Relationship Between Firm Value And Exchange Rate Risk Finance Essay
TheÂ foreign exchange market is a worldwide decentralizedÂ over-the-counterÂ financial market for the trading of currencies. Financial centers around the world function as anchors of trading between a wide range of different types of buyers and sellers around the clock, with the exception of weekends.
The foreign exchange market allows businesses to convert one currency to another foreign currency. The purpose of the foreign exchange market 'Forex' is to assist international trade and investment. For example, it permits a U.S. business to import European goods and payÂ Euros, even though the business's income is inÂ U.S. dollars. Some experts, however, believe that the unchecked speculative movement of currencies by large financial institutions such as hedge funds impedes the markets from correcting global current account imbalances. ThisÂ carry tradeÂ may also lead to loss of competitiveness in some countries.
The modern foreign exchange market started forming during the 1970s when countries gradually switched toÂ floating exchange ratesÂ from the previousÂ exchange rate regime, which remainedÂ fixedÂ as per theÂ Bretton Woods system. In a typical foreign exchange transaction a party purchases a quantity of one currency by paying a quantity of another currency.
The foreign exchange market is unique because of
trading volume results in marketÂ liquidity
continuous operation: 24 hours a day except weekends, i.e. trading from 20:15Â UTCÂ on Sunday until 22:00 UTC Friday
the variety of factors that affectÂ exchange rates
the low margins of relative profit compared with other markets of fixed income
the use ofÂ leverageÂ to enhance profit margins with respect to account size
The exchange rate expresses theÂ national currency's quotationÂ in respect toÂ foreignÂ ones. For example, if one US dollar is worth 50 Indian rupee, then the exchange rate of dollar is 50 rupee. If something costs 150rupees, it automatically costs 3 US dollars as a matter of accountancy. In a slightly different perspective, the exchange rate is aÂ price. If the exchange rate can freely move, the exchange rate may turn out to be theÂ fastest movingÂ priceÂ in the economy, bringing together all the foreign goods with it. Thus, the exchange rate is aÂ conversion factor, a multiplier or a ratio, depending on the direction of conversion.
Types of exchange rate
It is customary to distinguishÂ nominalÂ exchange rates fromÂ realÂ exchange rates.Â NominalÂ exchange rates are established on currency financial markets called "ForexÂ markets", which are similar to stock exchange markets. Rates are usually established in continuous quotation, with newspaper reporting daily quotation. Central bank may also fix the nominal exchange rate.
Another classification of exchange rates is based on the number of currencies taken into account.Â BilateralÂ exchange rates clearly relate to two countries' currencies. They are usually the results ofÂ matchingÂ of demand and supply onÂ financial markets or inÂ bankingÂ transaction. In this latter case, the central bank acts usually as one of the sides of the relationship.
Real exchange rates areÂ nominal rate correctedÂ somehow byÂ inflationÂ measures. For instance, if a country A has an inflation rate of 10%, country B an inflation of 5%, and no changes in the nominal exchange rate took place, then country A has now a currency whose real value is 10%-5%=5% higher than before. In fact, higher prices mean an appreciation of the real exchange rate, other things equal.
Other bilateral exchange rates may beÂ simply computedÂ fromÂ triangular relationships: if the exchange rate dollar/yen is 10 000 and the dollar/Angolan kwanza is 100 000 then, as a matter of computation, one yen is worth 10 kwanza. No direct yen/kwanza transaction needs to take place. If, instead financial market exists for yen to be exchanged with kwanza, the expectation is that actions by speculators will bring the parity of 10 kwanza per yen as an effect.
MultilateralÂ exchange rates are computed in order to judge the general dynamics of a country's currency toward the rest of the world. One takesÂ a basket of different currencies, select a meaningful set of relativeÂ weights, then computes the "effective" exchange rate of that country's currency.
For instance, having a basket made up of 40% US dollars and 60% German marks, a currency that suffered from a value loss of 10% in respect to dollar and 40% to mark will be said having faced an "effective" loss of 10%x0.6 + 40%x0.4 = 22%.
