The main objective of multinational financial management is to make financing and investment decision that add as much value as possible to the firm. The main focus of this report is on foreign exchange and the risks associated with it. The primary purpose of the foreign exchange market is to assist international trade and investment, by allowing businesses to convert one currency to another currency. This report will cover the risk management tools with reference to hedging and derivatives in depth. The main topics discussed in detail in this regards are exchange rates, foreign exchange risk exposure and the use of option.
Internationalization of businesses has long since begun when companies through stiff competition looked for new markets and cheap materials and labour. So today a global foreign exchange market is not something new. Money is easily transferred from investors and borrower and buyers and sellers even across borders. Since different countries use different currencies, money has to be converted. Conversion occurs when there is foreign currency exchange. The place where exchange of currency happens is called the foreign exchange market. The date on which two foreign currencies are exchanged is called a settlement date. Before discussing about the fundamental determinants of exchange rates, it is essential to know the significance of exchange rate.
The exchange rate expresses the national/domestic currency’s quotationA in respect toA foreignA ones. For example, if one US dollar is worth 10 000 Japanese Yen, then the exchange rate of dollar is 10 000 Yen. If something costs 30 000 Yen, it automatically costs 3 US dollars as a matter of accountancy. Going on with fictious numbers, a JapanA GDPA of 8 million Yen would then be worth 800 Dollars. Thus, the exchange rate is aA conversion factor, a multiplier or a ratio, depending on the direction of conversion. In a slightly different perspective, the exchange rate is aA price. If the exchange rate can freely move, the exchange rate may turn out to be theA fastest movingA priceA in the economy, bringing together all the foreign goods with it.
Firstly it is essential to distinguish nominalA exchange rates fromA realA exchange rates.A NominalA exchange rates are established on foreign exchange (forex) markets. Rates are usually established in continuous quotation, with newspaper reporting daily quotation (as average or finishing quotation in the trade day on a specific market). Central bank may also fix the nominal exchange rate. Real exchange rates areA nominal rate correctedA somehow byA inflationA measures. For instance, if a country A has an inflation rate of 10%, country B an inflation of 5%, and no changes in the nominal exchange rate took place, then country A has now a currency whose real value is 10%-5%=5% higher than before. In fact, higher prices mean an appreciation of the real exchange rate, other things equal.
There are three broad factors that affect foreign exchange rate: supply and demand for money, government intervention and inflation. Supply and demand of money:  the more people want a certain currency the higher the foreign exchange rate will be of such currency. The laws of supply and demand show that:  High supply causes low prices, and high demand causes high prices. When there is an abundant supply of a given commodity then the price should fall. When there is a scarce supply of a given commodity then the price should increase. Therefore, an increase in the demand for a commodity would cause it to appreciate in value, whereas an increase in supply would cause it to depreciate. I have taken the example of British pound and US Dollars to show how these forces work.
The following figure shows the demand for British pounds in the United States. The curve is a normal downward sloping demand curve, indicating that as the pound depreciates relative to the dollar, the quantity of pounds demanded by Americans increases. For Americans, British goods are less expensive when the pound is cheaper and the dollar is stronger. At depreciated values for the pound, Americans will switch from American-made or third-party suppliers of goods and services to British suppliers. Before they can purchase goods made in Britain, they must exchange dollars for British pounds. Consequently, the increased demand for British goods is simultaneously an increase in the quantity of British pounds demanded.
The following figure shows the supply side of the picture. The supply curve slopes up because British firms and consumers are willing to buy a greater quantity of American goods as the dollar becomes cheaper (i.e. they receive more dollars per pound). Before British customers can buy American goods, however, they must first convert pounds into dollars, so the increase in the quantity of American goods demanded is simultaneously an increase in the quantity of foreign currency supplied to the United States.
