the Institution] UK Foreign Exchange Rates Introduction Understanding exchange-rate preferences and policies is a precondition for analyzing the issues that governments raise during negotiations over the rules of international monetary institutions. exchange-rate policy has become an increasingly important—and contentious—aspect of economic management because of the integration of national financial markets. The reasons have to do with the relationships among national monetary policy autonomy, stable exchange rates, and international capital mobility. Each of these may be a desirable goal in itself, but all three are incompatible with each other. Governments must choose among: • Monetary policy autonomy and fixed exchange rates with low international capital mobility, • Monetary policy autonomy and international capital mobility with varying interest rates and volatile exchange rates, or • fixed exchange rates and international capital mobility with low monetary policy autonomy. (Holland, 2003, 210-16) With the increasing globalization activities, the foreign exchange rate risk becomes an important part management may have to think about. Foreign exchange rate risk seems closely related to firm cash flows volatility. In 2001, Allayannis and Ihrig’s theory (Allayannis and Ihrig, 2001, 805-35) suggested that firm cash flows volatility is determined by the nature of firms. But because it’s difficult to analyze most firms’ cost structure, this way didn’t figure out the relationship successfully. Foreign Exchange Rates and Euro as Determinant In 1999, the Euro is introduced as a common currency used among Europe countries. It’s a hypothesis that a common currency could reduce transaction costs, and exchange rate risk. It’s because the trade across countries avoiding the dealing of foreign currencies, then both of traders do not suffer the unexpected foreign exchange rate changes. The transaction cost occurred during the dealing of foreign currencies is eliminated as well. Then the relationship between foreign exchange rate and firm value could be observed through examining the affect of Euro on firms to check whether this hypothesis is feasible. In order to do so, there are three points need to be proved: After the launching of Euro, for many countries, stock market volatility increases. Compared to non-Euro countries and outside of Europe, those firms within Euro area due to higher exposure of Euro currency may experience lower increase. The introduction of Euro leads to the reduction of market risk, no matter this country is located in or outside of Europe. This point may testify that the nature of foreign exchange rate is non-diversifiable. Even though incremental foreign exchange rate exposures appeared in some firms, actually net absolute decreasing foreign exchange rate happened in the left 90% firms. (Buckley, 2002, 161-63) Then Euro could be stated have impact on foreign exchange rate exposure, because it arose the reduction of foreign exchange rate exposure. Excluding the above 3 points, the market beta and foreign exchange rate beta of multinationals is turned out to be determined by the firm’s characteristics, which refers to total sales, and foreign sales take place in Europe. Then the foreign exchange rate exposure reduced significantly for those multinationals with low total sales, but high foreign sales in Europe. In addition, geography and industry competition is relevant to foreign exchange rate beta as well. Compared to non-Euro Europe, market beta and foreign exchange rate beta in Euro area changed obviously larger because of the high exposure of Euro currency. High competition industries have larger reduction in foreign exchange rate beta than low competition industries. The reduction of market beta and foreign exchange rate beta means that both the market changes and foreign exchange rate changes have smaller effect on firms. (Dufey, 2002, 51-57) The high exposure of Euro currency enables firm experiencing lower market risk, eliminating the cost of capital, more capacity bearing higher business risk, and increasing firms’ value. Except the using of Euro state the relationship between firm value and foreign exchange rate exposure, lots of studies have stated the launching of Euro have other impacts on financial market. For example, the introduction of Euro increases the net debt issues in European bond markets (Rajan and Zingales, 2003, 95-98), has significant positive effect on European capital market (Galati and Tsatsaronis, 2003, p3), and drives the integration of equity markets (Fratzscher, 2002, 165-93) In the following part, we would focus on impact of single currency on both financial and non financial firms no matter where they locate in or outside Europe. Despite exchange rate stabilization due to introduction of euro, the stock return has become more volatile, thus providing no evidence of lowering in the volatility of stock for the foreign businesses operating in Europe. However introduction of Euro has significantly decreased the market risk for the companies having sales and asset in European countries. Thus allowing them to take high business risk and can sustain high financial leverage. The argument is supported by Bartov, Bodnar and Wong (2003, 35-68); as they provide evidence on increased financial risk for US multinational firms after breakdown of the Bretton woods system. The elimination of exchange rate risk in the participating countries is the major advantage of Euro. It encourages trade across European borders. Introduction of single currency has also reduced the transaction cost associated with transaction between European countries. Euro has forced the interest rate offered on government securities to be similar across the participating countries, thus lowering the risk and encouraging investors. In foreign exchange market euro does not seem to have changed the market fluctuation in a significant way. The article suggest that euro has resemblance with mark, in terms of its weight in global foreign exchange market activity, the tightness of