Some countriesÂ impose the existence of more than oneÂ exchange rate, depending on the type and the subjects of the transaction.Â MultipleÂ exchange rates then exist, usually referring to commercial vs. public transactions or consumption and investment imports. This situation requires always some degree of capital controls.
In many countries, beside the official exchange rate, theÂ black marketÂ offers foreign currency at another, usually at much higher rate.
Exchange rate regimes
When the exchange rate canÂ freely move, assuming any value that private demand and supply jointly establish, "freely floatingÂ exchange rate" will be the name of currency institutional regime. Equivalently, it is called "flexible" exchange rate as well.
If theÂ central bank timely and significantly intervenesÂ on the currency market, a "managedÂ floating exchange rate regime" takes place. The central bank intervention can have an explicit target, for example in term of a band of currency acceptable values.
In "freely" and "managed" floating regimes, a loss in currency value is conventionally called"depreciation", whereas an increase of currency's international value will be called "appreciation". If the dollar rise from 10 000 yen to 12 000 yen, then it has shown an appreciation of 20%. Symmetrically, the yen has undergone 8.3% depreciation.
Under this regime, a loss of value, usually forced by market or a purposeful policy action, is called"devaluation", whereas an increase of international value is a "revaluation". But central banks can alsoÂ declare a fixed exchange rate, offering to supply or buyÂ any quantityÂ of domestic or foreign currencies at that rate. In this case, one talks of a "fixed exchange rate".
The mostÂ stabile fixed exchangeÂ regimes areÂ backed by an international agreementÂ on respective currency values, often with a formal obligation of loans among central banks in case of necessity.
A "currency crisis"Â is a rupture of fixed exchange rates with an unwilling devaluation or even the end of that regime in favour of a floating exchange rate. It can dominate the attention of the public, policymakers and entrepreneurs, both in advance and after. For instance, people expecting a crisis can borrow inside the country, convert in a foreign currency, and lend that money. When the crisis comes they sell the bonds, convert to the national currency, pay back their loans.
Monetary unionsÂ phase out the national currencies in favour of one Some further countries can target to join the union and put in place economic and financial policies to that aim, especially if there are explicit conditions for entering into that monetary area.
An extreme national engagement to fixed exchange rates is the transformation of the central bank in a mere "currency board" with no autonomous influence on monetary stock. The bank will automatically print or lendÂ moneyÂ depending on corresponding foreign currency reserves. Thus,Â exports,Â importsÂ and capital inflows will largely determine the monetary policy.
Impact on other variables
Levels and fluctuations in the exchange rate exert a powerful impact onÂ exports,Â importsÂ and theÂ trade balance. AÂ highÂ and rising exchange rate tends to depress exports, to boost import and toÂ deteriorate the trade balance, as far as these variables respond to price stimuli.Â ConsumersÂ find foreign goods cheaper so theÂ consumptionÂ composition will change. Similarly, firms will reduce theirÂ costsÂ by purchasing intermediate goods abroad.
In extreme cases, local firms producing for the domestic market might go bankrupt. If the reason of appreciation was a soaring world price of main exportsÂ (e.g.Â energy carriers, like oil for many oil producing countries), the composition of the industrial texture would be starkly simplified and concentrated to those exports. This is at odds and works in the opposite direction of theÂ diversification of the economy that is often the stated goal of public strategiesÂ in countries depending on too few productions (high export concentration).
AÂ devaluationÂ or depreciation should work in the opposite direction, improving theÂ trade balanceÂ thanks to soaring exports and falling imports.
If, however, imports haveÂ an elasticityÂ to price less than 1, their values in local currency will grow instead of falling. Moreover, if the state, the citizens and / or the enterprises have a debt denominated in a foreign currency, their principal and the interests to be paid soar because of the devaluation. They usually squeeze other expenditures and launch a recessionary impulse throughout the economy.
Hosting different industries,Â regionsÂ usually exhibit a differentiated degree of international openness: exchange rate fluctuations will have an uneven impact on them. Similarly, the number ofÂ job placesÂ and the working conditions may be influenced by the degree of international competition and exchange rates levels.
Exchange rate influences also theÂ external purchasing powerÂ of residents abroad, for example in term of purchasing real estate and other assets (e.g. firm equity as aÂ foreign direct investment), so by different channels, also theÂ balance of payments.
