Study on the Determination of Exchange Rates Finance Essay

It is a theory which says that exchange rates between currencies are in stable position when their purchasing power is the similar 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 level 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. There are two versions to Purchasing power parity (PPP) and has been called as

Absolute PPP

This concept explains about the exchange rate between two countries will be identical to the ratio of the price levels for those two countries. This concept is derived from a basic idea known as the law of one price, which states that the real price of a good must be the same across all countries.

Relative PPP:

"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".

TheA balance of payments approachA (BOP)

Under the BOP approach, the home price of a foreign currency is determined just like the price of any commodity. The price is determined by connecting the market demand and supply curves for that foreign currency. Demand and supply for foreign exchange is determined by the flows of currency created by international dealings. According to the BOP theory of exchange rates, the supply and demand for a currency arise from the flows related to the BOP such as Foreign direct investments Exchange rate regimes Portfolio investment etc Equilibrium exchange rates are determined when the BOP is in equilibrium. Exchange rates will move in response to a BOP imbalance and, therefore, will restore the equilibrium to the BOP.

Asset Market Approach

It argues exchange rates are determined by the supply and demand from a wide range of financial assets: Movements in the supply and demand for financial assets revise exchange rates. Movements in monetary and fiscal policy revise the expected returns and perceived relative risks of financial assets, which in turn alter exchange rates. TheA asset market approachA assumes that whether foreign investors are willing to hold claims in monetary form depends on an widespread set of investment consideration or drivers such as Relative real interest rates Prospects for economic growth Capital market liquidity Political safety Corporate governance practices Speculation

Theories of Fund Flow

Funds flow is defined as the net of all cash inflows and outflows coming in and going out ofA various financial assets. Fund flow is usually measured on a monthly or quarterly or on a periodic basis.A The performance of an asset or fund is not taken into account, only share redemptions (outflows) and share purchases (inflows). A Net inflows create excess cash for managers to invest, which theoretically creates demand for securities such as stocks and bonds.A A

Law of one price

The theory that the price of a given security, commodity or asset will have the same price when exchange rates are taken into consideration. The law of one price is another way of stating the concept of purchasing power parity. The law of one price exists due to arbitrage opportunities. If the price of a security, commodity or asset is different in two different markets, then an arbitrageur will purchaseA the asset in the cheaper market and sell it where prices are higher. When the purchasing power parity doesn't hold, arbitrage profits will persist until the price converges across markets. The spot exchange rate is the price that is quote for immediate (spot) arrangement (payment and delivery). Spot settlement is usually considered to be a couplar of business days from deal date. The spot exchange rate is normally close to the current market rate because theA transactionA occurs immediately and not some time in the future. The forward exchange rates it the rate where contract price are set now but the delivery and payment will occur at a future date. Forward Spread is the price difference between the forward price of the security and spot price of the same security over a same period of time. Forward Spread can be calculated by taking the spot price today and forward price one month from today.

Pounds to Dollars - Appendix A

Dollars to Pounds - Appendix B

From the above graph (with reference to appendix A ) we can see the time series of the pound versus the dollar and vice versa. In January 2010 it was (£0.6187 = 1US Dollar) but in February 2010 it was (£0.6645= 1US Dollar), from this we can see the Dollar has appreciated by ({0.6645-0.6187} Aƒ-0.6187) = 0.07%%. And then for the next 4 months the pound rate has been fluctuating since September 2010.

Appreciation of Pound

The main reason for appreciation of any currency would be higher interest rates and lower inflation. If interest rates high then more investors invest in UK so it makes it more attractive to save money in the UK banks and UK financial securities like bonds. This will lead to increased demand for the sterling. If inflation is lower then it will make UK goods more attractive then US and hence the demand goes up.

Depreciation of Pound

Pound depreciates because of interest rate may go down and inflation go high making it investors a least return for their investments. . Other market factors also contribute for a currency to appreciate or depreciate as well. If there is demand for a particular currency then the currency will appreciate.

