The implications of the deviations of the purchasing power - Essay Example

The implications of the deviations of the purchasing power PPP of a multi-national company will get violated, when there exists any barriers to international trade or when there are any differences in the consumption taste of the people. For a firm, if its operation is so flexible, then deviation from purchasing power parity will provide opportunities in making profit. It has been joked that in order to make use of the changes in currency movement, it will be a better idea to put our factories on the top of a supertanker, so that the companies can put down the anchor whenever the company can function efficiently due to the changes in exchange rate movement.

But it will not be an appropriate idea or a better means every time to take the advantage of movements in exchange rate. If a company (engaged in free trade) takes an action against the same, then it will lead to PPP deviation until the profit-seekers make profit by way of arbitrage. The deviation from PPP causes in real exchange risk. The product demand of the company will get reduced, if the substitutes are available in the market. The deviation from PPP will also result in the variation of operating margins significantly.

This will in turn affect the competitiveness of the multi-national companies. The main reason for the failure of Law of One Price is the presence of transaction cost. When the deviation of the exchange rate from PPP raises, arbitrage forces will later on become more strong. For a company who deals with differentiated goods, by grouping under one category, the PPP will deviate and this will result in increase in arbitrage forces.Question 2: You are hired by a South African firm with all local costs that has recently entered the export market.

The firm prices their contracts in US$, as this is necessary to gain market share. They now realize that with 25% of sales as exports, they face a reasonably sized exchange rate exposure and are not sure whether they should hedge it or not. Knowing that you have training in international financial management, they ask you for advice. Provide a summary of your response on the types of foreign exchange risk this company faces and whether the firm should hedge the exposure. The Company Faces Transaction Risk and Economic Risk:“Transaction risk, which is basically cash flow risk, deals with the effect of exchange rate moves on transactional account exposure related to receivables (export contracts), payables (import contracts), or repatriation of dividends.

An exchange rate change in the currency of denomination of any such contract will result in a direct transaction exchange rate risk to the firm” (Papaioannou, 2006, p. 131). Economic risk means the impact of movements in exchange rate on the present value, due to changes in the cash flow in future. Transaction risk can be hedged tactically or strategically, to conserve earnings and cash flows. The transaction risk hedging will depend on the firm’s treasury view on the future currency rate movements.

The company will be able to translate the transaction and economic risk to its customer, by way of invoicing in Rand (South African Currency) or by using derivative hedges. Since the currency of determination is in U.S dollars, the company doesn’t have exposure to exchange rate in their future sales. Question 3: Discuss the implications of the international parity theories for decision making in international business operations.The economic theories which connect exchange rates, interest rates and price levels together are known as international parity theories.

If the Law of One Price is true for all goods, then the PPP rate of exchange can be found out from any price sets. By way of comparison of prices, the individual products price can be decided though Purchasing Power Parity exchange rate. International parity theories help in forecasting the difference in the inflation rate, and helps in explaining the trend in the exchange rate of goods in the long run. Interest rate Parity theory provides a link between international money market, and foreign exchange market.

Reference ListPapaioannou, MG 2006. Exchange Rate Risk Measurement and Management: Issues and Approaches for Firms. ASECU. South-Eastern Europe Journal of Economics. Available at < http://www.asecu.gr/Seeje/issue07/papaioannou.pdf> [Accessed on 26 March 2012]