TheA Law of One PriceA says that identical goods should sell for the same price in two separate markets. This assumes no transportation costs and no differential taxes applied in the two markets. For example, an ounce ofA gold should cost the same on commodity exchanges in Chicago and London. If the gold costs more on one exchange, then traders would have incentive to purchase the gold on one exchange and sell it at the other one. They would doA what is called anA arbitrage. Interest Rates: Interest rates, inflation and exchange rates are all highly correlated. By manipulating interest rates,A central banksA exert influence over both inflation and exchange rates, and changing interest rates impact inflation and currency values. Higher interest rates offer lenders in an economy a higher return relative to other countries. Therefore, higher interest rates attract foreign capital and cause the exchange rate to rise. The impact of higher interest rates is mitigated, however, if inflation in the country is much higher than in others, or if additional factors serve to drive the currency down. The opposite relationship exists for decreasing interest rates – that is, lower interest rates tend to decrease exchange rates Rate of inflation.  The faster prices rise, the lesser is the value of money. Traders watch the development of inflation closely because inflation is said to erode the value of money. If $20 can buy two pairs of running shoes four years ago, by inflation it is possible that only a pair of shoes can be bought at present time. As a general rule, a country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies. The countries with higher inflation typically see depreciation in their currency in relation to the currencies of theirA trading partners. This is also usually accompanied by higherA interest rates.
AA balance of payments (BOP)A sheet is an accounting record of all monetary transactions between a country and the rest of the world.A These transactions include payments for the country’sA exportsA andA importsA ofA goods,A services, and financial capital, as well asA financial transfers. The BOP summarises international transactions for a specific period, usually a year, and is prepared in a single currency, typically the domestic currency for the country concerned. Sources of funds for a nation, such as exports or the receipts of loans and investments, are recorded as positive or surplus items. Uses of funds, such as for imports or to invest in foreign countries, are recorded as a negative or deficit item.
The net of all cash inflows and outflows in and out ofA variousA financialA assets. Fund flow is usually measured on a monthly or quarterly basis.A The performance of an asset or fund is not taken into account, only share redemptions (outflows) and share purchases (inflows). 
Purchasing power parity (PPP) is a theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries’ price level of a fixed basket of goods and services. When a country’s domestic price level is increasing (i.e., a country experiences inflation), that country’s exchange rate must depreciated in order to return to PPP. The basis for PPP is the “law of one price”. In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency. Emperical Evidence: A particular TV set that sells for 750 Canadian Dollars [CAD] in Vancouver should cost 500 US Dollars [USD] in Seattle when the exchange rate between Canada and the US is 1.50 CAD/USD. If the price of the TV in Vancouver was only 700 CAD, consumers in Seattle would prefer buying the TV set in Vancouver. If this process (called “arbitrage”) is carried out at a large scale, the US consumers buying Canadian goods will bid up the value of the Canadian Dollar, thus making Canadian goods more costly to them. This process continues until the goods have again the same price.. Economists use two versions of Purchasing Power Parity: absolute PPP and relative PPP. Absolute PPP was described in the previous paragraph; it refers to the equalisation of price levels across countries. Relative PPP refers to rates of changes of price levels, that is, inflation rates. This proposition states that the rate of appreciation of a currency is equal to the difference in inflation rates between the foreign and the home country. For example, if Canada has an inflation rate of 1% and the US has an inflation rate of 3%, the US Dollar will depreciate against the Canadian Dollar by 2% per year. This proposition holds well empirically especially when the inflation differences are large.
Interest rate parityA is a relationship that must hold between the spot interest ratesA of two currencies if there are to be noA arbitrage opportunities. The relationship depends uponA spotA andA forward exchange rates between the currencies. ItA is Where sA is the spot exchange rate, expressed as the price in currency aA of a unit of currencyA b; A fA is the corresponding forward exchange rate; raA andA rbA are the interest rates for the respective currencies; and mA is the common maturity in years for the forward rate and the two interest rates. There are two types of interest rate parities – covered and uncovered.A Covered interest rate parity is when the interest rate returns of the two methods are equal and in parity because the investor “covered” himself through a forward contract against the currency changes.A Uncovered interest rate parity assumes that the difference between the interest rates of two currencies will equal the predicted depreciation of a currency.