Market Reasons for Pound to depreciate in the last six months:

Low number of mortgage approvals and mortgage lending and consumer credit rose. Concerns about a tepid economic recovery, high public debt and political uncertainty. Sentiment has also deteriorated in the last week after the Bank of England said it stood ready to return to its asset-buying scheme if economic conditions warranted (Reporting by Naomi Tajitsu; editing by Stephen Nisbet)

Foreign Exchange Risk Exposure

Foreign exchange risk is the risk that domestic values of assets, liabilities or operating income may increase or decreases due to surprising changes in exchange rates. Foreign currency exposures risk arises when a company has an income or expenditure or an asset or liability in a currency other than that of the balance sheet currency. When the exchange rate movements become completely volatile it may sometimes destabilize the cash flows of the business. Such destabilization of cash flows that which affect the profitability of the business is the risk from foreign currency exposures.

Classification of Exposures

Transaction exposures Translation exposures Economic exposures

Transaction Exposure

Transaction exposureA is the gain or loss that might incurred on the settlement of foreign exchange transaction. Transaction included such as the sale / purchase of product or services lending or borrowing of money or any Other transaction involving mergers and acquisitions.

Example:

The US firm loan of 10M US dollars at a rate of .65 today and the time of repayment of loan when the rate goes down to .59.Then the profitability of the transaction may be completely wiped out due to the adverse movement of the exchange rate.. Such transaction exposures arise whenever business has foreign currency denominated in receipt and payment.

Translation Exposure (Accounting Exposures)

Translation exposure is defined as an increase or decrease in the parent company's net worth caused by a change in exchange rates since last translation. Translation exposure arises because of the need to translate foreign currency assets or liabilities into the home currency for the purpose of finalizing the accounts for any given period. A typical example of translation exposure is the treatment of foreign currency borrowings.

For Example

Consider that a UK company has borrowed dollars to finance the import of capital goods worth $1, 00,000. When the import materializes the exchange rate was say .65 per dollar. The fixed asset imported was therefore capitalized in the company books for £65,000. If there is no change in the exchange rate the company would have provided depreciation on the asset valued at £65,000 for finalizing its accounts for the year in which the asset was purchased. If at the time of finalization of the accounts the exchange rate has moved to say £.70 per dollar, the dollar loan has to be translated involving translation loss of £5,000. The book value of the asset thus becomes £70,000 and consequently higher depreciation has to be provided thus reducing the net profit.

A Economic Exposure

Economic exposure expresses the extent to which the value of the firm would be affected by unexpected changes in exchange rates. Economic Exposure to an exchange rate is the risk that a change in the exchange rate affects the company's competitive position in the market. Economic exposure affects the profitability over a longer term span than transaction and even translation exposure. Economic exposure cannot be hedged as well.

Ways to overcome Exposure:

Hedging via lead and lag:

A One way of reducing transaction exposure is leading and lagging foreign currency receipts and payments. To "lead" means to pay or collect early, where as "lag" means to pay or collect late. The firm would like to lead soft currency receivables and lag hard currency receivables to avoid the loss from depreciation of the soft currency and benefit from the appreciation of the hard currency. For the same reason, the firm will attempt to lead the hard currency payables and lag soft currency payables. To the extent that the firm can effectively implement the Lead/Lag strategy, the transaction exposure the firm faces can be reduced.

Invoicing in the Local Currency

The firm can reduce the exchange risk by choosing the currency of invoice. Firm can avoid exchange rate risk by invoicing in domestic currency, there by shifting exchange rate risk on to buyer. Because of this act firm may lose its customers who wants them to be invoice in their local currency.

Forwards

A forward contract is an agreement between two entities to buy or sell the underlying asset at a future date, at today's pre-agreed price. This is one most direct method of eliminating transaction exposure is to hedge the risk with a forward exchange contract. For example, The loan of 10M by US firm to UK Company can eliminate the foreign exposure by depositing 10M to its bank at 1 yr forward rate. No matter what happens to the exchange rate over the period, the company will not make a loss on the loan to UK Company.

Futures: Currency and Interest Rates

A futures contract is an arrangement between two parties to buy or sell the underlying asset at a future date at today's future price. Futures contracts differ from forward contracts in the sense that they are standardized and exchange traded. The ultimate goal of an investor in using futures contracts is toA hedge perfectly to avoid their risk. By locking the prices at appropriate rate it removes the uncertainty about the future price. "The value (F) of a futures contract is the existing spot price (S) multiplied by one plus the interest rate over period (t), plus the cost of storage which is a function of time and the current spot price. Interest rate futures are the largely traded futures contracts in the world. They are based on relative interest rates and are used to hedge interest rate exposure. The value of an interest rate contract at maturity (V) is the notional principal value of the contract (N) multiplied by the spot interest rate on the maturity date of the contract (Si,t+n) minus the futures rate on interest (i) at time (t) that matures (n) periods later (Fi,t,n)".

