Treasury and Risk Management in an International Context - Assignment Example

Treasury and Risk Management in an International Context Question 1 Introduction Exchange rate system is an integral part of monetary policy that leads to establish a relation between values different currencies in foreign exchange market. As a result of rapid expansion of globalization and international trade, multinational companies experience currency differences because of having subsidiaries in various countries. Translation of aggregate profitability, net sales etc in the home currency would have been very difficult for these companies in absence of exchange rate system (Andersen, 2005). In the next segment of the paper, different exchange rate systems will be analysed in order to understand their economic implications on multinational companies and associates. Discussion Exchange rate Systems Exchange rate system shows the arrangement in which an authority controls value of different currencies in foreign exchange market with respect to other currencies. There are mainly two types of exchange rate systems such as fixed and floating exchange rates. Fixed Exchange Rate Fixed exchange rate system aims to fix the value of a currency against the value of a stronger currency, a basket of currencies or other measurements like gold. The system is better known as pegged exchange rate because it triggers to stabilize the value of a currency through pegging it with a steadier and internationally recognized currency. Hence, trading opportunities become more stabilized and predictable, especially for economies in which external trade is held responsible for large chunk of Gross Domestic Product (Ghosh, A, M. G. Wolf and H. C. Wolf, 2002). Fixed Exchange Rate Linked a Basket of Currencies Though, according to the theory, fixed exchange rate leads to establish greater economic stability and helps the multinational firms to forecast future currency rates so that risks associated with international pricing can be managed by them, in reality, devaluation or revaluation of currencies driven by inflation, interest rate and other economic variables do not allow currencies to remain fixed forever (Caves, 2007). Hence, the policymakers have adopted a resolution of fixing currency with a portfolio of a number of currencies with different weights such as euro, yen, British pound etc. This type of exchange rate is less susceptible to the economic occurrences of a particular country. For instance, increase in inflation rate will directly impact on a currency pegged with US dollar; however, if the currency is pegged with a basket of currencies, the effect of increasing inflation in US will be diluted by the presence of other currencies and will have less impact on the pegged currency (Askari and Modigliani, 2014). Figure 1: Fixed Exchange Rate System (Askari and Modigliani, 2014) Fixed Exchange Rate Backed By Currency Board System Currency board indicates a situation when issue of domestic currency is always supported by a hard currency, such as US dollar. The system aims to bring economic stability and tries to minimize exchange rate fluctuations as the domestic currency is always backed by a strong currency at a fixed rate of exchange (Gia, 2009). Floating Exchange Rate Figure 2: Floating Exchange Rate between US$ and Australian$ It may be defined as the system that allows a currency to fluctuate due to responses from market mechanism. The currencies follow this system is floating currencies. However, as floating currencies influence fluctuations in foreign exchange market, central bank intervenes from time to time in order to control extreme appreciation and depreciation of currencies. Such management of currencies are known as managed float (Kallianiotis, 2012). Possible Foreign Exchange Risks Experienced by Multinational Companies As a result of operating in different exchange rate regimes, the multinational companies experience some risks (Borghesi and Gaudenzi, 2012). Translational Risks Translational risk is a type of exchange rate risk that multinational companies face while dealing in foreign currencies. The higher the proportion of such foreign currency denominated asset-liability and equity quotients in their balance sheet, higher the risk of translation. Multinational companies tend to interpret their subsidiaries financial statements in the domestic currency of their headquarters. However, while preparing consolidated balance sheet, all multinational companies are required to translate the inputs of balance sheet into domestic currency. As the exchange rate market is inherently volatile, translation of figures over a particular period of time may prove to be favourable or unfavourable, depending on the on-going exchange rate (Foley and Manova, 2014). Therefore, translational risk affects the company’s profitability as well as their final accounts. Discrepancies also arise from accounting perspective. Translation of assets and liabilities are done at the rate of exchange in which balance sheet was recorded whereas profit and loss statements are translated at the average exchange rate for the whole financial year or at the rate on the date of closing. Share capitals are converted at the historical exchange rate. Apart from all these, depending on the contribution from foreign subsidiaries, location where the subsidiaries are situated and accounting method used by treasury and finance department increases the translational risk exposure (Collier and Ampomah, 2008). Transactional Risk The multinational companies also experience transactional risk that arises due to the time difference between signing a contract and its settlement. As the time differential increases, probability of increasing the risk also broaden depending on the degree of fluctuation of the exchange rates. In general, multinational companies try to anticipate future rates in a specific region and attempt to make strategies such as hedging to safeguard the company from transactional risk (Foley and Manova, 2014). Hence, it becomes easier for the multinational companies to measure the degree of transactional risk and mitigate the effect of such risks as compared to translation risk. In order to minimize the adverse effect of this type of risk, the treasury department of the companies tends to identify such risks first, and then they decide on hedging of the risk exposure. Finally, the company decides whether position should