International Fisher Theory states that an estimated change in the current exchange rate between any two currencies is directly proportional to the difference between the two countries’ nominal interest rates at a particular time.A
According toA International Fisher Theory hypothesis, the real interest rate in a particular economy is independent of monetary variables. With the assumption that real interest rates are calculated across the countries, it can also be concluded that the country with lower interest rate would also have a lower inflation rate. This will make the real value of the country’s currency rise over time. This theory is also known as the assumption of Uncovered Interest Parity.
The International Fisher theory is calculated by the following formula:A
E = [(i1-i2)/(1+i2)] A¢”°Ë† (i1-i2)A
Where: E represents the percentage change in exchange rate i1 represents the interest rate of country A i2 represents the interest rate of country BA For example, if the interest rate of country A is 10% and that of country B is 5%, then the currency of country B should appreciate roughly 5% compared to the currency of country A.A
It can be quoted in two ways : Direct Quotation : It means a rate of exchange quoted in terms of X units of home currency to one unit of foreign currency. Indirect Quotation It means a rate of exchange quoted in terms of Y units of foreign currency per unit of home currency. Example: Now ————————————————————————————Future (Spot Rate) (Future Spot Rate) Cs Fs Lets assume, the current exchange rate is $ 1.6/ £. If the UK inflation is 10% and US is 6%, what would be the exchange rate in one year .
Direct Quotation Formula:
Fs / Cs = ( 1 + i home / 1 + i foreign )
Fs = 0.625 £ / $ ( 1 + 0.10 / 1 + 0.06) = 0. 648 £ / $
Indirect Quotation Formula:
Fs / Cs = ( 1 + iforeign / 1 + i home )
Fs = 1.6 $ ( 1 + 0.06 / 1 + 0.10 ) = $ 1.541/ £
TheA forward rateA is the rate which appears in a contract to exchange a currency for another date in the future. It is distinguished from theA spot rate, which is the rate used in agreements to exchange one currency for another immediately. No currency changes hand between the parties in a forward contract at the time it is signed; the currency is exchanged at the maturity date of the contract date in the future. The bid ask spread represents the difference between the bid and the ask price. SomeA securitiesA will have a very small spread (as small as one penny) and others will have very high spreads which generally mean that theA securityA is very illiquid.
Current spread for US$ =bid rate- ask rate = 1.55813 – 0.64180= 0.91601
Current spread for GBP(£)= 1.55815-0.64179=0.91636
TIME SERIES PLOT:
GBP PER US DOLLAR:
From the plot, it can be observed that: In 2009: 1 USD = 0.61834£ In 2010 1USD = 1/1.56673 $ = 0.63827£
Hence the value of the GBP depreciated by: (0.61834-0.63827)/0.61834= 3.3%
Foreign Exchange Exposure: The sensitivityA of the real home currency value of an asset, liability or an operating income to an unanticipatedA change in the exchange rate, assuming unanticipated changes in all other currencies as zero. Foreign Exchange Risk: It is the variabilityA of the domestic currency values of assets, liabilities, operating incomes due to unanticipatedA changes in exchange rate. Amount lent by the US based firm to British Client for 1 Year is : $ 10,000,000 Suppose the spot exchange rate is $1.5/£. Therefore the British client will receive in Pounds can be calculated as: $10,000,000* £1/1.5 = £ 6,600,000 Therefor the client will return back £6,600,000. There are 2 scenarios to be considered: If the exchange rate becomes low: say $1.2/£ Therefore the client will be paying back £6,600,000*$1.2 = $7,920,000 Hence the foreign exchange risk exposure for the US based firm will be $10,000,000- $7,920,000 = $2,080,000 If the exchange rate becomes high, say $1.8/£ Now the client will be paying back £6,600,000*1.8$ = $ 11,880,000 Hence the clients risk exposure will be $1,880,000 or £ 1,044,444
The following are the ways in which the US based company and the British based clients can Hedge their foreign exchange risk: Hedge using futures or forwards contracts. This is the most common way of managing foreign exchangeA risk. A forward contract is a transaction in which the delivery of the commodity is postponed until the contract has been made. The delivery is often in the future, however, the price is well determined in advance. Hedging is the act of taking an offsetting position in a related security. A good example would be if you own a currency, you will sell a futures contract stating that you will sell the currency at a set price in the future. A perfect hedge can reduce risk to nothing except the cost of the hedge. Use options trading as aA strategyA to reduce foreign exchange risks. Just like stocks, currencies have calls and puts that allow buyers to buy or sell the financial asset at a predetermined price