1. Foreign exchange theory
The theory that explains and predicts relationships between two currencies is called the law of one price. These theories are underpinned by the general notion that if there are loss of wealth-maximizing buyers and seller with access to information, then the prices of identical goods and services in tow different countries must logically be the same, when expressed in the same currency, and the exchange rate will adjust to make sure that this is true. This is known as the law of one price.
From the above case, the exchange rate was US$1.9696 =$1 sterling, then a product or service costing $19.696 in the USA should cost $10 in the UK. Suppose that a particular product costs $11 in the UK and $19.696 in the USA, and then traders would seek to make a profit by buying the product in the USA and selling it in the UK. This would create additional demand in the USA, which would force up the price of the product there. The action of selling a US derived product in the UK market would also lead to the conversion of sterling into dollars, i.e. increase the demand for dollars and increase the supply of sterling. This would have the effect of strengthening the dollars against sterling. These adjustments in the supply and demand, both of the product and of the tow currencies, should drive the effective cost of the product.
Purchasing power parity.
If an holiday maker has, in effect, the same price in USA and UK, as the law of one price predicts, then differential inflation rates between the two countries must theoretically affect the exchange rate.
e1 = 1 + Ih
e0 1+ if
Where eo = the value of home country currency of one unit of the foreign currency at the start of a period.
E1= the value of home country currency of one unit of the foreign currency at the end of the period.
Ih = the rate of inflation in the home country during the period.
If = the rate of inflation in the foreign country during the period.
Since the law of one price does not work strictly in practice, it is not surprising to find that Purchasing power parity does not strictly operate in practice either.
Fisher effect.
The law of one price would lead to the conclusion that the real interest rate should be the same in any country assuming deposits with similar levels of risk. If this were not the case, funds would flow across boarders seeking the best returns to such an extent that interest rates would alter and exchange rates would change making real interest rates equal. This phenomenon is known as the fisher effect.
The context of investment appraisal;
1 + rn = (1+rr) (1+i)
Wher rn= the nominal interest rate
Rr = the real interest rate
I = the rate of inflation.
Then 1 + rr = 1+ rn
1+i
If real interest rates are equal in all countries, then
1+ rnh = 1+inh
1+rnf 1 + inf
Where rnh = the nominal (or money) interest rate in the home country
Rnf = the nominal interest rate in the foreign rate in the foreign country.
Inh = the rate of inflation in the home country.
Inf = the rate of inflation in the foreign country.
International fisher effect.
This combines the underlying principles of the general fisher effect and Purchasing power parity fisher implies that interest rates will move to take account of inflation rates.
1 + r nh = 1 + inh
1 + rnf 1 + inf
Purchasing power parity implies that exchange rates move in responses to differences in inflation rates
E1 = 1 + rnh
E0 1 + if
Since the interest rates referred to in the Purchasing power parity model are nominal rates, putting fisher and Purchasing power parity together we have
E1 = 1+ rnh
E0 1 + rnf
The international fisher effect therefore implies that the exchange rate is, in theory directly linked to nominal interest rates.
Interest rate parity.
One can trade for immediate delivery of the currency, when we shall be trading at a spot rate of exchange. Alternatively one can buy or sell the currency under a forward contract. Here delivery will take place on some specified date in the future but the exchange rate at which the transaction is effected is set now. Naturally the forward rate will be linked closely to the spot rate. In theory were the nominal interest rates the same, in the countries of currencies, the spot and forward rates would be the same. Remember that nominal interest rates reflect both real interest rates and the rate of inflation.
Interest rate parity.
Can be summarized in this context as saying that where rates will not be the same. The relationship is as follows;
1 + rnh = f1
1 + rnf e0
Where f1 is the future value, in the currency of the home country, of one unit of the foreign currency and the other symbols are as previously specified.
The future rate will be higher than the spot rate where the interest rate in the home country is larger than that in the foreign country. For example, you would have to pay more in that UK interest rates are higher than US ones, you would have to pay more in sterling for US dollars, if you were to take delivery of the dollars you would be able to benefit from the better UK interest rates for longer than if you were to exchange sterling for dollars immediately. The converse would also be true.
