International Finance Exchange Rate Analysis

Question: Describe about the difference between the interest rates of two nations is same as the difference between the forward exchange rate and spot exchange rate (Baker Riddick, 2013)? Answer: Exchange Rate Analysis Interest Rate Parity The theory of interest rate parity describes that the difference between the interest rates of two nations is same as the difference between the forward exchange rate and spot exchange rate (Baker Riddick, 2013). In foreign currency market, the role of interest rate parity is very much important. According to IRP, there is no arbitrage possibility in the market (Bishop, 2004). It does not matter that investor invest the money in home market or in the foreign market because the investor will get same return. Example: There are two options available for the investment in interest rate parity. One is domestic investment and another is foreign investment (Choi, 2003). Suppose, the amount of 2000 is available for the investment and the time period is one year. The spot exchange rate between U.S.A and Euro is $1. 2245/ In case of domestic investment, The rate of return is 3% for one year. The value of investment in US dollar = 2000 1.2245 = $ 2449 If the amount is invested in domestic market, the return will be: $ 2449 + ($ 2449 3%) = $2522.47 In case of foreign investment Suppose the amount is invested in Euro market at the rate of 5 % for one year. The forward exchange rate for one year is $1.20025/. So, the return = 2000 + (2000 5%) = 2100 Then, it is required to convert in US currency. So, the return in US currency = 2100 1.20025 = 2520.52 Therefore, it is observed that there is no arbitrage option from the investment even it is invested in foreign market. Purchasing Power Parity This theory implies that there is required to adjust the exchange rate between nations to make the currency value at par in regards to the purchasing power of individual nation (Eun, Resnick Sabherwal, 2012). This theory is used for comparing the income level of different nations. If the exchange rate is adjusted, the price of same will be same when it converted in a one currency. Example: Suppose the cost of a pen in Euro market is 3.6 and in US market is $3. Then the adjustment of cost between Euro market and US market is (3.6/3) i.e. 1.2. So, to spend one dollar in pen, it would have to spend 1.2 for obtaining the same quantity and quality pen. The mentioned theories cover the exchange rate and shows there is no arbitrage possibility. It will be better to use the theories altogether for getting better results. Forecasting Exchange Rate Purchasing Power Parity Method This method is very much popular method for forecasting the exchange rate. PPP approach follows the law that the price of a same product will be same if it is converted in one currency (Kirton, 2009). There will be no extra earning if on product is sold in one country after buying from another country at a cheap. According to the underlying principle, it helps to estimate that the exchange rate would change to offset prices changes for the impact of inflation (Levi, 2009). Suppose it is expected that the price of U.S. may increase by 5% over the upcoming year. On the other hand, it is expected that the price in Euro market will increase by just 3%. So, the difference in inflation rate between the two nations is 2%. It indicates that the increasing rate in price of U.S. is higher than the price of Euro. In such condition, PPP approach implies that it is required to depreciate the US dollar currency by 2% to make remain the prices of both nations equal. If the exchange rate between the US dollar is $1.25/. Then the forecast according to PPP will be as follows: (1+0.02) ($1.25/.) = $ 1.275/ That means it has to bear $1.275 to buy the one Euro. Economic Models Economic models is the another model which is based on the movement of specific currency and used to forecast the exchange rates (McKnight, 2008). In this model, the factors are used on the basis of economic theory. If there is any influence by any other variable can be included in the model. Suppose the forecast will be between US dollar and Euro for the upcoming year. The most influential factors are included in the model related to exchange rate. The factors are difference between two nations, difference rate between growth rates of GDP of two nations and difference between growth rates of two nations. The forecast by this model can be done as follows: US $ / Euro (1 year) = z + a(interest rate differential) + b(GDP) + c(income growth rate) Forecast can be generated only by putting all the values. a, b and c are the coefficient of how much exchange rate affected by the certain factor. This model is very complex to use and it also take so much time. Exchange Rate Exposure Transaction Exposure The risk related to exchange arises in case of MNC. MNC company operates the business all over the word. Exchange rate influences the business transaction between the different countries. Transaction exposure is one kind of risk. If the company has the obligation to pay or receive payment denominated in foreign currency in future, the risk arises due to fluctuation of exchange rate (Robin, 2011). The nature of transaction exposure is short-term to middle-term. Translation Exposure This exposure is related with the changes in financial statement due to fluctuation in foreign currency. MNC has subsidiaries in different countries in the world. All the subsidiaries formulate their statement according to their currency. When the statement is converted to the MNC currency, the figures of statement become affected by the fluctuation of currency (Melvin Norrbin, 2013). The nature of this kind of exposure is middle-term to long-term. Economic Exposure This exposure arises due to unexpected fluctuation in currency (Haites, 2013). The future cash flows of the organization get affected by this exposure. It also influences the market value. The nature of this kind of exposure is long-term. The competitive position of the organization can be affected by the unexpected changes in exchange rate. Unexpected change means difficult to estimate the exchange rate and economic exposure is very hard to mitigate rather than the others two exposures. Mitigation of Exposure The exposure risk can mitigated through several hedging the foreign currency exposure. Company can prevent the negative effect through hedging the foreign currency. There so many types of hedging techniques which can be followed to mitigate the risk such as forward contract, call and put options, cross hedging, money market hedge and interest rate swaps, etc. If the forward contracts can be applied the buying and selling can be done ate fixed rate on a prescribed future date. The volatility of the foreign currency cannot create effect on the future transaction by going to a forward contract. Foreign currency option protects from the opposite movement of exchange rate and the investor can get benefitted from favorable movements. The advantage of option is that it does to give obligation rather it gives right to buy or sale. Suppose ABC Ltd purchases goods from Norwegian on 1st March 2015. The price payable is NOK 2 million on 30th April 2015. The exchange rate at 1st March is NOK 11.60/. On 1st March 2015, the organization goes for a forward contract for purchasing the goods from Norwegian. The forward rate is NOK 11.90/. So at time of delivery of goods, the company has to pay 168067 whatever the spot rate reflects. References Baker, H., Riddick, L. (2013). International finance : a survey. Oxford: Oxford University Press. Bishop, E. (2004). Finance of international trade. Amsterdam: Elsevier. Choi, F. (2003). International finance and accounting handbook. Hoboken, N.J.: J. Wiley. Eun, C., Resnick, B., Sabherwal, S. (2012). International finance. New York: McGraw-Hill Irwin. Haites, E. (2013). International climate finance. London: Routledge, Taylor Francis Group, Earthscan from Routledge. Kirton, J. (2009). International finance. Aldershot: Ashgate. Levi, M. (2009). International finance. London: Routledge. McKnight, A. (2008). The law of international finance. Oxford: Oxford University Press. Melvin, M., Norrbin, S. (2013). International money and finance. 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