spread, its volatility, and its role as an anchor currency. It furthers argue that it has euro has no obvious impact on foreign exchange market liquidity. (Jorion, 2004, 331-45) Reducing Derivatives The most efficient way to protect the firms away from foreign exchange rate fluctuation risk so far is hedging. Foreign exchange risks are much more serious when they expose to the multinational companies compare to the domestic firms. The principal goal of using hedging is the reduction of foreign exchange rate exposure. Introduction of euro has contributed in reducing foreign exchange rate risk, which in turn has resulted in reducing the use derivatives. In pre euro era, financial instruments was used by the firms for hedging that risk i.e. derivatives, which is a key motive for the corporate to hedge foreign exchange (FX) risk, foreign e.g. forward and future option, swaps etc. (James, 2002, 244-50) In post Euro period there is overall decrease in using FX derivatives for hedging the risk with foreign exchange exposure, as adopting euro has decrease the foreign exchange rate exposure which infect reduce firms foreign exchange transaction cost, commission, bid asked spread and cost of managing foreign exchange risk. (Nguyen, et. al. 2005, 119-28) As for the subsidiary located in or outside of the euro zone has they moved from home currency to euro. There is no evidence showing that introduction of euro has resulted in reducing the use of derivatives. However, overall there was decrease in derivatives after euro adaptation, according to sample of firms it has not shown decline in the usage of derivatives which can be justify by some argument. Volatility of euro might have similar impact of against the other currency. Risk concern with merging eleven currencies by individual economies with different characteristics could have developed caution for risks. The elimination of currency movement has resulted in long term business arrangements between different countries, as investors are not worried about the currency movement. The prices are comparable among the participating countries, which has resulted in price stability in European Union. Trade and business has increased among the participating countries, as they are not worried about the exchange rate movement. As there are more trade flows between the countries, the economies are integrated, as economic condition of one country have effect on other European countries. Generally, the introduction of the euro will fundamentally reinforce the country's financial system, make it more flexible in dealing with the financial impacts, promote the investments and business, even integrate and upgrade the country’s macroeconomic stability and growth. (Laurence, 2005, 390-95) The introduction of the euro will bring many benefits. It would completely eliminate exchange rate risk, abolish the risk premium included in interest rates, eliminate currency exchange transaction costs, make cross border payments easier, faster and cheaper. There is a hypothesis that the introduction of euro has positive affect on the economies of participating countries. It’s because the trade across countries avoiding the dealing of foreign currencies, then both of traders do not suffer the unexpected foreign exchange rate changes. The transaction cost occurred during the dealing of foreign currencies is eliminated as well. The integration of money markets is one the major success of euro. The introduction of euro has removed the barriers of trade among the participating countries, provided opportunity for free trade and sharing business. It has also contributed in eliminating the exchange rate risk, thus encouraged the investors and foreign companies to engage in business in European Union. The establishment of medium size businesses in the region has encouraged competition. The single currency has given the transparency of prices, and better products for the consumers. The medium and long term stability in the interest rate has given boost to the economy. Thus it can be safely concluded that euro has successfully contributed in reduction of market risk and exchange rate exposure for non finance firms. Although there is weak evidence of lowering the volatility of stock, but overall reduction in market betas, and minimizing exchange rate risk has benefited the non finance and finance firms in or outside Europe. Policy Autonomy and Stable Exchange Rates Increases in international capital mobility have made the first option—policy autonomy and stable exchange rates—increasingly problematic. Given the depth and size of contemporary international financial markets, restricting international investment to retain policy autonomy can impose large costs on the domestic economy. Governments increasingly chose between retaining policy autonomy with a potentially volatile currency or giving up policy autonomy to maintain a stable exchange rate. When capital mobility was low, governments were free to adopt different monetary policies and maintain stable exchange rates. This freedom disappears when capital moves across international borders because asset holders will invest in the country whose monetary policy produces the highest expected returns, thus forcing a convergence of returns on short-term financial assets and of interest-rate policies. Although capital mobility makes it difficult to implement an autonomous monetary policy, it is still possible to influence the exchange rate. For example, if the central bank pushes interest rates below rates prevailing overseas, investors sell the currency and purchase foreign currency assets. This reduces demand for the domestic currency relative to foreign currencies, resulting in the depreciation of the exchange rate. The effects of exchange-rate changes on economic activity are straight-forward. When a currency depreciates, the prices of goods denominated in the currency decline relative to goods denominated in foreign currency. Imports denominated in foreign currency become more expensive, whereas exports denominated in the domestic