Treasury & Risk Management - Assignment Example

TREASURY & RISK MANAGEMENT Contents Contents 2 Introduction 3 Question 3 (a) A managed floating exchange rate 3 (b) A fixed exchange rate linked to a basket of currencies 5 (c) A fixed exchange rate backed by a currency board system 6 Question 2 8 Purchasing Power parity (PPT) 8 Arguments in favor of this theory 9 Arguments against the theory 10 Interest Rate Parity 11 Arguments for the theory 12 Arguments against this theory 13 Conclusion 13 14 References 14 Introduction The managed floating exchange rate can be defined as the exchange rate in which the government interferes at a definite interval for changing the direction of the float that is related to selling and buying of the currencies. The fixed exchange rate determines the value of the currency that is fixed in lieu of the precious metal or against the other currency or against the basket of currencies. The government of different countries determines a fixed exchange rate that is known as the pegged exchange rate. Question 1 (a) A managed floating exchange rate The main characteristics or features of the managed floating exchange rate system are that it is based on the market demand and supply. The exchange rate plays an important role and it plays the role of the price signal. The managed floating exchange rate system is based on the current and the trade account balance for defining the nature or the characteristic of the floating exchange rate system. The exchange rate is also used to determine the basket of currencies despite of the bilateral exchange rate (Abel and Ben, 2005). The managed floating exchange rate is sometimes referred to as the dirty float since the exchange rate is free and easy to fluctuate but the central bank of the countries has the responsibility to interfere and supervise different conditions for perceiving the instability. Figure 1: Managed float exchange rate system The above diagram signifies that the smaller band experiences more stability in the exchange rate as compared to the larger band where the stability in the exchange rate is less and the large band requires more intervention or supervision of the central bank. The implication of the managed floating exchange rate in case of the multinational corporation can be explained as the foreign subsidiaries of the multinational corporations require the local regulation and supervision for the use of the local currencies for determining and recording the financial transactions. Therefore it is required to convert the currency of the parent company at the end of the financial year in the financial statements and in case where the parent company formulates the consolidated financial statements of the company. The short term change in the exchange rate generally has a greater influence or impact on the contractual payment of the multinational corporations. Multinational corporations are able to hedge the transaction exposure by using or applying the internal and the commercial instruments which are subjected to adjustments. This can be explained with the help of the example such as suppose a multinational company in Australia has its subsidiary in Japan then the Japanese’s company will require dollar for paying off to Australia for the import of the goods and services that are supplied by Australia and also for funding any investment by the investor of Australia in Japan and the Japanese subsidiary can earn dollar by supplying the Japanese currency yen in the foreign exchange market to Australia (Arnold, 2008). Again on the contrary it can be explained that the Australian multinational corporation can get yen by paying for the imports from Japan and also in case of the capital investment that is made. (b) A fixed exchange rate linked to a basket of currencies The countries with fixed exchange rate are exposed to less risk and inflation rate as compared to the countries with flexible exchange rate system. The main advantage or the benefit of the fixed exchange rate is the minimization of risk associated with the exchange rate in case of the short run and it assist in marinating the fiscal and monetary policies of the government. Apart from the advantages the fixed exchange rate also possesses disadvantages or limitations that include the increase in the speculation in currency related to possible revaluations and the lack of monetary independence (Mankiw, 2002). The central bank of each country maintains the transaction of the currency by buying and selling of the currency in the foreign exchange market. For example if the value of the single currency is equal to 3 USD then the central bank has to maintain supply for providing dollars. Therefore the central bank is expected to maintain a high level of foreign exchange reserve (Shapiro, 2002). The implication in maintaining the fixed exchange rate that is linked to the basket of currency in case of the multinational company having its subsidiaries in other countries can be explained as the multinational companies are subjected to the economic risk that is associated with the fluctuation in the exchange rate. As most of the multinational companies carries out the function of importer and the function of exporter at a same point of time, therefore the exposure that is related to the risk arising out of exchange rate is restricted to the net cash flow of a particular currency and the risk is also related with holding of the foreign assets (Sexton, 2007). For example in case of the multinational company In USA having its subsidiary in London. The multinational company deals in car therefore the value for dollar in case of shipment of the cars to US that will be payable in three months. The present value of US dollar is known but the risk arises in case of the payment of euro in terms of dollar after three months since the value of the currency in case of the exchange rate system varies therefore it is required to establish a fixed exchange rate system to make proper adjustment that is required to determine the demand of export in relation to the variation in the exchange rate (Gottheil, 2013). The multinational companies with subsidiaries in foreign countries and listed in exchange have their headquarters in the euro area for the estimation of exchange rate variations. The multinational companies generally adopt the technique of hedging for reducing the risk related to the fluctuation in the exchange rate. The smaller exporters generally prefer