during a certain period of time or on a specific date (exercise date). Options is considered to be the most dependable form of hedge. When traditional positions are used with a forex option they can minimize the risk of loss in a currency trade. Use swaps: If firms in separate countries have comparative advantages on interest rates, then a swap could benefit both firms. For example, one firm may have a lower fixedA interest rate, while another has access to a lower floating interest rate. These firms could swap to take advantage of the lower rates. For example, our company based in the United States our client company based in England. Our company (US based) needs to take out a loan denominated in British pounds and our client needs to take out a loan denominated in U.S. dollars. The two companies swap to take advantage of the fact that each company has better rates in its respective country. When these two companies swap, they will be able to save on interest rates by combining the privilege they have in their own country’s market.
AA swapA is aA cash-settledA OTCA derivativeA under which two counterparties exchange two streams of cash flows. It is called anA interest rate swapA if both cash flow streams are in the same currency and are defined as cash flow streams that might be associated with some fixed income obligations. The most popular interest rate swaps areA fixed-for-floating swapsA under which cash flows of a fixed rate loan are exchanged for those of aA floatingA rate loan. AA currency swap  A is most easily understood by comparison with anA interest rate swap. An interest rate swap is a contract to exchange cash flow streams that might be associated with some fixed income obligations say swapping the cash flows of a fixed rate loan for those of aA floatingA rate loan. A currency swap is exactly the same thing except, with an interest rate swap, the cash flow streams are in the same currency. With a currency swap, they are in different currencies. Since the client is British based requires loan in terms of pounds and the home currency is US Dollars, my recommendation would be to go for currency swap to minimize the risk of foreign exposure since currency swap involves swap of two different currencies whereas for interest rate swap the currency should be the same.
A foreign currency option is an option which gives the owner the right to buy or sell the indicated amount of foreign currency at a specified price before a specific date. The Call Option establishes a ceiling for the exchange rate, and the option can be used to hedge foreign currency outflows (potential payments). The 2 major types of foreign currency options are:
A¢â‚¬A¢If S>X (Where S is the Spot price and X is the exercise or Spot exchange rate) Profit increases one-for-one with appreciation of the foreign currency. At (X+P) the holder of the option breaks even (ceiling price). Here P is the Premium. A¢â‚¬A¢If S<X The call option will not be exercised, because the holder is better off buying the foreign currency in the spot market. The holder will have a negative profit reflecting the premium,A P Profit Profile For a Call Option
The holder of a call option expects the underlying currency to appreciate in value. Consider 4 call options on the euro, with a strike price of 152 ($/A¢”šA¬) and a premium of 0.94 (both cents per A¢”šA¬). A¢â‚¬A¢The face amount of a euro option isA¢”šA¬62,500. A¢â‚¬A¢The total premium is: $0.0094A·4A·A¢”šA¬62,500=$2,350
The Put Option establishes a floor for the exchange rate, and the option can be used to hedge foreign currency inflows A¢â‚¬A¢If S>X => The call option will not be exercised, because the holder is better off selling the foreign currency in the spot market. The holder will have a negative profit reflecting the premium, P If S<X => Profit increases one-for-one with depreciation of the foreign currency. At (X-P) the holder of the option breaks even (floor price). Profit Profile for a Put Option
The holder of a put option expects the underlying currency to depreciate in value. Consider 8 put options on the euro with a strike price of 150 ($/A¢”šA¬) and a premium of 1.95 (both cents/ A¢”šA¬). A¢â‚¬A¢The face amount of a euro option is A¢”šA¬62,500. A¢â‚¬A¢The total premium is: $0.0195A·8A·A¢”šA¬62,500=$9,750
A person would buy aA call optionA in the commodities or futures markets if he or she expected theA underlyingA futures price to move higher. Buying a call option entitles the buyer of the option the right to purchase the underlying futures contract at theA strike priceA any time before the contract expires. This rarely happens and there is not much benefit to doing this, so don’t get caught up in the formal definition of buying a call option. Most traders buy call options because they believe a commodity market is going to move higher and they want to profit from that move. You can also exit the option before it expires – during market hours, of course.