Exchange rate devaluation (or depreciation) gives rise toÂ inflationary pressures: imported good become more expensive both to the direct consumer and to domestic producer using them for further processing. In reaction to inflation (actual and feared), the central bank can rise the interest rates, thus sending a recessionary impulse.
Currency crisis have a sweeping impact on income distribution. The few rich able to borrow (because they have collateral and the banks trust them) will get richer and the people purchasing imported goods facing inflation and reduction of real incomes.
Symmetrically, the central bank may use a fixed exchange rate as aÂ nominal anchorÂ for the economy to keep inflation under control, compelling domestic producer to face tougher competition as soon as they decide to increase prices or accept to pay higherÂ wages.
For statistics purposes, international comparisons of current values converted to a common currency are "distorted" by wide exchange rate fluctuations.
Exchange rate risk
When companies undertake international business, they take a risk because their investments and business operations may be affected by changes in the exchange rates for different currencies. This risk is known as exchange rate risk.
Increasingly, companies are fighting for a slice of global markets, particularly in developing nations, and putting money in foreign stocks. But all economies, even the most established, go through downturns periodically. In the case of developing nations, economies may be quite volatile-political upheaval and factors like the price of oil adding to their instability. The effect on company balance sheets, cash flow, and earnings can be dramatic.
For this reason, doing business internationally is inherently risky. For example, when profits are exchanged for the domestic currency, there is a risk that they will be reduced or disappear completely. And here's another element to consider: sometimes companies struggle to compete with competitors from countries whose currencies are weaker because their costs are lower and they can consequently offer lower prices to customers.
Introduction to risk faced by the firm's
The impact of the exchange rate variations on the firm value has been a focal issue in international finance as increasing exchange rate volatility in the post Bretton Woods period proved to be a non-trivial risk factor. According to a recent market microstructure analysis, the value of the US dollar changes 18,000 times on an average trading day, and the volatility of the major exchange rates, is estimated to be in the range 10-20% per year. The theoretical literature on exchange rate exposure provides support to the widely shared notion that exchange rate changes should impact the value of a firm due to the operational and financial cash flows denominated in foreign currency (translation channel), and the shifts in the competitive position of the firm (competitive channel). Starting with the pioneering work of Shapiro (1975), theoretical arguments developed suggest that a multinational firm with export sales and competition should exhibit exchange rate exposure and that the firm's exposure should be related to the proportion of export sales, the level of foreign competition, and the degree of substitutability between local and imported factors of production.
Foreign currency exposure literature reflects a consensus view that exposure arises from direct involvement in exports, imports, and or foreign currency denominated funding of operations as well as impact of exchange rates on the competitive position of the firm in its industry. Although these four sources may lead to exposure for all firms involved in the global economy, we argue that two of these sources, namely, exports and foreign currency liabilities render a point of variation for the difference in the nature of exposure of EMNCs. The export oriented developed country multinationals follow an expansion strategy where they first move into other developed economies and, only at later stages of market expansion prefer to move into emerging markets.
What You Need to Know
There is no definitive model for clarifying or predicting fluctuations in exchange rates-perhaps because the world of international finance is so fast-moving.
A forward transaction is the exchange of two currencies at agreed rate sometime in the future. It eliminates exchange rate risk by setting a fixed rate for a forthcoming transaction.
A foreign exchange option offers a guaranteed "worse-case" rate for a future currency exchange. It protects buyers against unfavourable currency fluctuations. The buyer is not obliged to exchange at the stated rate, but the option is there if they want to take it up.
Currency contracts enable producers who are struggling to compete (because of unfavourable exchange rate changes to try to match the cost and pricing structures of their competitors.
By establishing offices in foreign countries, companies can undertake business transactions in the local currency-reducing the adverse effects of exchange rate changes.
Companies can subscribe to services that monitor exchange rates and issue alerts. These services may use a scale to indicate the level of risk (for example, one in the U.S. has a scale from 100 - 200, with no risk at one end and crisis at the other).
It is not possible to take out insurance specifically against exchange rate risks.
