If exchange rate becomes 3, i.e. R= 3 $/ £, means that now three dollars are required to buy a pound thus, depicting Depreciation of US dollar.
If exchange rate becomes 1, i.e. R= 1 $/ £, means that now one dollar is required to buy a pound thus, depicting Appreciation of US dollar.
Factors that affect the Equilibrium Exchange Rate
1. Relative inflation rates- Eg. R= 2$ / £, If inflation in US in higher than in UK, then US goods will be costlier than that of UK goods and therefore, UK will export more goods to US and US will export less goods to UK.
This means that value of Dollar has Depreciated w.r.t. Pounds, or
Value of Pounds has Appreciated w.r.t. US dollars.
Factors that affect the Equilibrium Exchange Rate
2. Relative interest rates
If real interest rates of US are higher than that of UK, then the dollar is said to have appreciated as compared to pound.
Real interest rate = Nominal interest rate - Inflation
If interest rate of US > int. rate of UK (because of inflation, then wrong picture).
Therefore, real interest rate should be considered.
Factors that affect the Equilibrium Exchange Rate
No. of units of foreign currency required to buy one unit of home currency. i.e. for one unit of home currency, how many units of foreign currency is required?
eg. $0.02/ Rs 1, means that 0.02 dollars are required to buy one unit of home currency/ rupees.
FF 0.1462/ Rs 1, 0.1462 French Franc per rupee.
Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote UK Pound Sterling £/ GBP 66.92 US US Dollar $ 43.30 Canada Canadian Dollar Can$ 29.10
Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote UK Pound Sterling £/ GBP 66.92 0.0149 US US Dollar $ 43.30 0.0231 Canada Canadian Dollar Can$ 29.10 0.0344
Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Germany Deutschmark DM/DEM 22.94 Euro € 44.87 Netherlands Dutch Guilder DG/$f/ NLG 20.36
Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Germany Deutschmark DM/DEM 22.94 0.0436 Euro € 44.87 0.0223 Netherlands Dutch Guilder DG/$f/ NLG 20.36 0.0491
Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Switzerland Swiss franc sFr 0.0358 France French franc FF/ FRF 0.1462 Italy Swedish krona SKr 0.1931
Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Switzerland Swiss franc sFr 27.97 0.0358 France French franc FF/ FRF 6.84 0.1462 Italy Swedish krona SKr 5.18 0.1931
Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Italy Italian lira Lira/ Lit/ ITL 43.2901 Japan Japanese Yen ¥ 2.4994 Australia Australian dollar AU$ 0.0360
Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Italy Italian lira Lira/ Lit /ITL 0.0231 43.2901 Japan Japanese Yen ¥ 0.4001 2.4994 Australia Australian dollar AU$ 27.76 0.0360
A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security.
The relationship between percentage changes and basis points can be summarized as follows: 1% change = 100 basis points, and 0.01% = 1 basis point.
The yen has appreciated against the dollar by an amount equal to (0.0084746 – 0.0074074)/ 0.0074074 = 14.41%.
An exchange rate of ¥ 1= 0.0074074 translates into an exchange rate of $ 1 = ¥135 (1/ 0.0074074 =135). Similarly, the exchange rate of ¥ 1= $0.0084746 is equivalent to an exchange rate of $ 1 = ¥118. Therefore, the dollar has depreciated (against the yen) by an amount equal to (118-135)/ 135 = -12.59%.
Simultaneous purchase and sale of the same assets / commodities on different markets to profit from price discrepancies.
Eg. If the dollar price of pounds were $1.98 in New York and $ 2.01 in London, an arbitrageur would purchase pounds at $1.98 in New York and immediately resell them in London for $2.01, thus realising a profit of $0.03 per pound.
It refers to the International flow of short term liquid capital to earn a higher return abroad. It can be covered or uncovered.
1) Uncovered Interest Arbitrage
The transfer of funds abroad from to take advantage of higher interest rates in foreign monetary centres usually involves the conversion of the domestic currency to the foreign currency, to make the investment. At the time if maturity, the funds (principal + interest) are reconverted from the foreign currency to the domestic currency.
IFE uses interest rates rather than inflation rates
The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as “international Fisher Effect”.
