Causes of Exchange Rate Risks and Ways to Reduce Risks using Financial Markets
This essay needs to use calculation formulas to demonstrate opinions, and use referfence as much as possible. Referfence needs to be in the past five years.
The tutor asks to read Chapters 16-22 of International Economics 16th Edition Pugel, Thomas. And Chapter 26 of Economics 10th European Edition Michael Parkin.
This assignment is worth 50% of the module mark. The deadline time for the submission of the second assignment is 3pm on Thursday 13th January 2022. Work may be submitted on any date prior to the deadline. All assignments must be submitted electronically via the module site on Moodle. The file format has to be either MS Word or pdf. You can submit only one file. Instructions This is an individual piece of work. The assignment consists of one question. Word Limit: 1800 words Include one reference section covering all questions at the end of your assessment. The word count must be stated clearly on the cover page of your submission. If you exceed or fall short of the stipulated word limit by more than 10%, you should expect to be penalised. For this coursework, you will find below what is/is not included in the word count. Included: Quotations Excluded: Cover page, list of contents, list of tables and figures. List of references / bibliography (in-text Harvard style references are also excluded). Appendices (be careful on their use) All table row and column titles, labels on diagrams / graphs etc. In-text table content that exhibits numerical, primary or secondary data 2 Question Explain the causes of the main short- and long-term risks faced by large firms that result from exchange rate fluctuations (assume that the firm imports a proportion of its raw materials and exports a proportion of its production). Briefly suggest how firms may manage and / or reduce these risks using financial markets. Assessment criteria Marks will be awarded according to the following main criteria: Achievement of the objectives of the question Accurate explanation and appropriate use of relevant economic theories, concepts, analysis and methods including a critical assessment Logical structure of the arguments Clarity of explanation – fluency and conciseness of written exposition, grammar and correct spelling Demonstration of knowledge of the relevant literature and proper citation of sources. Keeping to the word limit, inclusion of word count.
CAUSES OF EXCHANGE RATE RISKS AND WAYS TO REDUCE RISKS USING FINANCIAL MARKETS
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Table of Contents 1. Introduction. 3 2. Causes of Risks due to Exchange Rate Fluctuations. 3 2.1 Economic Risk. 3 2.2 Translation Risk. 5 2.3 Transaction Risk. 7 3. Managing and Reducing Risks using Financial Markets. 8 3.1 Dealing with Economic Risks. 8 3.2 Dealing with Transaction Risks. 8 3.3 Dealing with Translational Risks. 10 4. Conclusion. 11 References. 12
Word Count: 2022 words
Causes of Exchange Rate Risks and Ways to Reduce Risks using Financial Markets
Introduction
Globalization allows businesses to emphasize sales and production activities to improve sales, which, in turn, affects the profitability, net cash flows, and market values of companies. The exposure to foreign exchange risk influences the international and domestic businesses' values in the end, leading to the adaptation of powerful strategies to overcome the currency fluctuation risks (Wen & Wang 2020). Multinational businesses operate efficiently to use financial and operational hedging against foreign exchange risks, strengthen the stock returns, and emphasize forward future and options to overcome such risks (Pugel 2015). The report aims to discuss the causes of short-term and long-term risks that might arise because of exchange rate fluctuations. In the end, the ways to manage and reduce exchange rate risks using financial markets are recommended.
Causes of Risks due to Exchange Rate Fluctuations
Large businesses deal with foreign currencies and exchange rates risks and are exposed to different currency risks like economic, translation, and transactional risks (Pugel 2015). When Tesco purchases DVDs from Japan, it pays in yen. Another example is when Chinese Airline's purchase engines from Rolls-Royce, the payment is made using yen. The section emphasizes the causes of risk for a large business like Mark & Spencer, who imports some raw materials and exports some production to other countries; it pays in the form of euro to European countries for import and receives pound from other countries.
Economic Risk (Long-Term Risk)
A fluctuation causes economic risks in the cash flows and market value in the future, where the impact is seen due to unanticipated exchange rate changes and a business's competitive position. The economic risk for companies relates to the strength of imports and exports. The results are long-term, and Purchasing Poer Parity (PPP) theory is applicable here where the currencies of different companies are compared through a basket of goods approach. The theory compares two and more countries' economic productivity and living standards. If Mark & Spencer exports to Eurozone from the UK, the euro could be weakened in terms of currency, i.e., €1.1 to €1.3 (Parkin et al. 2017). It means that now more Euros are required against the Pound Sterling, making the euro less valuable. The risk might arise when businesses are not aware of options, hedging and futures. Future and options guarantee a fixed amount of the pound received after a specific time to avoid losses. Options are treated like insurance policies, where the insurance prevents massive losses
These factors lead to economic risks due to the currency rate movements when currency movements are not preserved through hedging policies. Hence, swap is applicable in long-term risk (Hung 2021). In the exchange, the exports from the UK would be expensive while paying in the form of euros. In this case, if Mark & Spencer's product costs £100, the cost in Europe would be €130 (£*1.3) rather than €110 (£*1.1) (currency=£*Euro Rate). In this way, the products would be less competitive in Europe. Alternatively, the products imported from Europe would be cheaper in the UK, making the goods more competitive in the UK region.
Figure 1 shows that more export to Europe from the UK means that the European goods would increase in prices more than the UK products. Hence, European products will be less competitive. There would be high demand for UK products, increasing pound sterling. In this situation, Mark & Spencer or other large firms can experience economic risks when they do not overtly deal with overseas countries (Parkin et al. 2017). When importing cheaper products, the business suffers due to the risk of currency rate movements.
Figure 1: Equilibrium Point between Pound and Euros
Source: (Pettinger 2019)
Translation Risk (Short-Term Risk)
Another cause of risk is the foreign subsidiaries, where if the subsidiary of the weak currency's economy weakens, the assets will be fewer valuables in the situation (Bloom et al. 2018). The impact is short-term to holding companies because its influence is unclear in day-to-day cash flows. Its importance is seen in selling the proceeds or paying dividends. The translation risk faces consolidation effects. The situation is usually tackled by funding the condition using a foreign loan (Guzman et al. 2018). The theory applicable here is the Uncovered Interest rate parity which states that differences in interest rate will equal the relative change in foreign currency exchange during the same period (Bloom et al. 2018).
Balance Sheet is:
Assets= Liabilities+ Owner's Equities to calculate the leverage and liquidity position of the business.
After a loan, the financial position is usually like this:
Table 1: Initial Balance Sheet
Millions £
Long-Term Assets
2.5
Current assets
1.0
Total Assets (Long-term assets+ Current assets)
3.5
Equity = Total Assets
3.5
When the pound value weakens, the value of £3.5M would be reduced. However, relying on 50% of the borrowings would make the financial statement like this:
Table 2: Role of Loan in Translation Risks
Millions £
Long-Term Assets
2.5
Current assets
1.0
Total Assets (Long-term assets+ Current assets)
3.5
Loan (3.5/2)
1.75
Equity (3.5/2)
1.75
Loan+ Equity (=Total Assets)
3.5
The investment would be $1.75 million instead of £3.5 million; hence, if the currency value weakens, it will make only £1.75 million value less valuable instead of £3.5 million. The risk arises due to the fluctuation in the exchange rate and the business's liabilities of receiving or paying amounts in foreign currencies. Such exposure would be short to m...