be taken for hedging of all parts of the exposure or partial exposure and technique to be taken for hedging among all available techniques available such as forward market hedging or futures market hedging (Hau, 1999). Economic Exposure Unanticipated currency fluctuation on the future cash flow of a company leads to create economic exposure risk for a multinational company. Because of its long enduring effect in the long term business operations of the company, market value of the company is substantially affected by this kind of exchange rate risk. Hence, multinational companies are required to predict such risks well in advance, before taking any business decisions in order to determine the degree of economic exposure risk, associated with the exchange relations between their home currency and subsidiary’s domestic currency. In this way, they will be able to hedge the risk exposure in foreign currency payables and receivables (Chowdhry and Howe, 2000). As the economic exposure risk leaves a direct impact on the company’s net cash flow, controlling economic risk becomes a challenging issue for all multinational companies particularly when the effect of exchange rate volatility on net cash flows expands beyond the accounting period in which the fluctuation occurred (Hicks, 2008). Economic Impact of the Exchange Rate System on Multinational Companies Currency fluctuation is a natural consequence of floating exchange rate system. Such volatility in exchange rates deeply influences multiple economic variables such as relative demand and supply of the underlying economies, their inflation rate & interest rate differential (Kim, 2011). Hence, such economic considerations positively influence the business of multinational companies and their subsidiaries operating in those countries. In the next segment, how economic impact of exchange rate system influences the business of multinational companies will be analysed. Economic Growth The Gross Domestic Product (GDP) of an economy can be determined by an aggregate of consumption, investment, government spending and net export. GDP = C+I+G+ (X-M) Where, C = Consumption. I = Investment. G = Government Spending. (X-M) = (Export – Import) = Net Export. From this equation, it is evident that higher the value of net export, higher will be the GDP of a country. As the GDP of a country increases, the economic growth accelerates and the economy attracts more multinational companies to establish their subsidiaries in the country and expand accordingly. However, the value of import and exports are largely affected by the volatility in exchange rate systems that lead to affect GDP of the economy and in turn expansions of MNCs are concerned (Kim, 2011). Capital Flow Flow of foreign capital is always directed towards countries with sound economies and relatively stable currencies. Hence, foreign investors consider countries with a stable currency system for their further investment in order to avoid potential losses on account of foreign exchange fluctuations. Hence, a country with stable currency invites more Foreign Direct Investments (FDIs). Such FDIs enables many domestic companies to grow globally and facilitates smooth operations of the subsidiaries of multinational companies as well (Brigham and Ehrhardt, 2007). Inflation It has been experienced that currency devaluation in home country leads to create imported inflationary effect in the importer countries. For example, an unexpected decline in domestic currency by 20% may lead to increase price of imports by 25% or more, as 25% increase is necessary for the price to reach its original level if the price declines by 20% (Brigham and Ehrhardt, 2007). Interest Rate Strong domestic currency results in a tighter monetary policy, raising the interest rate high. In fact, tight monetary policy aggravates the possibility of attracting FDIs in the home country. Hence, the opportunity for MNCs to expand reduces (Brigham and Ehrhardt, 2007). Conclusion Exchange rate system facilitates multinational companies to operate globally as well as to translate their profitability into the denomination of their domestic currencies. However, as exchange rate system, especially floating exchange rate system is inherently volatile; it gives rise to certain risks such as translational and transaction risks. Moreover, fluctuations in exchange rate market leads to influence macro-economic variables which in turn affect the operations of multinational companies and their subsidiaries. Hence, the companies should exercise various strategies such as hedging for minimizing foreign exchange risks in order to ensure smooth running of their global businesses. Question 2 Introduction Interest Rate Parity (IRP) and Purchasing Power Parity (PPP) are two most important theories in the field of economics and international finance. PPP theory aims to determine the value of a currency in comparison with the values of other currencies. Interest rate parity indicates an equilibrium position where indifferent interest rate will be available to the investors of two countries on their bank deposits (Brigham and Ehrhardt, 2007). The next segment of this paper will explore the theories of Purchasing power parity and interest rate parity and evidences for and against of these theories. Discussion Purchasing Power Parity (PPP) Purchasing power parity determines the interrelationship between the price level of two countries and exchange rate of their currencies. Equilibrium is achieved at the point where the ratio of aggregate price level of two countries becomes equal to the exchange rate of those countries. In other words, purchasing power theory explains that a difference in rate of inflation in different countries leads to changes the exchange rates among these countries (Arize, Malindretos and Ghosh, 2014). Purchasing Power Theorem => (P$-P€/ 1+ P€) = (St- So)/ So Where, Ps is the expected rate of foreign inflation. P€ indicates the expected rate of inflation in home country. St is the expected spot rate at the time “t” and, So is the spot rate at time “0”. The economic theory also calculates the requirement of adjustments of the exchange rate of between the two countries so that it becomes identical to the purchasing power of each country (Ignatiuk, 2009). Absolute and Relative Purchasing Power Parity In the theory of international finance, two types of PPP exist. These are: Relative and Absolute PPP. Absolute purchasing