The IFE suggests that given two countries, the currency in the country with the higher interest rate will depreciate by the amount of interest rate differential. That is, within a country, the nominal interest rate tends to approximately equal the real interest rate plus the expected inflation rate.
However, the IFE argues that a rise in a country’s nominal interest rate relative to the nominal interest rate of other countries indicates that the exchange value of the country’s currency is expected to fall. This is due to the increase in the country’s expected inflation and due to the increase in the nominal interest rate.
This exposure refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuations. It arises from thepossibility of incurring exchange rate gains or losses on transaction already entered into and denominated in a foreign currency.
Accounting exposure/ translation exposure, arises because MNCs may wish to translate financial statements of foreign affiliates into their home currency in order to prepare consolidated financial statements. Or to compare financial results.
A US parent company has a single wholly owned subsidiary in France. This subsidiary has monetary assets of 200 million francs & monetary liabilities of 100 million francs. The exchange rate declines from FFr 4 per dollar to FFr 5 per dollar.
Functional Accounting Standard’s Board (FASB 52) differentiates between a foreign affiliate’s “functional” and “reporting” currency.
Functional currency is defined as the currency of the primary economic environment in which the affiliate operates and in which it generates cash flows. Generally, this is the local currency of the country in which the entity conducts most of the business.
The reporting currency is the currency in which the parent firm prepares its own financial statements./; This currency is normally the home country currency, i.e., the currency of the country in which the parent is located and conducts most of its business.
Accounting exposure is the potential for translation losses or gains. Translation is the measurement, in a reporting currency, of assets, liabilities, revenues and expenses of a foreign operation where the foreign accounts are originally denominated and/ or measured in functional currency.
One method of measuring an MNCs economic exposure is to classify the cash flows into different items on the income statement and predict movement of each item in the income statement based on a forecast of exchange rates.
This will help in developing an alternate exchange rate scenario and the forecasts for the income statement items can be revised.
A firm exporting its products after a domestic devaluation may well find that the return per home currency expenditure on advertising or selling is increased because of the product’s improved price positioning.
Pricing Strategy- Market Share vs Profit Margin
To begin the analysis, a firm selling overseas should follow the standard economic proposition of setting the price that maximizes dollar profits (by equating marginal revenues and marginal costs). In making this decision, however, profits should be translated using the forward exchange rate that reflects the true expected dollar value of the receipts upon collection.
MNCs with world wide production systems can allocate production among their several plants in line with the changing home currency cost of production, increasing production in a nation whose currency has devalued and decreasing production in a country where their has been a revaluation.
Assumption- Company has a portfolio of plants worldwide.
Suppose, The US parent and the German Affiliate have to receive net $ 40,000 and $ 30,000 from one another. Then, under a bilateral netting system, only one payment will be made – the German affiliate pays the US parent an amount equal to $ 10,000.
Bilateral Netting System US Parent German Affiliate US Parent German Affiliate Pay $ 30,000 Pay $ 40,000 Pay $ 10,000 After Bilateral Netting
For eg, countries with a high export growth rate are more likely to be able to service their debt and are expected t enjoy better credit worthiness rating since exporters are the main source of foreign exchange earnings for most of the countries.
It can be measured in terms of a country’s rate of growth and its rate of inflation. The inflation can be regarded as a proxy for the quality of economic management. Thus, the higher the inflation rate, the lower the creditworthiness rating.
4. Political Instability undermines the economic capacity of a country to service its debt.
Political instability generates adverse consequences for economic growth, inflation, domestic supply, level of import dependency and creates foreign exchange shortage from imbalance between exports and imports.
There is a difference between Cost of capital for MNCs and Domestic firms because of the following:
1. Size of the firm: Firms that operate internationally are usually much bigger in size than firms that operate only in the domestic market. MNCs generally borrow substantial amount of funds by virtue of their size and are in a position to get it at cheaper rates.
2. Foreign exchange risk: An exceptionally volatile exchange rate is not much appreciated as it leads to wide fluctuations in in the cash flows of an MNC. It would be difficult for the firm to meet its fixed commitments and therefore, the shareholders and creditors demand a higher return which, in turn, would increase the cost of capital of the firm.