currency become less expensive. Demand for the cheaper domestically produced goods increases at the expense of demand for foreign currency goods. Conversely, currency appreciation switches demand from domestic goods to foreign goods. Exchange-Rate Policy The exchange rate is the market price of one currency in terms of another. There are certain policies that influence the stability and level of exchange rates. An exchange rate is stable when its value does not change much over time. The exchange rate may be at a competitive level so that the prices of domestic goods are equal to or less than prices for goods produced overseas using similar inputs, or it may appreciate above this level. The level of the exchange rate can be measured in nominal or real terms. The nominal exchange rate is just that—the price of one currency in terms of another. The real exchange rate takes account of changes in prices in different countries to measure the competitiveness of their products. This distinction between real and nominal exchange rates is important because on many occasions the pound, franc, and lira depreciated in nominal terms but appreciated in real terms since domestic inflation was high. The first dependent variable in this book is not the stability or level of the exchange rate but exchange-rate policy, defined as the authorities' attempts to influence the market exchange rate. (Mordecai, 2003, 32-35) Policy is only one of many factors that determine actual exchange rates. International investors, traders, and manufacturing industry value the predictability of returns from domestic and international sales and investments that is produced by currency stability. It is true that they can reduce uncertainty about exchange-rate changes with various forms of inexpensive insurance available in well-developed financial markets, including currency futures, options, swaps, and other derivative contracts. However, such insurance is not widely available for more than one year, making it difficult to hedge against the longer-term risks of exchange-rate fluctuations that influence planning, production, marketing, and investment decisions. The exchange rate was a contentious issue in British politics. Sharp appreciation led to an intense lobbying campaign from industry and trade unions against the Thatcher government's policy of reducing inflation with high interest rates. But this policy mix pleased many banks and financial firms because it maintained the value of their assets and restored London's role as a leading international financial center. British authorities chose to treat the exchange rate as the residual of domestic macroeconomic policy. The goal of the policy choices of the Conservative government—pursuing monetary targets and encouraging currency appreciation—was to reduce inflation as quickly as possible. Once sterling peaked, the authorities tried to prevent rapid depreciation that threatened to increase inflation. Two factors led authorities to consider more comprehensive exchange-rate arrangements, such as bringing sterling into the ERM (Exchange Rate Mechanism). (Lang, and Lundholm, 2003, 246-71) First, monetary targeting became an unreliable policy guide, leading some to see the exchange rate as a natural nominal anchor for stabilizing investors' expectations. Second, economic fundamentals—the over-appreciation, along with decreases in the price of oil—led to a secular decline in the value of sterling, and some believed that entry into the ERM could reduce the likelihood and severity of currency crises. This belief did not mark a shift to a competitiveness-oriented exchange-rate policy; rather, ERM entry was interpreted as a way to stabilize expectations, discourage depreciation, and increase the government's credibility in the financial markets. Thatcher opposed ERM entry because it would reduce the government's ability to implement an autonomous monetary policy but consistently authorized short-term increases in interest rates to support sterling. Although there was not a consensus on ERM entry, there was a consensus on preventing rapid depreciation or levels of interest rates that could fuel domestic inflation. Floating Exchange Rates Floating exchange rates are not, however, the only means by which an economy can adjust to shocks from outside. Other instruments for stabilizing the economy after a shock include capital movements, fiscal policy, flexible wages and other costs, and the mobility of production factors. It is important to stress that floating exchange rates are a means for the national economy to adjust to major shocks from outside. In the case of disturbances affecting one sector only, changing the exchange rate may not be justified. Nor does a floating rate provide adequate protection against disturbances of domestic or monetary origin, such as inflationary wage hikes. At worst, the floating rate may contribute to the perpetuation of economic instability; cautionary examples can be found in the economic history of various countries. Fixed Exchange Rate A fixed exchange rate is one that is not allowed to fluctuate. For example, country A might commit itself to fixing its currency at a predetermined rate to that of country B. The authorities of country A will hence intervene to maintain the fixed rate. Fixed exchange rates maintain exchange rate stability yet might have adverse effects on the economy. The relative significance of floating and fixed exchange rates for general economic stability is a traditional bone of contention among economists. The impact of monetary union on overall economic development will depend primarily on how it affects the credibility of economic policy. At best, the resulting boost to the credibility of a small country's monetary policy could be substantial. This would depend on the monetary policy pursued by the Central Bank, on the one hand, and on the credibility of domestic economic policy associated with a floating exchange rate, on the other. The fixed effect proved statistically most significant, with a negative sign for monetary