power leads to equalize the real price level across countries in the international context whereas Relative Purchasing Power Parity originates when the percentage change in price level as well as exchange rates of two nations meets over a period of time (Yusof, 2007). Evidences For and Against Purchasing Power Theory The general notion behind purchasing power parity is to maintain uniformity of currencies so that same basket of goods bought in a currency of home country will be able to obtain at an equivalent amount in foreign currency at an existing exchange rate. However, rationale of PPP theory is subject to argument as possibility easy arbitrage exist neither in the service sector not in property markets engaged in international trade. Hence, the idea of internationally sound arbitrage holds good only in relation to the law of one price which explains when a price is translated in a common currency, that price level of an internationally traded good should be equal worldwide (Yusof, 2007). According to the law, if a same good is appointed in each country’s basket with a constant weight in order to construct the aggregate price level, the PPP theory should hold good in the concerned countries. Objections can be drawn on be ground that in real world, there exist transportation cost, tariffs as well as taxes, the effect of which leads to violate the law of one price. The price differential between United States and Canada for similar goods can be exemplified broadly as a supporting evidence of this hypothesis. Moreover, all goods are not traded internationally and the relative weights attached to the goods for formulating aggregate price indices are also not identical (Ferreira and León-Ledesma, 2003). Secondly, the goods produced by the countries are always differentiated. The concept of perfectly substitutable goods or assets is also imaginary in the practical scenario. In fact, as the PPP theory is supported by the concept of tradable goods, implication of it provides better result while calculating it taking into accounts the producers’ price index. However, in order to derive its existence in real world, consumers’ price index should be considered (Keynes, 2006). Interest Rate Parity (IRP) It shows that difference in interest rates of two countries are equivalent to the differences in forward and spot exchange rate. Interest Rate Parity => (i$- i€)/ (1+ i€) = (f0-S0)/ S0 Where, i$ is the interest rate in foreign country. i€ is the interest rate in home country. S0 is the spot rate at time 0. f0 is the forward rate at time 0. Assumptions Interest rate parity theorem is based on the following assumptions. i> Capital is perfectly mobile i.e. opportunities are there for the investors to swap their domestic assets in exchange of foreign assets. ii> In terms of liquidity and inherent riskiness, all assets are perfectly substitute. Based on the assumption of capital mobility and perfect substitution of assets, it can be expected that investors will tend to hold either foreign or domestic assets, in which they are gaining a higher return. Hence, equilibrium is attained where the return on domestic assets and foreign assets tends to be identical as a single investor from either side would anticipate identical return from either of the investment decisions (Brigham and Ehrhardt, 2007). Two types of IRP can be experienced in international financial framework. Covered Interest Rate Parity Covered Interest Rate Parity is a situation when arbitrage condition is not fulfilled by using forward contract for hedging against the company’s exposure to exchange rate risk. It is based on the hypothesis that returns from interest rate gained from different currencies should be identical if these are covered against changes in currencies (Giovanis, 2007). More specifically, if an investment is protected by obtaining a position in forward market, such investment in US deposits will fetch same returns if invested in foreign currency. Uncovered Interest Rate Parity Uncovered IRP arises if arbitrage condition cannot be fulfilled without exercising forward contract for hedging against exchange rate risk exposure. This type of IRP is based on the assumption that the differences in interest rate of two different county’s currency are likely to be equivalent to the depreciation of the currencies. In other words, a 10% depreciation of US dollar against euro can be compensated by 10% increment of interest rates of dollars (Brigham and Ehrhardt, 2007). Evidences For and Against Interest Rate Parity Theory Most of the economic theories are based on the concept of ceteris paribus which means remaining all other things constant. The theory of interest rate parity is not an exception. IRP also holds good only when capital mobility i.e. easy exchange of domestic capital for foreign capital and perfect substitutability of investors’ asset exists (Silver, 2010). However, as significant differences are there in terms of asset holding between domestic and foreign asset investors in reality, it is really difficult to achieve an ideal scenario in which IRP theory may hold. Covered IRP is based on the assumption of no transaction cost which is also impossible in real world to exist. In real world, as long as the government bonds as well as bank deposits are risk free, the interest rate parity theory perfectly holds in such economies. However, in countries where the banks and governments cannot secure the payment promises as a result of economic and financial unrest, no risk free rate on investment is available and hence, chance is limited for interest rate parity theory to hold (Giovanis, 2007). Conclusion Purchasing power parity and interest rate parity tend to institute a consistent relationship between the interest rate, inflation and exchange rates of two countries. Though, the practical applicability of these two theorems is a debatable subject, the theoretical concept holds immense importance in the field of economics and finance. Reference List Andersen, T. J., 2005. A Strategic Risk Management Framework for Multinational Enterprise. 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Managing Financial Risk for Multinational Companies in South East Asia. Bloomington: AuthorHouse. Zorzi, M. C. and Chudik, A., 2013. Spatial Considerations on the PPP Debate. [PDf] Available at: < http://www.dallasfed.org/assets/documents/institute/wpapers/2013/0138.pdf> [Accessed 28 February 2015]. Read More