Theoriesof Foreign Exchange Rate
Theexchange rate is the value of one country’s currency in terms ofanother country’s currency. The exchange rate has two quotationswhich are either direct or indirect. A direct quotation is when acurrency of another country is articulated in terms of the localcurrency while an indirect quotation is when a local currency isarticulated in terms of another country’s currency (Ghatak &Sánchez-Fung, 2007). There are various theories that explainexchange rates such as interest rate parity theory and purchasingpower parity.
InterestRate Parity Theory
Interestrate parity theory is considered as a primary decree in theinternational market (Piersanti, 2012). This theory argues that thedissimilarity in the exchange rate between two countries is the sameas the divergence between the forward exchange rate and the spotexchange rate. The theory posits that investors will be uninterestedin the difference of the interest rate that will be offered bydifferent financial institutions in two countries (Wang, 2009).However, this condition does not always hold since sometimesinvestors can earn reckless gains from covered interest arbitrage.Interest rate parity theory assumes that there is free movement ofcapital amid two countries, and domestic and foreign assets areperfectly substitutable. This means that expected returns on domesticassets will be the same as the exchange rate. In order to makearbitrage profits impossible, when the interest rate on the foreigncurrency is dissimilar to that of the domestic currency, forwardexchange rate must be higher than spot exchange rate by a largeamount (Ghatak & Sánchez-Fung, 2007). For interest rate paritytheory to hold, covered interest arbitrage must be in place.
InterestRate Parity Theory = Ft,T= St(1 + idx T/360)/(1 + ifx T/360).
id= domestic nominal risk
if= foreign nominal risk
St= time t spot rate (value of domestic currency in terms of foreigncurrency)
Ft,T= forwardrate for delivery at date T and time t
Take,for instance, a company in Japan wishes to calculate a one-yearforward rate between Japanese yen and the United States dollar. Spotyen is selling at 148 Japanese yen per one US dollar. Japanese yenhas an interest rate of eight percent per year while the US dollarhas an interest rate of 9 percent per year. Therefore, forward ratewill be as follows
Ft,one year= St(1 + id)/ (1 + if)= 148 JPY/USD * (1 + 0.08) / (1 + 0.09) = 146.64 JPY/USD.
PurchasingPower Parity Theory
Purchasingpower parity provides a relationship between prices of goods andservices and the exchange rate (Wang, 2009). For example, in case theprice of one ounce of gold in Japan is higher than one ounce inCalifornia, then traders will buy gold in Japan and sell it inCalifornia. This trade is expected to continue until the time pricesequalize between the two countries.
Thefixed version of purchasing power parity theory is
Stppp= domestic price level (pd)divided by foreign price level (pf)
Consideran example where, an average consumer in Japan consumes a basketworth 1241.2 yens while, in America, an average consumer uses goodsand services worth 755.3 dollars. Then, the equilibrium exchange ratewill be
Stppp= PUSA/PJapan= USD 755.3/ YEN 1241.2 = 0.6085 USD / YEN. This means that oneJapanese yen is equivalent to 0.6085 US dollars. Purchasing powerparity theory is more accurate than the interest rate parity theory.
Thistype of exposure affects companies that are concerned with globaltrade. In such cases, the exchange rate fluctuates when the companieshave already committed themselves to financial obligations (Ghatak &Sánchez-Fung, 2007). This makes them suffer from huge losses.Companies can use the hedging strategy to minimize losses.Transaction exposure is usually felt by a company that is tradingusing foreign currencies. More funds are often required from thebuyer’s side to make the transaction complete. For example, assumethere are two companies A which is based on US and B which is basedin Japan. The transaction between these two countries will be doneusing Japanese yen as the local currency. By the time the deal isbeing signed, the exchange rate between the two countries is 1 $:1.64 Yen. This implies that company A will pay one dollar to companyB for every 1.64 yens. However, transaction exposure will set in whenthe exchange rate changes before the transactions are over. Changescan be in favor of company A or against it. When changes favor A,then A will use less dollars for every 1.64 yens.
