Foreingh Exchange Risks - Assignment Example

 Foreign Exchange Risks Contents Foreign Exchange Risks 1 1.1Introduction 3 1.1.1Foreign Exchange in Hong Kong 4 1.1.2Foreign Exchange in Bulgaria 6 1.1.3Foreign Exchange in Bermuda 8 1.1.4 Purchasing Power Parity and Interest Rate Parity 10 1.1.5Advantages and Disadvantages of PPP and IRP 10 1.1.6Conclusion 11 References 12 1.1 Introduction Foreign exchange risk has been an integral part of the business and economic environment. It is a kind of financial risk that exists when financial transaction in different currencies happens. It needs to be mentioned that every country has its own currency and business transactions are carried using the base currency. However, with the advent of international business, there has been a rise in foreign exchange suggesting the fact that currencies are exchanged for economic and business purpose. However, foreign exchange has significant risks associated with it. One of the key risks is in the form of currency deviation where the value of the currency either increases or decreases based on the market movement. At the same time, interest rate and purchasing power parity also play an important role in enhancing the risk factor associated with foreign exchange. There are a number of tools helping in safeguarding against the foreign exchange risk. One of the key tools is in the form of hedging. Hedging is all about taking one or multiple risks to offset other or multiple risks in a planned and significant manner. Hedging may not be an ideal choice in all the cases as the value of currency increases or decreases based on market sentiments and especially rise and fall in the demand for a specific currency (Bartram, and Bodnar, 2013). Foreign exchange has emerged as one of the key and profitable business options for a number of organisations but includes a number of risks. If the market value of one currency decreases, it may affect the overall market value of the transaction and may result in either huge or significant amount of loss. Overall, it can be said that foreign exchange risks are always a concerning phenomenon requiring financial planning and strategies (Bartram, 2002). The major purpose of this discussion is to deal with the issue of foreign exchange risk along with assessing and analysing key factors affecting it in the context of the Estonia, Hong Kong, and Bulgaria. 1.1.1 Foreign Exchange in Hong Kong Hong Kong’s economy is considered as an open economy with high volume of imports and exports adding value to the economic system of the country. This makes it important to make the currency stable in order to safeguard the interest of the business organisations (Bordo, 2003). The Hong Kong dollar is linked to the US Dollar and the Linked Exchange System has been in existence from last two decades. The link is maintained through the strict Currency Board System ensuring that the entire monetary base is backed by the US Dollar at the linked exchange rate. There are a number of companies headquartered in Hong Kong using foreign exchange. The likes of HSBC and Shangri-La Hotels and Resorts have been in business from last many years and have been exposed to foreign exchange risks. While the former helps in facilitating the foreign exchange transactions, the later also deals in foreign exchange. It needs to be mentioned that currencies are exchanged at the fixed and floating rate. Fixed exchange rate is set by the government as the official exchange rate (Latter, 2002). On the other hand, the floating exchange rate is determined by the market through the assessment of the demand and supply. Floating rate is often termed as correcting rate where differences in the demand and supply are automatically corrected. If the demand for a specific currency is low, its value will decrease and thus making imported goods expensive and stimulating the demand for local products and services. Heakal (2015) believed that in reality, the concept of fixed and floating rate of interest does not prevail as the government takes necessary initiatives in ensuring stability and controlling inflation in a planned and systematic manner. In terms of Hong Kong, it can be said that even if floating rate of exchange is practiced, exchange rate fluctuations will lead to uncertainty in the long run and might increase the cost of doing business mainly to hedge the exchange risk (O'Connell, 2008). From currency basket perspective, it can be said that it is commonly used to avoid risk in currency fluctuation. The European and Asian currency units are example of currency baskets. There is no doubt that Hong Kong has been doing quite well being linked to the US Dollar but there has been debate over the use of currency basket. Wider basket of currency will help in safeguarding Hong Kong’s status as the international trading hub. Simpson (2011) also believed that pegging Hong Kong dollar against Yuan will help in growing the business dominance in a significant manner. With emerging talks of currency baskets to be used in the exchange system; the currency board system may not seem to be fruitful for a number of organisations but in the long run, this may help in mitigating the exchange risk to an extent through a systematic approach. Latter (2002) stated that with the US dollar going down, there is always a possibility of rising exports but with market correction and improved scenario for the US dollar; situation for Hong Kong may become adverse. There is no doubt that Currency Board needs to maintain fixed rate of exchange along with maintaining a minimum amount of reserves. Additionally, under the Currency Board, the monetary policies are not driven or affected by the authorities but through the demand and supply (Balino and Enoch, 2007).The Currency Board simply issues currency and offers the service of converting the local currency into the anchor currency (dollar) at a fixed exchange rate. However, the biggest risk in this regard is from the view point that little demand will lead to little value of the currency and rise in the domestic trade and high demand leading to little demand for domestic goods and services. In order to balance this, it is important to safeguard the market mechanisms through the fixed interest rate. From Hong Kong’s perspective, it can be said that the country has been doing well while pegged against the US Dollar from last thirty years and introduction of currency basket may add further value in the future (Simpson, 2011). 