to adopt the technique of hedging and invoicing for reducing the exchange rate risk (McEachern, 2008). (c) A fixed exchange rate backed by a currency board system Like the central board which normally issues currency that is notes and coins that are in circulation in a country, sometimes the job of issuing notes and coins in taken up by the currency board. What currency board essentially does is that it issues currency of a country that are anchored or pegged to a stable foreign currency. The international currency that the local currency is normally pegged to is an international currency that is strong and internationally traded. How valuable and stable the local currency will be is directly dependent on the international currency (Berger, 1995). The international currency can be either dollar or pound or euro. The exchange rate that is followed under a currency board system is a typically fixed one. In a currency board system what happens is that the country following the system does not gets its monetary policy fixed by the monetary authority of the country but it is actually determined by the demand and supply. The amount of currency that a currency board issues is directly backed by the amount of foreign reserves that is hold by the country. That is to say the amount of foreign currency that the country following the currency board system should be 100% of the total amount of cash and coins in circulation in the country (Hong Kong Monetary Authority, 2013). In fact the amount of the foreign currency that the country should hold as reserve should be greater than 100% of the total amount of currency in circulation to account for other liabilities of the country. The main advantage that a currency board system offers is that it is counter to inflation. The currency board system offers automatic convertibility that is the right to automatically convert domestic currency at the fixed rate to foreign currency to which the currency is pegged (Berger and David, 1997). The system actually ensures stability and a reduction of risk in testing times just like the fixed rate system, however unlike the fixed rate system the currency board system’s additional benefit lies in the fact that the necessary interest rate changes and the attended costs for the economy under this system is lower than the fixed rate system. From a multinational company’s perspective the system is very advantageous as it reduces the risk associated with a multi currency environment. Coupled with the factor that the system is probably better than even the fixed rate exchange system while providing the same benefits of a fixed rate exchange system it is no doubt that the different countries, particularly those with volatile currencies are contemplating on the fact as to whether to adopt this system or not. Additional benefit that is derived out of using this system is that the inflation is contained and that means the demand for goods produced by the multinational company will never diminish (Cetorelli and Gamberra, 2001). Question 2 Purchasing Power parity (PPT) PPT theory has been developed for measuring the purchasing power of one currency in relation to the purchasing power of another country. PPT is considered as an economic theory that determines or analyzes the required amount of investment for determining the exchange rate between countries. It can be calculated as Where, S can be determined as the rate of exchange of currency of one country with that of another country. P1 can be determines as the measurement of the cost of the goods on the basis of currency of one country. P2 can be determined as the measurement of the cost of goods that is related to the currency of another country. The main objective of framing or developing the concept or the theory of purchasing power of parity is for charging a common price of the identical products or goods which is sold in two different countries of the world when it is expressed or converted in same currency. Purchasing power parity reduces the risk of manipulation and wrong calculation determining or comparing the exchange rate. The purchasing power parity explains the functions of the efficient market that is identical or similar to the goods that are charged with a common price (Chortareas, Girardone and Ventouri, 2011). The need or the requirement of purchasing power parity has originated due to the arbitrage factor which has compelled the market forces to play an important and vital role for bringing equilibrium in the price. This concept is mainly developed to remove the arbitrage opportunity that is developed on the concept of buying the products in one country and selling the same product in other country (Coccerese, 2005). The theory also excludes various factors which includes the tariff, transportation cost and the transaction cost. This theory assumes the goods and services that are dealt in the competitive market between the countries (Koch, 2009). Arguments in favor of this theory The evidence for the theory can be explained as this concept is developed on the basis of the law or the concept of charging one single and identical price for the products in the absence of trade barriers and the transaction cost and it establishes the fact that the identical or the similar goods will be charged with the same price in the different markets in case of the price that are converted or expressed in one common currency. The main functions that are performed in case of determining or explaining the theory of purchasing power parity are it eliminates the arbitrage opportunity, to maintain stability in the exchange rate of the currency between the countries. The validity of the purchasing power parity can be explained by the fact that the law of one price which is applied in case of the individual product and the purchasing power parity that is determined in case of the general price level (Corts, 1999). Therefore if law of one price is applicable for all commodities therefore the purchasing power parity is also applicable or valid for determining the price level for all commodities. Arguments against the theory The evidence against the theory of purchasing power parity can be explained as the determination of the purchasing power parity is very critical and complex because the currency of the countries do not only varies or differs in case of the uniform price level. The disadvantage or the limitation of the purchasing power parity is that it establishes