The Significance of International Finance - Essay Example

International finance Task Introduction Foreign exchange is a market concept that means, converting currency of one country into that of another. Therefore, foreign exchange market is the market that hosts the currency conversion process. The process of currency conversion depends on exchange rates. An exchange rate is the cost charged for converting the value of a country’s currency into the value of another. Therefore, the establishment of foreign exchange market was to create a system that could facilitate the conversion of a country’s currency into another and offer insurance services against adverse consequences of foreign exchange rate fluctuation. A spot exchange rate is the rate used in an instant currency conversion agreement between two or more parties. Spot exchange is carried out in a spot exchange market, which is part of the foreign exchange market. On the other hand, forward exchange rate is the rate agreed on today, to convert currencies at a future date specified in the agreement. The international Fisher Effect states that the currency of a country whose interest rate is relatively higher is likely to depreciate against the currency of another country whose interest rate is relatively lower (Madura 2011, pp. 114-120). This essay, therefore, presents a discussion on whether the International Fisher Effect holds, the significance of the international finance, a test to ascertain whether the International Fisher Effect hold in two countries (Italy and the United Kingdom). The test is dependent on exchange rate and the interest rate of the two countries. The data used cover the year between 2008 and 2013. Lastly, the method used to verify the relationship between the exchange rates and interest rate is regression. A conclusion is provided in response to whether the two variables are affecting each other. The significance of the International Finance In order to deeply understand the significance of the international finance, it is necessary to be familiar with the elements of the international finance. They are the exchange rate, the interest rate and the rate of inflation. There are three theories that depend on these elements. They are the International Fisher Effect, the Law of One Price and the Purchasing Power Parity. These three theories are more or less related. The international finance is a concept that means cross boarder borrowing of funds, cross border investment activities between organizations and the governments, cross boarder purchases and sales. Purchasing Power Parity theory states that the prices of like products should be same in different countries, when the currencies of the trading countries are converted into one denomination (same currency). There are two versions of the purchasing power parity. That is, the absolute and relative purchasing power parity. Absolute Purchasing Power Parity theory asserts that the real prices of commodities must be the same in all countries. As a result, the absolute Purchasing power parity can be achieved when the purchasing power of the local and foreign currency are alike, after exchanging the currencies to foreign denomination, using the prevailing exchange rate. On the other hand, relative purchasing power parity asserts that differences in the exchange rates between a local and a domestic country should be equal to the variability in the countries’ relative prices (Adler & Lehmann 1983, pp. 321). Comparatively, the International Fisher Effect theory behaves in the same manner as the Purchasing Power Parity. The theory states that the currency of countries with relatively high nominal interest rates tends to depreciate against the currency of countries with relatively lower nominal interest rates. Available evidence presents a mixed result as in the case of the Purchasing Power Parity theory. That is, in the short-run, the relationship between the exchange rate and the interest rate is weakly established, as there are deviations. However, in the long - run, there is a possible relation between the exchange and the interest rate. Therefore, the evidence states that the International Fisher Effect is not suitable for forecasting short-run deviations in the spot exchange rates (Chen & Knez 1995, pp. 221-230). Factors affecting the exchange rate There are many factors affecting the future spot exchange rate. They are level of export and import, currency demand, the interest rates, the inflation rates, the balance of payment and money supply level in an economy. Only two factors are discussed in this context (inflation and interest rate). Inflation- inflation is a condition that involves a period of high commodity prices in a country. If the local products were more expensive than the foreign products, the local consumers would prefer the foreign products. This situation would lead to a high demand for foreign products, thus more export activities. The local country would pump more of its currency in the foreign exchange market in order to pay for the foreign products. A further increase in the supply of a local currency (increase in a foreign demand) leads to an automatic reduction of the local currency’s value. The cause of the reduction is the force of demand and supply. The reduction in the value of the local currency would lead to an increase in the exchange rate against between the local and the foreign denominations. The increase in the exchange rate would be caused by the automatic devaluation of the local currency. Therefore, if the devaluation were projected to continue further into the future, the prices of currency future contracts would be low (Madura 2011, pp. 114-120). Interest rates- the difference in the rate of interest between countries is one of the major causes of future price movements. If a country’s monetary authority decides to increase the money supply on an economy, the demand for the local goods would be higher than the supply, assuming that the production rate is constant. The increase in demand would lead to an increase in the prices of the local commodities. The effect would reduce the purchasing power of the local currency, thus the value would reduce. The purchasing power of a foreign currency would therefore be greater than that the local currency. These series of activities would eventually cause lower the price of the local currency. If the effect is projected to continue further into the future, the future currency prices