1.1.2 Foreign Exchange in Bulgaria In mid 90s, Bulgaria was facing severe banking and financial crisis resulting in a period of hyperinflation. The economy was far from stabilisation resulting in high prices of goods and services. There was a decline in exports and GDP was falling at an alarming rate with a decline in purchasing power parity. The government was in talks of introducing the currency board in order to stabilise the suffering economy (Gulde, 1999). With the introduction of Currency Board in the year 1997, the Bulgarian economy was successful in dealing with the everlasting financial and economic challenges. However, there were heated arguments over the selection of the anchor currency. A number of administrators voiced for the US Dollar considering its global appeal and acceptance while majority of other administrators vouched for the Deutsche Mark based on the reason that it helps in being integrated with the European Community. Additionally, the Deutsche Mark ideally suited the trade and infrastructure of the country and thus making it as a pegged currency was an ideal bet (Coppola, 2003). With the introduction of the Currency Board, the lev was backed 100% by the German Mark and further traded freely at a fixed rate of 100 leva. Additionally, interest and inflation rates declined to a new height and the economy was on the verge of stabilisation. As discussed before, Currency Boards often use fixed exchange rate helping them to stabilise the market and economy in a significant manner. However, it needs to be mentioned that fixed interest rates will no longer be able to fix a country’s trade terms irrespective of the economic differences arising or existing in the market (Williamson, 2005). In terms of the big countries, currency boards with independent monetary policies may find it difficult to sustain against severe economic pressure but as a whole often helps in safeguarding the interest of common people by controlling inflation and exchange rate in a planned way (Heakal, 2015). Bulgaria Air and Vivacom are two Bulgarian companies these companies often witnesses foreign exchange as a part of their business. With the Bulgarian currency pegged against the Deutsche Mark; there was some sort of stability in the Bulgarian economy but these companies were also receiving different currencies for the exchange purpose. This was either done on a fixed or floating rate of interest principle. There is no doubt that from currency basket perspective, inclusion of other currencies in the form of Euro, Dollar, and Pound would have facilitated the cause of service industry but pegging against the Deutsche Mark also helped in reviving the Bulgarian economy to a great extent. It needs to be mentioned that fixed rate of interest seems to be a favourable idea for a number of companies involved in foreign exchange along with facilitating the domestic trade in favourable periods. However, there is a disadvantage associated with it in the form of forcing economies to involve in imports when the market correction makes the pegged currency stronger than the local currency (Hanke, 2014). In the context of the floating exchange rate, it can be said that it brings uncertainty in terms of the trading amount and value of the exchange. Additionally, floating rate of exchange may trigger inflation that can affect the economy as a whole. On the other hand, fixed exchange rate under the Currency Board may help in stabilising the economy along with mitigating instabilities in the economy. Additionally, it also helps in reducing volatility and fluctuations in the market. As a whole, the economic implication of fixed exchange rate under the Currency Board seems to be more favourable compared to the floating exchange rate using the base currency. In addition, currency basket can further help in managing stabilities embedded with fixed exchange rates but Bulgaria does not have a Currency Basket. Overall, it can be said that the foreign exchange risks have been widely covered through the Currency Board in last few years through the use of fixed exchange rate (Hanke and Schuler, 2004). 1.1.3 Foreign Exchange in Bermuda Bermuda is known for its robust economic performance in last few years. It also has the highest per capita income compared to many developed nations across the world. However, it is also affected by a number of risk factors in the form of financial risk and over dependency on the US. Bermuda has a Currency Board and the Bermuda Dollar is traded against the US Dollar at the fixed parity. The currency board system was introduced years before and has been a successful force in shaping the Bermuda economy. Companies like Genpact and Mandarin Oriental Hotel Group has been the leading companies operating in Bermuda and have been engaged in foreign exchange. It needs to be mentioned that being in the service industry; these two companies are often relying on foreign exchange to conduct business activities. There is no doubt that with the local currency traded against the US Dollar, there is every possibility of safeguarding the business needs. Furthermore, it helps in dealing with uncertainties and market volatility in a systematic manner (The Economist, 2013). The Currency Board System in Bermuda was introduced years back in order to strengthen the financial industry along with mitigating the financial risk. However, the biggest advantage of pegging against the US Dollar was seen during the time of recession when high inflation and low per capita income affected the overall financial scenario in Bermuda. As the Bermuda currency is pegged against the US Dollar, there has to be direct impact on the Bermudian economy. Additionally, the government cannot interfere much in this regard as financial policies need to be derived and formulated only by the Currency Board System. However, during good times when dollar was doing fairly good, there has been a significant amount of positive impact on the economy. This also helped the economy to do well for a good period of time (Tiwari, 