Foreign exchange rates have a crucial impact on the economy of a country. It affects imports and exports as well as their prices. Foreign currency dictates the prices of commodities, and if prices are high, investors will minimize on trade hence economic growth would suffer.
Q 1. The rate of inflation affects the currency rates. Inflation increases the price of commodities in a country. (Agarwal, 2009).He further asserts that if there is increased money supply and limited goods, the exchange rates will be re-adjusted to fit the demands. A high inflation rate implies that there will be a reduction of purchasing power due to the limited number of persons holding the money. A high rate of inflation can affect the exchange rate if the government does not have a fixed exchange rate. This is an effective way to hedge against foreign currency risk. This means that in the case of inflation, the currency rate cannot decrease and hence the prices of commodities will not be affected. If the currency rate is not fixed, the prices will be susceptible to high inflation rates causing them to go up. Therefore, international trading will be reduced causing the foreign exchange rate to be weakened. Based on this, I would inform my client not to invest in this country, because of the high prices which will have a detrimental effect on the current exchange rates.
The value of the currency affects the economic growth of a country. In the event of a robust economic growth, there would be increased imports. (Agarwal, 2009). Affordable prices would result to increased imports and exports. Imports would increase because of increased demand which will be as a result of reasonable prices. In this country, exports and imports will be on the decline because of the high prices. Every investor desires value for money and they would want a higher purchasing power which equates to importing more goods at reduced prices. It would not be wise to invest in such a country because there would be slow movement of goods which will have an adverse impact on the currency rates.
Q 2. Exchange rate fluctuations are inevitable, and they can occur at any time of the year. They are caused by various factors such as inflation, public debt, terms of trade and much more. Companies engaging in exportation or importation of goods ought to hedge against exchange rate fluctuations, to maintain reasonable profit margins.
One of the ways to hedge against varying foreign exchange rates is known as hedging. (Shackman, 2015).Hedging can be done in the form of purchasing a put option of a call option. Both of them guarantee steady revenue despite a change in the foreign exchange. For instance, if you bought two put options at $500, you’ll receive $500 or more, even after a fall in the exchange rate. In this case, the manager who imports goods from Japan can buy the options at a pre-determined price, and this will ensure that the price will be constant even when purchasing his raw materials from Japan. This will provide steady profit margins in the business.
Exchange rate management is an effective way of preventing price hikes during massive foreign currency fluctuations. Overshooting foreign exchange rates hurt the market a lot. (Goyal, 2013).Further, he suggests that the central bank should intervene to prevent very high-interest rates from harming the business. This means that the bank should come up with an equilibrium rate which will be used by the country to hedge against unreasonable foreign exchange hikes. Alternatively, it can put up instruments which prevent excessive currency fluctuations. This will impede the business from being exploited as well as paying high prices for certain goods.
The use of currency futures helps in foreign exchange hedging. Currency futures are an appropriate method of flexible risk management. (Goyal, 2013).It involves exchanging one currency with another at a specified price and at a certain date. This will protect the buyer from fluctuations because despite an increase in the currency, the buyer will buy the currency at a pre determined price, set during the signing of a contract.
In this given case, I would manage risk using the above methods namely; hedging, exchange rate management and use of currency futures. As a manager, all these methods would make sure that I import the raw materials at a reasonable price despite the foreign exchange fluctuations.
Q 3. On many occasions, foreign exchange fluctuations are a shocker to many companies . In other words, there is no company which wants to get itself in a position where they will have to pay more for the same goods and services. In the case where Indian and Brazilian currencies drop dramatically and the value of the Mexican peso increases significantly, I would increase my target markets. According to Shackman, when an exchange rate increases, it would be wise to expand your market base and attract more customers. (Shackman, 2015) In fact, it will lead to more sales because more people will be consuming the product. He also adds that, on doing so, you will be hedging against political risk because more people will be consuming the product. This means that if a government realizes that more people are consuming a single product, it will be impossible to eliminate it from the market.
If the company wants to mitigate risk, it must enter into forwarding contracts. Forward contracts assist the company to protect against risk exposure as well as netting the exposure. (Avadhani, 2010).The researcher further asserts that to mitigate transaction exposure, the foreign company ought to invoice all sales in their home currency. Therefore, this means that they will not be affected by the foreign exchange hikes which will be experienced in a foreign land. Besides, forward contracts ensure that they don’t pay exorbitant prices for the same goods and commodities.
Before a company makes this necessary move, it must consider trade rates and how they contort their profits, currency exchange dangers and portfolio dangers. (Shackman, 2015).Some trade rates may negatively affect a business. Therefore, a company must put the various business rates into consideration. Currency rates may have a negative or positive impact on a business. When the prices are high the currency rates decrease, and it may reduce profits margin of the firm. On the other hand, this may entirely depend on whether a company purchases its products using a fixed interest rates, it can hedge against harsh prevailing conditions of the market. Regarding portfolio, a company must know which assets to invest in and how to mitigate risk to avoid losses.
In summary, it is evident that businesses are affected by foreign exchange rates. High exchange rates cause an increase in prices and this has a direct impact on inflation. Therefore, a company should put all these factors into consideration before setting up a business in a foreign land. This is an appropriate way to hedge against risk since it increases the profit margin.
Agarwal, O. (2009). Chapter 5: Foreign Exchange Risks. International Financial Management. Himalaya Publishing House, Mumbai, India.
Avadhani, V. (2010). Chapter 7: Management of International Transaction Exposure. International Financial Management. Himalaya Publishing House, Mumbai, India.
Goyal, A. (2013, Sep 19). Dealing with Currency Volatility. Businessline.
Shackman, J. (2015). The Economic and Financial Environment of International Business. Trident University International, Cypress, California.