For example assuming that the spot rate is $1 = $1.9696 or $1 = $0.51. Assume also that the rates of interest expected to prevail for the next year are 6% in the USA and 13.6% in the UK. The person who received our $0.51 could invest this in the UK such that it would grow to $0.58 by the end of the year. By that time taking account of the interest that we could each earn, the effective rate of exchange is $1 = $0.51. This would be the future rate for a transaction to be carried out in one year’s time.
Suppose the present exchange rate against sterling bound is 0.51 bounds to the dollar. Suppose also you anticipate that in six months the dollar will depreciate to £0.58 per dollar. What will you do with this information? Let me express the exchange rate as dollars per Sterling bound. The present dollar price per Sterling bound is 1.9696, and you expect the price to rise to 1.7241. You might want to keep the dollar today if you thought that the dollar value of the Sterling bound was going to rise. If you sell Sterling bound at $0.51 per Sterling bound and are correct in your expectation that the dollar will depreciate. You will earn a 25 percent profit on your speculation.
If many investors have these same expectations about the Sterling bound exchange rate, they will all be truing to have several ways to speculate in the foreign exchange market at low costs, and they do not require an expected return of 25% per year to justify their speculative trades. In fact, traders will speculate currencies such as the Sterling bound on the promise of a return of only a few percent per year in excess of what they could earn on treasury bills.
Then one should say that the dollar is trading at a forward discount against sterling. Were the opposite state of affairs to apply, sterling would trade at a forward discount against the dollars. The size of the premium or discount depends; of course, partly on how far into the future the exchange will occur.
2. A) foreign exchange risks
Given the conditions of this case the UK parent of the company will have various exchange risks. The exchange risk the company will undergo will be in three categories; transaction risk, translation risk and economic risks. The transaction risk is the risk which the exchange rate will move to the direction of the business transaction. In dealing with this transaction risk the company has many ways to mitigate this form of risk. Ways in which a firm can mitigate this risk include maintaining a foreign currency bank account meting the transactions forward exchange contracts, using currency options using currency features, money market hedge and doing nothing.
i) Currency features: Contracts are quite like forward contracts in that they bind the parties to exchange of two currencies of amounts, at exchange rates and none a future date all specified in the contract. Where futures differ from forwards is that they exist only for exchanges between relatively few currencies, relatively few values and relatively few points in time, i.e. they are standardized contracts.
ii) Currency options:- Currency options offer a solution to problems of lack means that provides an opportunity for the business to benefit form any favorable movement in exchange rates and exposure to overseas debtor defaults. Other methods eliminate transaction risk i.e. both the downside and upside risk are eliminated. A foreign exchange options gives the owner the right, but not the obligation, a rate and at a time specified in the option contract.
iii) Money market hedge: – Business use money market hedges to avoid transaction risk by combining the spot foreign exchange market with borrowing or lending.
iv) Forward exchange contacts:- this makes it possible for trade at an exchange rate set today and the currencies will not be exchanged until a specified in the future.
v) Netting the transactions:-A business that trades both as a buyer and a seller in the same foreign currency may be able to set receipts from sales against payment for purchases, perhaps best effected by opening a bank account in the foreign currency. Even if precise netting were not possible because for example, receipts in the foreign currency exceeded payments, only the balance would need to be converted.
vi) Maintain a foreign currency bank account:- If the business maintains a separate bank account in each of the currencies in which it transacts foreign business, it may be possible to delay conversion until such time as it judges the rate to be particularly favorable.
vii) Trading in the home currency:-It is possible for the UK business to avoid the transaction risk by insisting that purchases and sales are denominated in sterling. This simply shifts the risk from the business to tits suppliers and customers. To the extent that it is common for sellers to quote prices in the currency of the buyer, it will tend to be feasible to buy form a broad and be invoiced in the home currency. When the time for settlement arrives, sterling is paid. By the same token, however, foreign customers will usually expect to be invoiced in their own currency. Insisting on invoicing in the home currency, and penalized by having to accept lower prices. Also insisting that all suppliers invoiced in the buyers home currency may deny the business the opportunity to buy from certain foreign suppliers who are only prepared to invoice in their home currency.
viii) Doing nothing:-The methods for dealing with transaction risk all seek to stop the worst happening, or to make sure that the business does not suffer if it does. To this extent they are like insurance policies and they have costs associated with them. With most risks in one personal life we tend not to insure them unless the adverse event is unlikely to occur and/or it will be very damaging if it does. The reason for this is that insurance premiums are likely to be reasonably high compared with the potential loss where the loss is a likely one. Adverse exchange rate movements are summer weather, but in the UK there is such a likelihood of these occurring that the premium would tend to be high. Ice cream sellers tend to self insure i.e. they bear the risk themselves. It is only events or those that would lead to a very major disaster for the business that would be worth insuring against.