Translationexposure is the probability that the income, equities, assets orliabilities of a company will adjust if the exchange rate changes.Companies that can be affected by translation exposure are the onesthat record their assets in foreign currencies (Piersanti, 2012).Also, firms that produce goods that are consumed in foreign countriessuffer from translation exposure. For example, if a company ownsproperties worth one million yens in Japan and the exchange rate isone dollar is equivalent to 1.64 Yen. These properties are worth609,756.098 dollars. If the exchange rate changes to 1$: 1.50 Yen,the value of properties will change to 666,666.667 dollars. Thisimplies that the change in exchange rate has increased the value ofassets from 609,756.098 to 666,666.667 dollars.
Thistype of exposure is caused by unexpected fluctuations of currency ina company’s potential cash flow. The exposure often affects themarket value of a company. Economic exposure is usually difficult tohedge because it exposes greater risks to companies that havebranches in foreign countries and mainly deal with foreigncurrencies. For example, assume company A is based in America andgets over 50 percent of its revenues from other branches that arelocated in foreign countries (Wang, 2009). In its forecasting, it hasincorporated a gradual decline of the value of the dollar againstforeign currencies in the next two to three years. However, the valueof the dollar appreciates instead of depreciating. Therefore, thecompany will suffer from economic exposure since the revenues thatthe company generates from foreign countries will be lower afterconversion into dollars, thus reducing profits.
Exchangerate forecasting helps in evaluating risks and gains involved in theglobal business environment. Two methods that can be used to forecastexchange rate are the econometric model and time series model. Themethods are discussed below
Theeconometric model considers factors that are believed to influencethe movement of a particular currency (Wang, 2009). Econometriciansuse the factors to come up with a model of calculating exchange rate.For example, if GDP, growth in income (IGR), and interest ratedifference (INT) are believed to influence exchange rate betweenJapanese yen (JYN) and US Dollar (USD), then this model can be usedto calculate the exchange rate equilibrium as follows: USD/ JYN = a+ x (INT) + y (GDP) + z (IGR) where, x, y, and z are co-efficient.
Thismodel is considered technical and is based on the assumption thatprice patterns of the past can be used to predict the future patternsof prices. This same case applies to the foreign exchange rate. Thereare programs that use data to generate models that are used toproject exchange rate stability.
Futureand Forward Contracts Mitigation
Inforward and future contracts, the trading parties make an agreementof buying and selling of an asset for a price settled today (theforward price) but the payments are to be made on a later date.Contracts negotiations are based on future exchange rates. Thismeasure cautions companies against transaction exposures.
Itis a type of mitigation whereby an investor takes a new position bypurchasing a good that has price movements that are similar to theprice movement of the goods he initially wanted to buy. It cautionscompanies from transaction exposure.
Putand Call Options
Aput option is the option to buy or sell stock when a person thinksthat the price of assets is going to drop. A call option gives aperson the right to buy the stock at a given price before theexpiration date. This protects companies from economic exposure.
Thismeasure protects companies from currency risks through locking inpartner’s currency (Wang, 2009). It protects companies fromtransaction exposure. For example, consider a case where company Afrom Germany and company B from the United States are engaged in thetransaction of selling and buying clothes however, the two companieshave an agreement on the exchange rate that they need to follow. Insuch a scenario, an increase or decrease in the exchange rate wouldnot affect the transactions of the two companies.
Afirm can caution itself from transaction exposure by reconstructingits operations. Such reconstruction of operations will help in theefficiency of carrying out day-to-day activities (Ghatak &Sánchez-Fung, 2007). For instance, consider company C from Japanthat buys spare parts from the United States. When the exchange ratebetween Yen and dollar is not favorable, the company may restructureits operations of purchasing spare parts.
Ghatak,S. & Sánchez-Fung, J. R. (2007). Monetaryeconomics in developing countries.Basingstoke: Palgrave Macmillan.
Piersanti,G. (2012). Themacroeconomic theory of exchange rate crises.Oxford: Oxford University Press.
Wang,P. (2009). Theeconomics of foreign exchange and global finance.Berlin: Springer-Verlag.