Swaps

"An interest rate swap is a that transfors fixed payments into variable obligations or vice versa. Foreign exchange swaps allow a firm to quickly restructure its balance sheet, by giving it the opportunity to exchange fixed obligations for interest-sensitive obligations (or vice versa)." AA currency swapA is an agreement between two parties to exchange the principal loan amount and interest applicable on it in one currency with the principal and interest payments on an equal loanA in another currency.A These contracts are valid for a specific period, which could range up to ten years, and are typically used to exchange fixed-rate interest payments for floating-rate paymentsA on dates specified by the two parties.

Interest Rate Swaps

One party pays a fixed rate of interest; the other pays a floating rate of interest. The fixed interest payment remains unchanged throughout the life of the deal. It is paid annually, semi-annually or quarterly in arrears. The floating interest is paid on a three or six monthly basis. Because it is reset using the relevant Libor rate it will vary depending on short term interest rates. It too is paid in arrears.

Different Types of Foreign Currency Options:

A currency option is same as the stock option except that the underlying asset is foreign exchange. The buyer of option has the right but no obligation to enter into a contract with the seller. Hence the buyer of a currency option has the right to his advantage to enter into the specified contracts.

American Option:

An American option provides the buyer the right to exercise the option at any time between the date of writing and the maturity date. An option contract which is exercised at any time between the date of purchase and the expiration date

European optionA

A European option can be exercised only on the expiration date and not before.

Options

There are two types of options calls and puts. " Call Options give the buyer the right but not the obligation to buy a given quantity of the underlying asset, at a given price on or before a given future date". AA call option will have intrinsic value only when the spot price is above strike price Put Options give the buyer the right, but not the obligation to sell a given quantity of the underlying asset at a given price on or before a given date. A Put option will have intrinsic value only when the spot price is below the strike price.

Deep in the money option:

An option with an exercise price, or strike price considerably below (for a call option) or above (for a put option) the market price of the underlying asset. Considerably, below/above is considered one strike price below/above the market price of the underlying asset.A  When Call Options expires in the Money Option, then the Money call options will be automaticallyA exercise if there is enough funds to buy the underlying stocks at the strike price you bought the call options.A If there is enough money in the trading account to buy (take delivery of) the underlying stock, then it should be sold and take profit before the call options expires. It is arguable the same that some one could exercise the in the money call options, take delivery of the underlying stock and then immediately sell the stocks or can make same profit by simply selling the options and the cost involved will be more in the case of exercise, buying and selling of the stocks. For example, if the current price of the underlying stock of A Ltd was £50, a call option with a strike price of £40 would be considered deep in the money. On the exercise of the option the holder can gain a profit of £10 pounds.

Reasons why options with different expiration date are traded at different premiums.

Purchase of option can limit the exposure risk. The option writer always accepts the risk which purchaser avoids. The writer therefore needs to be paid in compensation. The cost of an option to a purchaser is known as the option premium. Option price is made up of intrinsic value and time premium. The intrinsic value is calculated on the assumption it expires today. Time premium depends on the difference between today's date and expiry date. The longer the expiry dates the higher the premium. Time value is equal to the total premium less the intrinsic value. Time value also called as the extrinsic value. It reflects the amount of money buyers are willing to pay in expectation that an option will be worth exercising at or before expiration Holding a longer expiration options gives an edge over the option holder who holds the short expiration date. Longer option holder will have longer time span to track the currency movement and can exercise them when it is the most beneficial to him.

Choice of call or put option to British exporter.