would be lower too because the price of the underlying asset would be lower (Madura 2011, pp. 114-120). Significance of the international finance Based on the knowledge of the PPP, the IFE, LOP and the factors affecting the future spot exchange rates, the following are the significance of the international finance: first, Multinational companies use this concept to guide investment plans. Considering the theory that the currency of a country with a relatively higher interest rate is likely to depreciate, the Multinational Corporations use this information to conduct a research to determine countries whose interest rate are high. They, therefore, avoid investing in such companies to avoid incurring losses due to adverse fluctuation of the exchange rates. The practical experience of this is the fact that most Multinational Corporations avoid undertaking any investment in the developing countries due to the high interest rates in such countries (Severov 2006, pp. 40-63). Second, being aware of the exchange rate fluctuations and the effects borne, the Multinational Corporations develop strategies to minimize the adverse effects such as losses due to unfavorable fluctuation in the exchange rate. Some of these risk reduction strategies involve the use of derivatives to hedge against the exchange rate risks. The following are some of the hedging strategies that would be implemented by the multinational Corporations: the money market hedging and the currency option. The money market hedge is a strategy that involves borrowing or lending to the money market. The borrowing strategy is an agreement involving a pre-determined exchange rate to be used in currency conversion. The pre-determined exchange rate is arrived at following a market analysis of the exchange rate movement. In this strategy, the pre-determined rate is to be applied regardless of the spot rate on contract maturity. Therefore, an unfavorable exchange rate movement would be mitigated by the application of the pre-determined rate. The borrower would pay less than he would have if the spot rate were used in currency conversion, thus mitigating losses (Severov 2006, pp. 40-63). Currency option is another strategy that involves a right, but not an obligation to buy or sell a specified amount of currency at a pre-determined exchange rate for a future transaction. In a call option, the holder of the option (buyer) is entitled to premium payments to compensate for the unfavorable exchange rate movements until the maturity of the contract. When the contract matures, the option buyer has the right to decide whether to buy the option or not depending on the exchange rate. That is, the buyer can decline the option purchase if the spot rate reflects a devaluation of the currency of the option buyer (Severov 2006, pp. 40-63). How to conduct the test There is a heavy reliance on various books and journals on the International Fisher Effect. The contents of the said secondary sources of information will act as a guide through the review process. The most important guidance sought from the sources is the testing and result presentation methods. A regression analysis has been used to help ascertain the nature of the relationship between exchange rate and interest rate in Italy and the U.K. Coefficient of correlation has been used to aid the process as below. The coefficient of correlation (r) measures the degree of relation between the dependent and independent variable. (r) varies between positive one and negative one. When the values of r approach positive one, it shows that as the independent variable increase or decrease, the dependent variable also increases or decrease at a higher degree. On the other hand, a negative (r) shows an inverse relationship between the dependent and the independent variable. Concerning IFE, an inverse relationship between the dependent and the independent variables show that IFE holds. That is, a negative (r) shows that IFE holds while a positive (r) shows that IFE does not hold. The formula for determining the correlation coefficient is as follows: r = . In the below table, the dependent variable (Y) is the exchange rate, whereas the independent variable (X) is the interest rates (Madura & Fox 2007, pp. 192-233). UK vs. US X Y X^2 Y^2 XY 5.512 0.684041 30.38214 0.467912 3.770434 1.212 0.618544 1.468944 0.382597 0.749675 0.7 0.641108 0.49 0.411019 0.448776 0.874 0.643625 0.763876 0.414253 0.562528 0.827 0.614931 0.683929 0.37814 0.508548 0.513 0.603355 0.263169 0.364037 0.309521 SUM 9.638 3.8056 34.0521 2.41796 6.34948 Using the formula or finding r, below is the result (6*6.349482) - (9.638*3.805604) {(6*34.05206) - (9.638)^2}^0.5 * {(6*2.417959)-(3.805604)^2}^0.5 1.419 (10.56-0.173) r = 0.137 Italy vs. US X Y X^2 Y^2 XY 4.634 0.718546 21.47396 0.516308 3.329742 1.228 0.694155 1.507984 0.481851 0.852422 0.811 0.748391 0.657721 0.560089 0.606945 1.391 0.772857 1.934881 0.597308 1.075044 0.573 0.76402 0.328329 0.583727 0.437783 0.221 0.725111 0.048841 0.525786 0.16025 SUM 8.858 4.42308 25.9517 3.26507 6.46219 Using the formula for finding r, below is the result (6*6.462187) - (8.858*4.42308) {(6*25.95171) - (8.858)^2}^0.5 * {(6*3.265069) - (4.42308)^2}^0.5 -0.41 (8.78 - 0.173) r = - 0.0476 The result of the tests The test show that the International Fisher Effect holds between Italy and US. This is due to r = -0.0476 showing an inverse relationship between the interest rate and the exchange rate. On the other hand, the International Fisher Effect does not hold between the US and the UK for the reason that r= 0.137 (Madura & Fox 2007, pp. 192-233). In conclusion, the International Fisher Effect theory does not hold in the short-term but in the long-term. However, it still does not hold for all countries, but for a few. For instance, in the above tests, the IFE theory holds between the US and Italy , whereas it does not hold between the UK and the US. List of References Adler, M., and B. Lehmann 1983, “Deviations from Purchasing Power Parity in the Long Run,” Journal of Finance, Vol. 38, pp. 1471–87. Chen, Z., and P.J. Knez 1995, “Measurement of Market Integration and Arbitrage,” Review of Financial Studies, Vol. 8, pp. 287–325. Madura, J 2011, International Financial Management, Cengage Learning, Inc, Florence, KY. Madura, J., & Fox, R 2007, International financial management, Thomson Learning, London. Severov, G. P 2006, International finance and monetary policy, Nova Science Publishers, New York. Read More