Companies (particularly small and medium-sized enterprises) can get help and advice about selling to international markets from the U.S. Export-Import Bank.
What to Do
Companies could avoid exchange rate risk by doing business exclusively in their own countries-but for large businesses this is hardly a realistic proposition. Another not much more practical option is to insist on using one's own currency for all transactions. However, asking all customers to use dollars is inflexible, and forces them to take on all the risk so it's not likely to go down well.
A more pragmatic approach is to learn about the fundamentals of exchange rate risk in order to reduce its negative impact. It is a complex subject, much of it best left to experts, but it's worth finding out enough to be able to act wisely on advice.
The main indicators of risk are the relationships between interest, inflation and exchange rates. The most significant relationships have been described as follows:
Purchasing Power ParityÂ (PPP). This is the idea that in a stable marketplace, the relationship between exchange rates of different countries should be in the same ratio as the price of a fixed basket of goods and services. In other words, there is parity between the purchasing power of currencies and their exchange rates. There are different ways of expressing this, but most commonly it is:
Rate of change of exchange rate = difference in inflation rates
International Fisher EffectÂ (IFE). This theory suggests that differences in interest rates between countries are expected to be offset by future changes in exchange rates. For example, if an investor earns a higher interest rate in another country, any gains are offset by an unfavourable exchange rate. The relationship is expressed as:
The expected rate of change of the exchange rate = the interest-rate differential
Unbiased Forward Rate. This theory suggests that the forward exchange rate (the rate at which a forward transaction takes place) is the most accurate measure of expected future exchange rates. This is stated in simple terms:
The expected exchange rate = The forward exchange rate
These measures aside, protecting a company against exchange rate risk depends on careful monitoring. Currency exchange rates are affected by politics, inflation, the state of import and export markets, capital flow, consumer confidence, and many other economic and social factors. Moreover, individual governments often take action-often controversially-to control the volatility of currencies. These factors result in exposure to three main types of risk:Â economic,Â translationÂ and transaction.
Economic exposure: the risk that a company's profits will be eroded by exchange rate changes because of rising operating costs. Companies are very limited in the actions they can take to protect themselves in this situation.
Translation exposure: the risk that exchange rate changes will diminish a company's income, assets, equity or liabilities. Their denomination is therefore significant-although some analysts believe that real assets (those that are physical and identifiable rather than financial) are hardly affected by currency movements at all. To insulate against this risk, fund managers undertake "currency hedging." This is a sophisticated technique involving keeping a close watch on exchange rate changes and diversification of a company's holdings in different currencies.
Transaction exposure. the risk that exchange rates will change after a contract is agreed, but before it is completed (or after borrowing/lending agreements are established but before repayments have been made), and that major losses will occur as a result. This is a problem frequently faced by companies working in international markets. It's not usually practical to demand advance payment from customers (and impossible to apply this in a borrowing/lending situation), so a technique called "factoring" is used to reduce the risk. This involves selling off a company's foreign accounts receivable to a "factoring house," which then takes on the responsibility for credit and collections. Factoring houses typically buy the accounts receivable at 90-95 % of their value, although the discount may be greater. Companies often recoup their losses through product price adjustment.
Exchange rates can be affected by risks associated with a particular country. For example, there may be political or military involvement, or restrictions may be imposed. There are also commercial factors, like a major foreign customer becoming bankrupt or defaulting. Of course, major customers at home can default too, but they are not operating under unfamiliar legal or regulatory systems. It is possible for companies to insure themselves against such risks, but this can be very expensive.
