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 countrys 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 AUSs 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. 138 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 countrys 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 1930s) ? 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 economys growth and inflation and indirectly affect the exchange rate. I will discuss how government policies affect the exchange rate.