Exchange rate risk is the risk that the company or investors have to face because of changes in the exchange rate (Adler, & Dumas, 1984) and when the company will be making investment in Euro Zone then it will have to face risk because of changes in the value of currency of Euro and Pound Sterling. …
Currently the board of directors of the company are analysing the feasibility of setting up a subsidiary company in European Union. However in order to start a new subsidiary company it is important for the management to know what important concepts and factors they have to consider while moving from one state to another. This report analyse important concepts that the management should know while setting up a new subsidiary in European Union. This report to the CEO of the company is mainly divided into three parts; the first part explains about the foreign currency translation and related terms, the second part explains about the feasibility of forecasting spot and forward rates of exchange and how management can use it effectively for the company, and the third part explains the internal and external hedging techniques.
FOREIGN CURRENCY TRANSLATION
The rate at which one currency is exchanged for the other currency is called as the Exchange Rate or foreign exchange rate (O'Keefe, 2010). As in this case, the sterling to euro exchange rate is 0.90 therefore it means that for the value of one unit of pound sterling to euro is 0.90 and one unit of euro can exchanged for 0.90. There are two important concepts to be considered; sport exchange rate and forward exchange rate. Spot Exchange Rate The current exchange rate at which the currency will be changed right away is called the Spot exchange rate (Ehrmann, Fratzscher, &Rigobon, 2011). Forward Exchange Rate Forward exchange rate can be defined as the exchange rate at which the currency will be changed later on at a specified date but the rate is quoted at present time (Fama, 1984). Direct and Indirect Rates of Exchange When the cost of one unit of foreign currency is represented in units of local currency then it is referred to as Direct Quotation whereas when the cost of one unit of local currency is presented in foreign currency units then it is referred to as Indirect Quotation (Khan, 1993). Previously, indirect quotation was not used as widely however now indirect quotation has been accepted widely across the world. Direct exchange rate is presented as: 1 Pound Sterling = 0.90 Euro Indirect exchange rate is presented as follows: 1 Euro = 1.111 Pound Sterling Cross Rates Between Paris of Currencies Currency pair is defined as the quotation of the relative value of a particular currency against the unit of other currency in the foreign exchange market. Counter currency or quote currency are the terms used for the currency which is used as the reference whereas base currency or transaction currency are the terms used for currency which is quoted (Siegel, 1972). When there are two currencies and both currencies are not the official currencies of the country in which the exchange rate quote is provided then it is referred to as Cross Rates. However, at times when US Dollars are not involved despite of which country the quote is provided in then this is also referred as Cross Rates (Instaforex). One way to calculate the cross rates is by taking an average of the bidding and asking rate for both the currencies against dollars and then with the help of formula for current prices, the current value of ...
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