Currency and exchange rate fluctuations and its adverse effects on the earnings
The value of theÂ Indian Rupee compared to theÂ U.S. dollarÂ impacts the value ofÂ ADRÂ shares of TTM and its business operations. Tata Motor's stock is listed on theÂ NYSE.Â An increase in the value of theÂ INRÂ translates to higher share price and dividend payments in theÂ ADRÂ shares all else constant. An appreciatingÂ INRÂ can purchase moreÂ U.S. dollar. However, on the flip side, a strengthening INR adversely impacts the export earnings of TTM. The Company's exports constitute 9.8% of theÂ revenuesÂ and imports constitute 4.6% of material consumption.Â TTM undertakes steps toÂ hedgeÂ theÂ currencyÂ risk for its operational requirements, but a weakening of the rupee against the dollar or other major foreign currencies adversely affects the cost of borrowing and consequently increases the financing costs.Â Additionally, with the acquisition of Jaguar Land Rover, around 66% of TTM revenues are contributed by this subsidiary.Â The fluctuations in the value of theÂ British PoundÂ against the dollar and other currencies like Indian rupee would affect theÂ net profits
Constant exchange rate
If a company sells in a foreign currency that means that underlying trends in its sales and profits can be obscured by foreign currency movements. The result is that growth in turnover or profits in the company's reporting currency (the currency its accounts are in) will not give investors a full view of how the business performed.
Consider a very common situation: a British company sells largely abroad and sets its prices (and is paid) in dollars. Suppose sales increased in dollar terms by 10%, but that the dollar fell against the pound and was on average 4% lower during the year than it was the previous year. The result is that the sales growth shown in the accounts will only be about 6%.
Most companies that are significantly affected by exchange rate fluctuationsÂ discloseÂ sales, and sometimes profits, in a way that strips out the effects of exchange rate changes.
This can be done in a number of ways including:
Translating the current year's turnover and operating profit using the previous year's exchange rate. This is what we mean by constant exchange rates.
Stating the sales and profits in the appropriate foreign currencies.
Stating how much sales or profits were reduced or increased as a result of exchange rate changes.
Constant exchange rates are not always better indicators of performance. Some countries have high inflation and currencies that depreciate persistently (the two are linked, seeÂ interest rate parity). This means that adjusting for the fall in such a currency gives an overoptimistic view of growth. This most often happens when looking at companies with significantÂ emerging marketsÂ operations.
The ideal solution would be to look at inflation adjusted growth numbers but this requires a considerable amount of analysis.
Effect of exchange rate on Business
The results of companies that operate in more than one nation often must be "translated" from foreign currencies into U.S. dollars. Exchange rate fluctuations make financial forecasting more difficult for these companies and also have a marked effect on unit sales, prices, and costs. For example, assume that current market conditions dictate that one American dollar can be exchanged for 125 Japanese yen. In this business environment, an American auto dealer plans to import a Japanese car with a price of 2.5 million yen, which translates to a price in dollars of $20, 000. If that dealer also incurred $2, 000 in transportation costs and decided to mark up the price of the car by another $3, 000, then the vehicle would sell for $25, 000 and provide the dealer with a profit margin of 12 percent.
But if the exchange rate changed before the deal was made so that one dollar was worth 100 yen-in other words, if the dollar weakened or depreciated compared to the yen-it would have a dramatic effect on the business transaction. The dealer would then have to pay the Japanese manufacturer $25, 000 for the car. Adding in the same costs and mark up, the dealer would have to sell the car for $30, 000, yet would only receive a 10 percent profit margin. The dealer would either have to negotiate a lower price from the Japanese manufacturer or cut his profit margin further to be able to sell the vehicle.
Under this FX scenario, the price of American goods would compare favorably to that of Japanese goods in both domestic and foreign markets. The opposite would be true if the dollar strengthened or appreciated against the yen, so that it would take more yen to buy one dollar. This type of exchange rate change would lower the price of foreign goods in the U.S. market and hurt the sales of U.S. goods both domestically and overseas.
Let's again look at a hypothetical example. Suppose that a small manufacturer of automotive components is confronted with currency fluctuations of the magnitude that have been illustrated above. In such a competitive industry, profit margins tend to be quite small, and the large automobile assemblers, such as Toyota, consistently apply pressure for even lower prices (and, therefore, lower margins) on the components they outsource. If the small manufacturer experiences a 20 percent increase in the value of its domestic currency vis-à-vis the Japanese yen (in the case of Toyota) and is unable to pass along the currency swing by increasing its prices to its Japanese customers, it will find itself losing money on each part it sells to that customer. However, if the small manufacturer can work with its customer, one of its subsidiaries, or a third party in Japan that has a product that the manufacturer could use in its own production or operations or that it could effectively resell to another party, the potential exists that the 20 percent change in the value ofÂ the manufacturer'sÂ domestic currency would not impact the net price of the component parts thatÂ the manufacturer isÂ selling to the Japanese customer.