The GBP is depreciating against US$: For example: $1.7 = £1 or £0.70 = $1 ( For simple reason assume round figures) Now $1.4= £1 or £0.80 = $1 The above said figures suggest that the Pounds is depreciating against the US$ or in other words the US$ is appreciating against the Pound. This indicates that the GBP is getting cheaper against US$. If this situation could be handled properly then it will be beneficial to both importer and exporter. The assumption is that the British exporter sells goods to a US based customer and the US customer pays in the US$; and rarely the British exporter has to convert the US$ receipt in to the GBP. If the GBP depreciates against the US$, it is considered to be a favourable movement for the British exporter as he gets more GBPs. For example, if the customer owes him $10,000 when $1.7=£1. And forward rate is used, at the time when payment will be due, is $1.4 =£1. Therefore the receipt in the GBP is: Previously: $10,000/$1.7 = £5883.23 If the GBP depreciates: $10,000/ $1.4 = £7142.857 Hence it can be seen from the above figures that depreciation of the GBP is actually beneficial to the British exporter. Instead the risk that the exporter faces is the GBP appreciation against the US$. Let's assume that the forward rate is $1.9 = £1. In that situation the GBP receipt will be as follows. Previously: $10,000/$1.7 = £66,667 If the GBP appreciates: $10,000/$1.9 = £5263.158 Exporter may wish to hedge against risk of the GBP being appreciates against the US$. The currency options are one of the hedging instruments available to the exporter. Provided that the GBP is to appreciates against the US$ and exporter occasionally receives the payment in the US$, he may wish to buy the Put options for the US$. He may buy put option to sell the US$ to option writer at $1.7:£1 or £0.70:$1. So, in the future if the GBP depreciates and price becomes $1.4:£1 or £0.80:$1 then he will abandon the option or let the option expire The other possibility is that the exporter may want to use the options for speculation purposes. If it is probable that the GBP is to depreciate against the US$, he may wish to buy the call options of the US$. The call option will give him the right to buy the currency at specified rate, which in our case is £0.70:$1. Eventually when the GBP will depreciate to £0.80:$1 he can exercise his option and buy the currency for £0.70:$1 and sell it for £0.80:$1. This will earn him handsome profit of £0.10 per US$. REFERENCES USED ACCA TEXT BOOKS CIMA TEXT BOOKS INTERNET - ESPECIALLY WEBSITES LECTURE HANDOUTS POUNDS2DOLLARS WEBSITE INVESTOPEDIA,WICKEDPEDIA CFA - FINANCIAL ANALYSIST BOOKS LIBRARY RESEARCH INCLUDES GOING THROUGH VARIOUS BOOKS WRITTEN BY VARIOUS AUTHORS PRESS RELEASES AND JOURNAL RELEASES Bodie, Zvi; Kane, Alex; and Marcus, Alan J. (2002) Investments, 5th edition, published by McGraw-Hill. Bodnar, Gordon M. and Wong, M.H. Franco (2000), "Estimating rate exposures: some 'weighty' issues." Working Paper 7497, National Bureau of Economic Research. Choi, Jongmoo Jay, and Prasad, Anita Mehra, (1995) Exchange risk sensitivity and its determinants: A firm and industry analysis of U.S. Multinationals, Financial Management, Vol 24, No 3, p. 77-88. Eiteman, David K., Stonehill, Arthur I., and Moffett, Michael H. (2001) Multinational Business Finance 9th edition, published by Addison-Wesley Longman, Inc. Jorion, Philippe. (1990) The exchange-rate exposure of U.S. multinationals, Journal of Business, Vol. 63 Issue 3, p.331 Levich, Richard M. (2001) International Financial Markets, 2nd edition, published by McGraw-Hill. Miller, Kent D. and Reuer, Jeffery J. (1998) "Firm Strategy and Economic Exposure to Foreign Exchange Rate Movements, Journal of International Business Studies, 29, 2, (Third Quarter), 493-514. Pantzalis, Christos, Simkins, Betty J., and Laux, Paul A. (2001) Operational Hedges and the Foreign Exchange Exposure of U.S. Multinational Corporations, Journal of International Business Studies, 32, 4, p. 793-812. Solnik, Bruno, (2000) International Investments 4th edition Published by Addison-Wesley Copyright Addison Wesley Longman WEBSITES USED WWW.SCRIBD.COM https://en.allexperts.com/q/Management-Consulting-2802/2009/10/International-Financial-Management.htm https://www.wendyjeffus.com/images/Foreign_Exchange_Instruments%2C_Measuring_and_Managing_Foreign_Exchange_Exposure.doc

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