or develops the basis of multilateral comparison of the products or the products or the goods on the cost of destroying the comparison of the products or goods on unilateral basis. The basis of consumption is different for different countries therefore the purchasing power parity calculated on the basis of consumption in US will vary or differ from the purchasing power parity of China. The theory of purchasing power parity is more valid and reliable if it is applied after an interval of time as it cannot be applied on a regular basis or period of time (Fethi and Pasiouras, 2010). The other shortcoming of this theory is that it does not take into consideration the tariffs and the transportation cost since the consumption pattern in case of the non traded goods and service varies from countries to countries. It is based on the efficient market price hypothesis therefore the stable price doesn’t allow or permit the market to function effectively and efficiently. This theory is not at all suitable or applicable at the time of recession since the relative price and the consumption pattern will change between the countries (Lozano, 2001). Interest Rate Parity The theory of interest rate parity is considered as the most important and influential theory in the international finance and it is considered the best and the most efficient method of determining the value related to the exchange rate and the reason for the fluctuation in the exchange rate. The interest rate parity explains the relationship among the exchange rate of the currency of the respective countries. The assumptions on the basis of which the interest rate parity develops are that the capital is considered as mobile and it facilitates the investors in determining or ascertaining the exchange rate of the domestic asset in terms of the foreign assets (Pastor, 2002). The interest rate parity can be calculated with the help of the following formula (1 + i$ ) = E t ( St + k ) / St ( 1 + ie ) Where, E t (St + k) can be explained as the exchange rate of the future spot for the time t + k K is considered or explained as the time period from the time t into the future. St is considered as the current exchange spot rate for the time t i$ is considered as the currency of one country. ie is considered as the exchange rate of another country. This theory also explains the interest rate differential that exists in the currencies between the countries and it can be explained with the help of the premium and the discount provided in case of the foreign exchange rate in determining the foreign currency. There are two types of interest rate parity which includes the covered interest rate parity and the uncovered interest rate parity (Weill, 2004). The covered interest rate parity explains the interest rate differentials in case of the spot and forward premium of the countries and the uncovered interest rate parity which explains the expected appreciation or depreciation of the currency in case of charging lower or higher rate of interest. Figure 2: Interest rate parity The figure above represents that the uncovered interest rate parity is favorable in case of the foreign exchange market and it explains or signifies that return from investing domestically is equivalent to the return from investing in abroad. In interest rate parity the opportunity of arbitrage is not possible and it does not consider whether the investment has been made in case of home or domestic currency or the investment made in case of foreign currency since the rate of return from this investment will be same. The interest rate parity applies the nominal rate of interest rate for establishing or developing the relationship between the forward and the spot rate (Brown, 2003). Arguments for the theory The rate of return is same in case of the investment made either in home or foreign currency and when the currency in the home country is measured in terms of domestic currency. In case of the situation when the interest rate of the domestic currency is less than the interest rate of the foreign currency then it is required to trade with the foreign currency at a forward discount for receiving the benefit of higher rate of interest in the foreign country for preventing the arbitrage. When the foreign currency is not traded at a forward premium than it is benefit for the interest rate of the domestic country since the investors can gain the benefit by making investment in the domestic market (Goddard, Molyneux, Wilson and Tavakoli, 2007). Arguments against this theory The countries with the increasing rate of interest experiences an appreciation in the currency due to the increase in demand and increase in the yield and it is not related to arbitrage. The main limitation of the interest rate parity is that the forward exchange rate depends on the interest rate differential, there is also diversity that exist in case of the short term interest rate in case of the money market which includes the commercial paper, treasury paper etc that develops problem or obstacle in case of the interest rate parity. This theory creates a disparity between the interest rate differential and forward rate differential. Conclusion Therefore the demand of the Australian dollar is termed as the capital inflow and it signifies the export and the supply of the Australian dollar represents the capital outflow and it signifies the import and the capital outflow. Therefore maintaining the equilibrium in the demand and supply of the currency of the two countries is the function of the managed floating exchange rate. When the foreign currency is not traded at forward discount then there is a possibility of the arbitrage opportunity that exist in case of the domestic investors. Therefore the domestic investors can gain the benefit through the investment in the foreign market. The purchasing power parity explains that when the exchange rate of the currency of one country is similar or equilibrium to the exchange rate or currency of another country then the purchasing power parity theory is considered or regarded as equivalent. References Abel, A. and Ben B. 2005. Macroeconomics. London: Pearson Education. Arnold, R.A., 2008. Macroeconomics. Mason: South Western Cengage Learning. Berger, N. 1995. “The Profit-Concentration Relationship in Banking – Tests of Market Power and Efficient-Structure Hypothesis”, Journal of Money, Credit and Banking. 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