This sort of approach to dealing with the pricing challenges that arise when currency fluctuations are of a significant magnitude is in itself a challenge. Such an approach requires the cooperation of the marketing/sales and treasury/finance functions inÂ an organization. Depending on the complexity of the arrangement that needs to be structured, this approach might also require the involvement and/or agreement of other functional areas of business such as procurement, production, and operations. However, when viewed in the context of the alternative (that is, abandoning customers in markets whose currencies have significantly depreciated), the challenges inherent in using this non-traditional approach to being market friendly might seem to be very worthwhile.
How Foreign Exchange Rates Affect Your Business
Top of Form
Keeping an eye on the foreign exchange market is very important as the change in rates can have a profound effect on your business. As the exchange rates are quite volatile, the amount you spend today and tomorrow can be different for the same product. With business deals, this can amount upto a lot of money. A good website will help you with theÂ foreign exchange comparisonÂ and an expert can also be spoken to for advice on getting the best deals.Â
Impact on the business
Every business gets affected by the currency rates. Currency comparison and availability will help you see what kind of a difference it can make. If you are planning to transfer money, it will help to compare the companies offering this service as well. Only restriction most exchange services have is the non availability of cash which can lead to delay. This delay will sometimes be compensated by the company if the money is not transferred at the said time.Â
Exchange rates and business
As there are a large number of companies dealing with foreign exchange, theÂ exchange rate comparisonÂ will help your business a lot. Businesses can bid and offer the currencies at different rates and this will enable you to save as well. A good way to go about it is find a website that lists the best companies offering this service. By checking their rates and reputation, you will be able to make a good decision and help your business grow.Â
Exchange rates affect tourism a lot as there are people who choose to travel when the rates are attractive.Â Currency comparisonÂ is the best way to settle a price to the lowest and encourage the people to travel at the best rates. There are a lot of other businesses which are affected by exchange rates as well and hence having someone keep an eye on the rates is a good idea.Â
Choosing a foreign exchange company
While choosing a company for foreign exchange along with the exchange rate comparison, you should also keep in mind the minimum amount specified. When it is for businesses, generally the minimum amount is quite high. Having a good advisor on the job will make a big difference and this will help you wait for the best rates before transferring your money. This is one of the easiest ways of cost cutting and avoiding unnecessary costs. Waiting till the rates are favorable is the right way to go.
Bottom of Form
By analyzing the whole scenario, we can say that it is very difficult to analyze the impact of exchange risk on firm's value. The main thing in this is that the exchange risk is basically affected by the inflation and government policies and firm's value is also affected by this, so to say that it is affected by exchange rate or the change in profit is due exchange rate .it is very difficult to prove. So far there are lot of studies being done to check whether there is any effect of exchange rate on firm's value, but all are concluded on the same point that, it is very difficult to analyze the impact of exchange rate on firm's value. So, far only one modern theory proves that there is a effect of exchange rate on firm's value and this theory also has its limitations, it explains only the impact of exchange rate on import and export. This theory says that when the exchange rate of one country declines in respect to other there is a chance of profit in export and import. But problem occurs when there is too much up and down in exchange rate. What happens when this situation arises is that government of that country change its policies to keep interest of both importer's and exporters. The government of that country take such steps that both importer and exporter should feel comfortable. Now to explain further i have taken an example of a Swedish firm. In this Swedish firms is affected by exchange rate fluctuations.I have examine the exchange rate exposure over return horizons of one week, one month, and three months, and found that it increases with the length of the horizon. I also study the cross-sectional pattern of exposure, across industries as well as several firm attributes. When firms are aggregated at an industry level, we do not detect any exchange rate exposure when an exchange rate index is used as a proxy for exposure. However, when individual currencies are considered, I found some exposure at an industry level, although not of an overwhelming magnitude. This conclusion is confirmed in the evaluation of an international asset pricing model, as the exchange rate exposure of a firm does not show any relation to the firm's risk.
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