Interest and Exchange Rates Influence on Multinational Corporations - Essay Example

How Changes in Exchange Rates and Interest Rates Affect Costs and Prices of Firms Operating in International Markets? What Effect These Changes Might Have On A Multinational Corporation Decision To Invest Globally? Student Name School How Changes in Exchange Rates and Interest Rates Affect Costs and Prices of Firms Operating in International Markets? What Effect These Changes Might Have On A Multinational Corporation Decision To Invest Globally? Abstract Changes in interest and exchange rates directly affect profitability of companies having international business by influencing their investment decisions, production costs and prices. High interest rates are associated with higher business risk and make cost of capital more expensive, thus reducing profitability and amount of business investments in the region over a long-run period. On the other hand high interest rates are positively related to short-term exchange rates due to increased demand of the national currency. This results in higher prices of exported products and services, followed by decrease in exports, and increase in imports. Businesses’ investment decisions for international markets are thus influenced not only by current interest and exchange rates, but also by expectations for future developments. The purpose of this analysis is to give a justified explanation of the effect of those changes. Currency exchange rates The driving force of international currency exchange markets are businesses, people and financial institutions that either speculate with exchange rates or are involved in international commerce. The exchange rate is the price of one country’s currency in terms of another country’s currency (Ross, S. et al, 2005). Few countries fix the exchange value of their currency to other key currency such as US dollar or the euro. The exchange rate between most currencies is usually determined by market forces of supply and demand. When for example the UK pound “strengthens” or “appreciates”, this means that the value of the UK pound rises, so it takes more foreign currency to buy one pound. Basically, increased demand for one currency positively impacts the value of this currency on the foreign exchange market. Higher exchange rate of UK pound versus US dollar means that goods and services imported by UK into the US market will be more expensive, i.e. prices of UK products will be higher (↑). UK businesses operating on the US market will sell at higher prices, oppositely, US goods and services imported into the UK will be cheaper. Thus UK products will face decreasing demand abroad and exports will diminish. The result will be decrease in output for companies with international sales. Interest rates Interest rates play an important part in investment and saving decisions. Interest rates are the main instrument of central banks to conduct their monetary policies. Interest rates have impact on foreign exchange rates. Higher relative interest rates (↑) attract higher financial investments in the short-run due to expectations for higher returns. The simplest way to explain this is to compare bank interest rates between two countries. If, in UK interest rates for deposits are 5%, compared to US deposit interest rates of 3%, then it will be economically sound for businesses to transfer their bank accounts to UK banks for higher returns. This, in turn will increase demand for UK currency, also increasing supply of US dollars. Increased demand will increase the value of the UK pound as compared to the US dollar, thus positively influencing the foreign exchange rate of the pound (↑). On the other hand, expectations for future changes also influence exchange rates. Higher interest rates (↑) have negative long-run effect on investment decisions of international businesses. Although higher interest rates attract more bank deposits, they are associated with unfavourable business situation and higher business risks for returns on investments; therefore they result in higher cost of capital (Barron’s, 1994, cited by Murphy, 1996). Since businesses worldwide are highly dependent on loan conditions, it is economically justified for businesses to invest in regions where business climate is securer, i.e. interest rates are lower. Demand for currencies of countries with high long-term interest rates therefore will decrease, and the value of these currencies will diminish. Also, when businesses expect that inflation processes will undermine the value of their investment in a country, demand for local currency will decrease. Another way to look at investment decisions of multinational corporations are investment spending on land, buildings, equipment, inventories for future production. These are influenced by comparison between expected rate of return from the investment, and the interest rates. When investors believe that rate of return is higher than the interest rate, the investment will probably be undertaken. Interest rates also impact costs of produced goods and services. The cost of holding inventory is the interest paid if companies have loans. Interest expenses on holding inventory could have a significant impact on profitability (Interest Rates Affect Agricultural Markets, 2005). These are fixed costs and have to be paid independently of production levels. Higher interest rates from expensive loans increase those costs and represent additional financial burden to companies. Financial investments Having explained basic influences of interest and exchange rates on commodity markets, it’s worth paying some attention also to monetary markets influences and the effect of expectations on investment decisions. Speculation about future changes in exchange and interest rates direct many business decisions with regard to present transactions and future sales and purchases. In that regard, basic supply-and-demand laws prove that forward rates should be the same as future spot rates. If forward rate are higher than future spot rates between two currencies, then businesses would not agree to forward rates in exchanging currencies, the forward exchange rate will then fall to attract traders, and vice versa. Similarly, there is a relationship between spot exchange rates, forward exchange rates and relative interest rates, explained by the Interest Rate Parity. Regarding investment decisions, there is no fundamental advantage to borrowing or lending in one currency over another, since the IRP rule implies, that the difference in interest rates must reflect the difference between forward and spot exchange rates (Karpoff, J., 2001). This means that differences between interest rates of two counties are offset by changes in the relative values of the two currencies (Ross, S.A., 2005). where r€ - euro interest rate; r$ - dollar interest rate; f€/$ - forward rate of exchange; s€/$ : spot rate of exchange Conclusion International businesses base their investment decisions on expected returns on investment, which are influenced by national fiscal and monetary policies. Companies are likely to invest where favorable investment conditions are present, namely where lower risk for investments, greater confidence in business and political situation, and greater relative returns on investment are expected. Through their monetary policies central banks can influence interest rates thus affecting monetary supply and international exchange rates, cost of investments and cost of holding inventories, but also prices, and competitive power of businesses. Higher interest rates are likely to attract financial investments in the short run and increase exchange rates of national currencies, thus increasing price levels and reducing demand and exports. Still, expectations for higher relative inflation and high interest rates have negative impact on investment decisions over the long-run. High long-run interest rates have the psychological implications of decreased confidence and security, but also directly affect cost of borrowed capital, thus increase fixed production costs. Practical experience Karpoff (2001) proves that when financial investments are involved, as opposed to exchange of real goods, markets are becoming increasingly internationalized. One probable reason for that is that there are much lower transportation costs in moving currencies, and exchange is easier to take place. Differences between interest rates are offset by changes in the relative values of currencies, so international businesses should find equal opportunities in borrowing or lending in those currencies, provided risk levels are similar. References 1. Ross, S.A., Randolph W.W., Jaffe J. (2005), Corporate Finance. 7th Edition. McGraw Hill 2. Murphy, A. (1996), Determinants of Exchange Rates Between Two Major Currencies. The Multinational Business Review 3. Interest Rates Affect Agricultural Markets, June 2005, Article. Retrieved from www.agric.gov.ab.ca 4. Karpoff, J. (2001), Foreign Exchange Markets Presentation. Foundations of Asset Valuation Read More