2003). In the context of the floating exchange rate, it can be said that Currency Board prevents governments from setting their own interest rates and financial policies. When domestic wages and prices are floating; floating exchange rate can help in adjusting economic disturbances by facilitating rapid changes in the business and trade. Additionally, floating exchange rate can be controlled and customised by the government and the economy can be strengthened in a significant manner. However, in the case of Bermuda, the fixed exchange rate embedded with the Currency Board is not subjected to such economic implications. In case, major risks evolving from this are in the form of uncertainty over the market dynamics and instability in the currency exchange and other economic activities. Additionally, floating exchange rate may lead to inflation especially when exchange rate falls and import prices rise. This may affect the entire economy in a serious manner. On the other hand, fixed exchange rate minimises market instability along with reducing volatility in a systematic manner (Tsang and Ma, 2002). It needs to be pointed that floating exchange rates cannot be introduced in the Currency Board System and thus fixed exchange rate has to be managed. Fixed exchange rate has its benefits being discussed before and the benefits of the Currency Board System is shaping the suffering economy are also discussed in length. On the basis of the entire discussion on floating exchange rate, fixed exchange rate, currency basket, and Currency Board, it can be said that currency board system is ideal for small nations often helping in shaping the economy (Kent, 2008). Additionally, it also helps in mitigating the financial and economic risks in a systematic manner. Though, Bermuda does not practice currency basket; its economy has no suffered much after excluding the recession in the US. Overall, it can be said that in order to better understand the significance of above financial activities, it is important to understand other factors in the form of purchasing power parity and interest rate parity in a critical manner (Kreinin, 2010). 1.1.4 Purchasing Power Parity and Interest Rate Parity Purchasing power parity is a part of economic theories analysing the relative value of different currencies. It helps in estimating the exchange rate between the two currencies. It also helps in explaining the appropriate exchange rate of two currencies for the exchange that has to be at par with the purchasing power of the two country’s’ currencies. On the other hand, interest rate parity is a condition under which investors will be indifferent to the interest rate available on bank deposits in two different countries (Suranovic, 2008).. In the context of the foreign exchange, the interest rate parity states that the return on domestic assets will equal to the available exchange rate and adjusted expected return on foreign currency assets. Both interest rate parity and purchasing power parity plays an important role in defining the concept of foreign exchange along with signifying its role in currency exchange. Additionally, both these concepts often affect the demand and supply of currencies in a critical manner (Schwartz, 2003). 1.1.5 Advantages and Disadvantages of PPP and IRP Major advantage of purchasing power parity is in the form of its stable nature. It is often believed that PPP are relatively stable compared to market rate or interest rate. It is also considered as a good way of measuring the well being of any country in a simple and precise manner (Selgin, 2009). Major disadvantages include difficulties in measuring the overall impact and benefit. Example: Suppose Japan has higher DGP per Capita ($18) compared to the US ($16) it means Japanese makes $2 more than that of Americans. However major disadvantage can be in the form of prices of goods and services. Suppose, one gallon of fruit juice costs $6 in Japan while $2 in the US. It means $6 in Japan exchanges to only $2 worth of US goods. This means that even if the GDP is higher people may be poor because of the high cost of living and expenses. On the other hand, major benefits of Interest rate parity are in the form little change in the interest rate arbitrage opportunities for foreign investors, and arbitrage opportunities for domestic investors under different scenarios. On the other hand, major disadvantages are in the form of little implication in last few years and appreciation in the currency with high interest rate. Example: Suppose, banks in Britain are offering 10% interest rate while banks in the US are offering 5% interest rate and further assume that 1 British Pound= $2. As per the interest rate parity it will be expensive to buy pounds in one year than it is right now. Another example can be; suppose investors are expecting a 3% return on domestic investments in all countries but this cannot be true in all scenario. Suppose that the U.S. nominal interest rate and inflation rate are 5 percent and 2 percent, respectively. At the same time if the UK inflation rate is 1% and the exchange rate is not forecasted to change UK investors will surely look for pound denominated security having nominal interest rate of 4%. This exchange rate implies that a real return of 3% to domestic investors may not offer real return of 3% to foreigners. 1.1.6 Conclusion On the basis of the above discussion, it can be said that both fixed and floating exchange rates have their own advantages and disadvantages and irrespective of the discussed advantages and disadvantages, it is important to have a credible monetary authority to function and safeguard the interest of the economy. Additionally, the Currency Board has advantages but Currency Basket also has advantages. Overall, it can be said that the Currency Board has the potential to shape the economies based on fixed exchange rate but requires favourable financial environment and dynamics to succeed in the long run. References Bartram, S M.; Bodnar, G M. (2012). Crossing the Lines: The Relation between Exchange Rate Exposure and Stock Returns in Emerging and Developed Markets. Journal of International Money and Finance 31 (4): 766–792 Bartram, S M. (2002). 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