Economic risk
This is when a company is affected by movement exchange rates. Economic risks covers areas such as loans taken in foreign currencies that ends up becoming very costly more than it was accepted. Repayment of the principle amount becomes also very expensive; therefore, this is described as economic risk. This includes the possibility of the home currency becoming strong against the foreign currency so the value of operating cash flows is less than the budget. It is also very difficulty for the company to operative competitively in the foreign market when the supplies come form the home country and the home currency is stronger than the foreign currency.
In managing this risk it is very difficult y to manage it. There are techniques which are used to manage these risks such as options and forwards contract. The approach that is used includes;
Currency swaps.
Trying to trade in foreign countries where there is known to be some intent on the home government part to hold the home currency at a broadly constant exchange rate, relative to relevant foreign ones;
Taking steps to try to balance payments and receipts in the same currency.
Currency swaps will solve this problem because a borrower based in a different country who agrees with the current countries debt holder to exchange the debt. This means that the business men form the United States operating in UK will agree to pay the principles and interest of a debt of a UK company operating the US as well as the UK Company agrees to pay debt for the company in UK.
Translation risk.
This risk is associated with the fact that the business will have assets in the foreign country whose currency weakens against the home currency thus suffering reduction in the shareholders wealth. The risk it does not involve the flow of cash into or out of the home country but involves the translation of items in the profits and loss account and the balance sheet. It does not real affect the investment of funds or funds generated from trading. Translation risk has economic impact of the company because it reduces net worth of the company in the eyes of the shareholders. The assets may be very productive wherever they are because of a weak dollar it becomes useless. There are many ways of managing this risk. The strategies involve managing this risk includes;
Avoiding being too exposed to one single foreign currency by having operations in a range of countries each with different, unlinked, currencies.
Trying to trade in foreign countries where there is known to be some intent on the government part to hold the home currency at a broadly constant exchange rate with the relevant foreign currencies.
Taking steps to try to finance much of the foreign investment with funds borrowed in the local currency, so that translation losses of assets of values are matched by gains on liabilities.
B) The us subsidiary owed $ 14,381,000 by Japan subsidiary
Owes Germany subsidiary €20million
The Japan subsidiary owed ¥15.5 million by Germany subsidiary
Owe it $ 700,000
Dollar accounts
US subsidiary
Owed by Japan sub 14,381,000/1.9696 = 7,301,482
Owes the Germany 20, 000,000/1.4837= 13,479814
Net remittance 6,178,332
The Germany subsidiary
Owed USA sub 20, 000,000/1.4837= 13,479,814
Owes Japan sub 15,500,000/ 227.5 = 68,132
Net remittance (13,411,682)
Japan sub
Owed by Germany sub 15,500,000/ 227.5 = 68,132
Owes by USA sub 14,381,000/1.9696 = 7,301,482
Net remittance 7,233,350
3. The supply of and demand for foreign exchange
One can analyze changes in the foreign rate using supply and demand, as it is done when studying price changes in other markets. The supply of foreign exchange arises from foreigners who want to supply their own currencies to buy dollars, which they will then use to buy goods and make investments. The demand for foreign exchange arises because UK residents want to exchange their for foreign currencies in order to buy foreign goods and make foreign investments. I will assume that these demand and supply curves slope in their usual directions. The vertical axis measures the UK currency price of foreign currency, and the horizontal axis measures the amount of foreign currency purchased and sold per period.
The foreign exchange rate can change because of a shift in either the demand curve or the supply curve in the foreign exchange market. In the graph A of the figure, demand curve shifts out, so that the new equilibrium foreign exchange rate is at E2 and in graph B the supply curve shifts back, also yielding an equilibrium foreign exchange rate E2.
