The foreign exchange market is one of the most important financial markets. It affects the relative price of goods between countries and so can affect trade. It means that it affects the price of imports and so affects a country’s price level (inflation rate). It also affects the international investment and financing decision. In this project, we will try to find why exchange rate would give many risks to a company and how a company can hedge itself.
The price of one currency expressed in terms of another currency is called an exchange rate. With the price it is normal to quote them as the price for one unit of the good. The price of a jacket is how much you have to pay to get 1 jacket. The price of a car is how much you pay to get 1 car. The exchange rate between AUS and US from AUS’s point of view is how many AUS dollars you have to pay to get 1 US dollar. Since you have to pay about AUS$1.55 to get 1 US dollar the exchange rate between AUS and US is 1.55. In this case, the US dollar is the “commodity” currency and the AUS dollar is the “terms” currency.
We denote this SAUS/US=1.55. If a currency appreciates it becomes worth more and so you need less of it to buy one unit of another currency. This makes imports cheaper. For example, if the AUS dollar appreciates then SAUS/US will fall from 1.55. On the other hand, If a currency depreciates it becomes worth less and so you need more of it to buy one unit of another currency. This makes imports more expensive. For example, if the AUS dollar appreciates then SAUS/US will rise from 1.55.
Why does FX give risks to a company?
Every daily exchange rate is changing over time. It might fluctuate slightly or go up and go down sharply. On the diagram1 is the daily exchange rate between AUS dollar and US dollar from 4 January 1999 to 17 March 2000. It shows that it fluctuates over time and the spread is from 0.6018 to 0.6738. If we consider this point, we can see how important the exchange is. For example, if the yearly international sales are $10 million US dollars and if the exporter wants to convert US dollars into AUS dollars, he/she may need to hedge for himself/herself. If the exporter can buy a forward contract in a year time at SUS/AUS=0.6138 in 1 January 1999, he/she will receive $AUS16.3 million dollars in 1 January 2000. However, if the exporter does not do anything about it, the exchange rate is SUS/AUS=0.6583 and he/she will only receive $AUS15.2 million dollars. There is a large difference between those two strategies about $AUS1.1 million dollars. Thus, we can how large the difference is.
However, there are still many other effects to affect the exchange rates such as:
A country’s economic condition has a great effect on the exchange rate such as inflation rate, interest rate. From theory, it can be observed in the covered interest parity, uncovered interest parity and purchasing power parity. We all know that at a booming period, the exchange rate should appreciate that is bad to exporters and at a recession period, the exchange rate should be depreciate that is bad to importers. However, the following case is to illustrate that when the exchange is depreciating, there is no advantage to either exporters or importers.
Financial crises can take various forms. It can be individual crisis, multiple countries crisis and global recession. Some examples are:
A purely speculative attack on a fixed exchange rate (such as New Zealand in 1984)
A stock market and property collapse which leads to banking problems and eventually bankruptcies and a slowdown or prolonged recession in the economy (The Great Depression of 1930’s)
International financial crisis in which a crisis in one country spreads across multiple countries (the Asian Financial Crisis 1997-1998)
There are still many other financial crises over centuries. However, most of those crises cause the great depreciation on exchange rates. I will discuss the most recent issue in this century: the Asian Crisis.
The excessively lending, borrowing and spending and an overly view about the future growth and a poorly banking system. This creases “self-fulfilling”. Investors think only that there are always profitable investments, low interest rates and stable currencies. Most other investments may not be such profitable at that stage. They were still making an expansion decision because of government encouragement and poorly banking system. However, investors were sensitive for the profitability. Then they start to doubt the highly leverage firm that could pay the debt or not. Finally, they started to pull the money out of sharemarkets and debts in those countries. Some of the firms closed down.
However, it was not the end of the story. There was a second attack to corporate firms. Because of pulling out the funds from firms, the foreign investors were trying to exchange back to their own currencies. Then the exchange rate started to drop down sharply. Some importers were losing much money and bankrupt in this period. However, some exporters also suffered in this depreciation of exchange rate because the costs of raw materials imported from overseas were more expensive than before.
Currency Crisis made the government to be panic. Then the government was trying to stablise the exchange rate by increasing the rate of interest. However, this action slowed down the investments again and more companies had more problems in paying their debts. There was a strong linkage between Asian countries meant that some companies borrowed from foreign companies then to make the foreign companies went bankrupt too. It is because the borrowers could not pay their debts and the feign lenders could not pay their debts as well.
From, it shows that companies must try to hedge themselves. If not, some of them will be bankrupt like some companies in Asian crisis.
Government sometimes will influence the exchange rate by direct and indirect ways. Direct way means that the government is trying to control or stablise the exchange rate by using policies. The exchange rate may increase the government debts or there is a strong negative effect to importers when the exchange rate depreciates and vice versa. Indirect way means that the government may try to control the economy’s growth and inflation and indirectly affect the exchange rate. I will discuss how government policies affect the exchange rate.
Inflation is a negative influence to the economy. The government always tries to control as low as possible. However, it may forego the economic growth because of that. Thus, the government will use different policies to expand or contract the economy.
If the government is trying to control the inflation by using contractionary monetary policy, it means that the government starts to increase the interest rate and decrease the money supply. According to the Covered interest parity, the exchange rate will depreciate sharply. It results that there is a negative effect to exporters and the government if there is a budget deficit which borrows form overseas. The exporters will receive less for their exports and the government has to pay more interest. Hence, there is a risk for a company to lose money in that period. The materials imported from overseas are more expensive and the price of goods is hard to compete with overseas. However, the interest rate will come back to the original point because of higher interest rate attracting oversea funds to come into the country.
If the government is trying to expand its economy, it will use the expansionary policy. Usually the government will reduce the interest to attract the investors to invest into corporate companies again. According to CIP, if the interest rate is going down, the exchange rate will appreciate quickly. The percentage of appreciation in exchange rate will be as the same as the percentage of increase in interest rate. If the percentage of increase in interest rate is large, the percentage of appreciation in exchange rate will large as well. Thus, if the importers do not hedge themselves, they will lose much money in this circumstance.
If the government wants to intervene the exchange rate, it can still use the monetary policy. However, most of the free-market countries do not intervene the exchange rate. Most of other countries that do intervene the exchange rate have fixed exchange rates, target zones, or managed floats.
If a country has a fixed exchange rate, companies within that country do not need to worry about the hedging of exchange rate. However, one thing needs to worry about is that the government is trying to float the exchange rate. If the government realise the limitation, the exchange rate may go down sharply. It is because the government always sets its fixed exchange rate at a greater dollar value in order to import goods cheaper.
Target zone is that there are upper and lower limits. For example, there are 5% limits and the exchange rate is equal to 2. Thus, the upper limit is 2.1 and the lower limit is 1.9. If one day the exchange is reached 2.1, the government will start to intervene and depreciate the exchange rate and vice versa. In this case, the companies may not need to hedge themselves that depends how large the target zone is.
The managed float is that there is not formal exchange rate target, the government will only intervene when the exchange depreciates or appreciates too much in a short period. The companies in that country may need to hedge themselves because there is no formal target and they can still make losses in that period.