union members and a positive sign for nonmembers with pegged currencies. That is, currencies pegged to single money outside monetary unions yield better economic performance. Moreover, the exchange rate regime alteration helped the real effective exchange rate adjust to its equilibrium level, improving the growth of exports ratio to GDP. Therefore floating exchange rates would be better because of the economic effectiveness and the better performance it proposes. Modeling the real exchange rate as a function of real wages and the unemployment rate implies that real exchange rate movements are affected by conditions prevailing in the production sector of the economy. In this case, a smooth transition rather than a sharp switch between regimes could be justified in terms of frictions in the product market due to product heterogeneity, government imposed barriers to trade, or labor market inflexibility distorting the rapid adjustment of wages. The dynamics of the real exchange rate, real wages and unemployment vary both with large versus small real exchange rate disequilibria and rising versus falling unemployment regimes. The short-run real exchange rate adjusts to disequilibrium deviations of the real exchange rate from its long-run level only outside an interval band. When regimes of rising versus falling unemployment are taken into account, fast real exchange rate adjustment occurs in periods of falling unemployment. This implies that prices and wages are more flexible when real output is high. (Weise, 2006, 85-108) Conclusion Economic growth basically means higher incomes; higher incomes determine a higher standard of lifestyle. Every government tries to stimulate growth within the economy. However, too much growth can lead to a number of problems, this is it is the governments objective to stimulate as much growth as possible, however, without inflation and balance of payment problems. There are two types of economic growths, these are: actual growth and potential growth. Actual growth relates to percentage annual increase in national output: the rate of growth in actual output. Where as potential growth is the speed at which the economy could grow it is the percentage annual increase in the economy’s capacity to produce: the rates of growth in potential output, examples of these are an increase in resources, such as natural resources, labor, and capital. The pattern that the economic growth tends to follow is a cyclical fluctuation. There are some areas in which the economic growth is a lot faster, this is known as a boom period, and however these areas are also followed by periods when the economic growth has slowed down. This form of pattern is commonly known as a business cycle. This form of economic growth can be seen in appendices 2 for the last two decades. Fluctuations within the economic growth that occur are known as a business cycle. Fluctuations such as these often transpire at around every five years. As many governments as possible try to dampen the effects of a business cycle and try to achieve more of a balanced long-term growth, however this has not been very successful for many governments. The series in which the business cycle follows is firstly with a recession, which is then followed by a recovery, which in turn follows a boom. Following a period of a boom, there is then a downturn leading towards a recession. This is known as either a stagnation or series of slow growth. Subsequently, a period of recovery is then immediately followed. Points at which incomes and outputs are decreasing are known as a depression or a slump. In the rules of the ERM it stated that all of its members who were a part of the ERM would have to help the other struggling currencies stay within its legitimate bands. This meant that the other members of the ERM would have buy pounds or cut its interest rates in order to make the pound more appealing to its investors. However, the help offered was very limited and there did not seem any point to buy any pounds when the effect would be very minimal in comparison to global money flows. References Allayannis, G., Ihrig, J., 2001. Exposure and markups. Review of Financial Studies 14 (3), 805-835 Bodnar, G.M., Wong, M.H.F, 2003. Estimating exchange rate exposures: some ‘weighty’ issues. Financial Management 32, 35–68 Buckley, Adrian (2002), Multinational finance, 4th Edition, Harlow: Financial Times /Prentice Hall: 161-63 Dufey, G., 2002. Corporate finance and exchange rate variations. Financial Management 1 (2), 51-57. Fratzscher, M., 2002. Financial market integration in Europe: on the effects of EMU on stock markets. International Journal of Finance and Economics 7, 165–193. Galati, G., Tsatsaronis, K., 2003. The impact of the Euro on Europe's financial markets. Financial Markets, Institutions and Instruments 12, 3 Holland, John (2003), International financial management, 2nd edition, Oxford: Blackwell. 210-16 James C. Van Horne (2002), Financial management and Policy, 12th international edition. 244-50 Jorion, P., 2004. The exchange-rate exposure of U.S. multinationals. Journal of Business 63 (3), 331-345 Lang, M. and Lundholm, R. (2003) Cross-sectional determinants of analysts ratings of corporate disclosures. Journal of Accounting Research 31 (Autumn): 246-271. Laurence S. Copeland (2005), Exchange rates and international finance, 4th edition. 390-95 Mordecai Kurz, Hehui Jin, Maurizio Motolese, 2003 “Determinants of Stock Market Volatility and Risk Premia” SIEPR Discussion Paper No. 03-01. 32-35 Nguyen, Hoa Robert Faff and Andrew Marshall “Exchange Rate Exposure, Foreign Currency Derivatives and the Introduction of the Euro: French Evidence”Hisham S. Foad, 2005, “Exchange Rate Volatility and Export Oriented FDI” Emory University, Atlanta, GA. 119-28 Rajan, R., Zingales, L., 2003. Banks and markets: the changing character of European finance. Oxford Press: 95-98 Weise, C.L. (2006): “The asymmetric effects of monetary policy: a nonlinear vector auto-regression approach,” Journal of Money, Credit, and Banking, 31, 85-108. Read More