I have noted that a demand for foreign exchange arise when UK residents want to buy foreign currencies to buy foreign goods and foreign investments. The amounts supplied and demanded depend on the exchange rate, all other things being equal, because the cost of buying goods and making investments across international boundaries depends in part on the exchange rate. To analyze the elasticities of supply and demand in the foreign exchange market and to see the reasons for shifts in supply and demand curves I must look at the determinants of international trade and investment.
supply
Demand
E
Q
Supply and demand curves for foreign currency determine the equilibrium exchange rate, E, and the quantity, Q of foreign currency traded each month. To analyze this market, I need to analyze the determinants of the elasticities of supply and demand and look at how changing economic conditions to changes in the supply and demand curves.
E1
E0
In the panel A, the dollar price of foreign exchange rises because the demand curve shifts to the right. In graph B, the Sterling pound price of foreign exchange rises because the supply curve shifts to the left. The shift in the demand curve in graph A might reflect an increased preference by UK residents to buy foreign goods, thus requiring that they buy more foreign currency in order to buy the goods. The shift in the supply curve in graph B might reflect a decrease preference by foreigners to buy UK goods, thus reducing the supply of foreign currencies to buy Sterling pound in order to buy US goods.
MECHANISM OF FOREIGN EXCHANGE MARKET
Suppose you plan to travel abroad to the UK, say. Before leaving the United States, will want to have some Sterling bound currency available for expenses when you arrive. One can probably get Sterling bound he wants by going to your local bank buying them for dollars. Where does your bank get the Sterling bounds? The local bank works through large banks in major cities. These large banks engage actively in buying and selling foreign currencies. Most of these transactions are deposit transfers rather than transactions in physical currency, but large banks do deal in currency for the convenience of travelers. Banks may buy Sterling bounds, for example, from visitors to the United States from the UK who need to exchange Sterling bounds for dollars to finance their travels in the United States. Banks charge small commission on these exchanges to cover their costs of doing business.
Most foreign exchange trading is in deposits rather than in currency. Major Banks maintain bank accounts in foreign banks. These accounts are denominated in foreign currencies in foreign currencies. Moreover, many large U.S. banks have their own branches abroad. Similarly, foreign banks have branches in the United States and maintain banks accounts in dollars in U.S. Banks these large banks in countries around the world buy and sell foreign currencies as needed by their customers. Ordinarily bank them try to avoid taking large positions in foreign currency. That is a bank maintains working balances in foreign currencies but does not have a large investment in foreign currency. That way should exchange rates change, the bank will not be exposed to large losses on its holding of foreign currencies.
Most companies manufacturing companies and others-have extensive business dealings in foreign facilities. These firms routinely exchange billions of dollars worth of foreign currencies every year as part of their normal business transactions. These firms sell and buy their completed equipment to countries abroad, and receive payments in foreign currencies for the items they sell. Thus in the normal course of business these firms are buying and selling foreign currencies almost every day.
The exchange rates vary substantially over time. I will begin by analyzing why these fluctuations occur, but perhaps the first question is why anyone should care whether they do or not.
Suppose am interested in buying a product from a broad. Suppose I want to buy a stereo receiver that has a price ¥30,000 in Tokyo. If the exchange rate is ¥150 to the dollar then the price of this piece of equipment in dollars is $200. If the exchange rate should change, the dollars price of the receiver will also change. Suppose that the exchange rate change to ¥120 per dollar. Then assuming the price of the receiver remains. In general US buyers of foreign goods are better off when the number of units of foreign currency per dollar is higher rather than lower. If the dollar goes to ¥200 then the dollar price of the receiver becomes $150, assuming that its yen price in Tokyo remains at ¥30,000.
Although those who are buying goods form abroad are generally better off when the foreign currency value of their own currency is high. Manufacturers of goods for sale abroad are generally better off in the reverse circumstance. Consider the stereo manufacturers in Tokyo. When the price of the receiver is ¥30000 and the exchange rate is ¥150 per dollar, the price of the receiver in dollars is $120 per dollar. When the exchange rate goes to ¥200 per dollar the receivers dollar price is $150 as we have already seen. US demand for the product will be stronger at a price of $150 than at $200, and so the manufacturer is going to sell more of them at the lower dollar price. Other things being equal those exporting goods prefer a relatively depreciated exchange rate to a relatively appreciated one.
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