PutA writing is an essential part ofA optionsA strategies. Selling a put is a strategy whereA an investor writesA a put contract, and by selling the contract to the put buyer, the investor has sold the right to sell shares at a specific price. Thus, the put buyer now has the right to sell shares to the put seller. Selling a put is advantageous to an investor because he or she will receive the premium in exchange for committing to buy shares at the strike price. If the price of the stock falls below the strike price, the put seller will have to purchase shares from the put buyer when the option isA exercised. Therefore, a put seller usually has a neutral/positive outlook on the stock or expects a decrease inA volatilityA that he or she can use to create a profitable position. 3.) Two options which are similar in all respects but with different expiration dates would not trade at the same premium due to the consideration of time value of money. The value of an option can be calculated using The Black-Scholes model. It is used to calculate a theoretical call price (ignoring dividends paid during the life of the option) using the five key determinants of an option’s price: stock price, strike price, volatility, time to expiration, and short-term (risk free) interest rate. The original formula for calculating the theoretical option price (OP) is as follows: Where: The variables are: S = stock price X = strike price t = time remaining until expiration, expressed as a percent of a year r = current continuously compounded risk-free interest rate v = annual volatility of stock price (the standard deviation of the short-term returns over one year). See below forA how to estimate volatility.A ln = natural logarithm N(x) = standard normal cumulative distribution function e = the exponential function
An option is said to be deep in the money when it is very favourable to exercise the option. A call option is said to be deep in the money if its exercise price is extremely lower than the strike price. For example: Suppose the exercise price agreed for the option was 40 £ and the strike price is 70£, then it is obvious that the buyer will definitely but the option. Hence it does not go unexercised. On the other hand a put option is said to be deep in the money if its exercise price is higher than the share price. For example: Suppose the exercise price of the option was set at 50£ and the strike price is 30£. Then the seller will definitely sell the option and exercise the option since it profits the seller. Hence a deep in the money option never goes unexercised. If GBP (£) were to depreciate against US $, British exports would become cheaper. This can be illustrated using the following figures used in section A. The GBP depreciated from 0.61834£ to 0.63827£, so the foreign market will demand for more products from the UK, so exporter will buy the put option to protect the value of his receivables.
The risk management tools used by the bank with specific reference to hedging and derivatives have been discussed in depth. Exchange rates which are the most important factor to be considered in international investment have been discussed considering the current spread in the market. The calculation of the foreign risk exposure has also been performed and it is advised that the use of option as a hedging technique would benefit both the home company and the foreign company. Therefore as far as foreign exchange market is conserved it is very essential to keep a watch on all the risks that a company may face and be prepared to minimize of the risk.
Solnik, B. & McLeavey, D., 2004. International Investments. 5th Edition. London: Pearson Education. Buckley, A., 2004. Multinational Finance. 5th Edition. London: Pearson Education. Shaprio, Alan C., 2003.Multinational Financial Management. 7th Edition. US: John Wiley & Sons, Inc.
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