QUESTION

A study of the Exchange Rate System and Hedging Against Exchange Rate Risk

SOLUTION

1. Bath PLC

Bath Plc. is a UK based firm which deals with firms in US. The company has a large number of transactions due over the next 5 month and the main objective of the management is to minimise by the risk by using various hedging techniques.   The hedging techniques under consideration are namely

1.1 futures

1.2 Swaps

1.3 Options Pricing

The objective of each of the techniques is to minimise the exchange rate exposure that the business subject to and therefore minimise risk in the business.

1.1 Futures

Bath Plc. transactions due over the 5 month period are as follows

Net Payments = £ 643.2

I.          No forward Contract

If however no hedging technique is adopted by the corporation at the current spot rate of $ 1.9210 the company will have to pay £643.2 x 1.9210 which is $ 1235.58 or 1236 approx.

II.          3 month forward Contract

If however the firm chooses to enter into a 3 month forward contract then at the rate of $1.9120 forward for the net payments of £643.2 then the firm will pay £643.2 x $ 1.9120 which is $1229.7 or 1230 approx.

III.          1 year forward contract

If the firm chooses to enter a 1 year forward contract then at the rate of $1.8945 forward for the net payments of £643.2 the firm will pay £643.2 x $1.8945 which is $1218.54

Therefore Bath Plc. would greatly reduce the exchange rate exposure by entering into a 1 year forward contract whereby it will pay only $1218.54 in comparison to $ 1235.58 when no forward is used.

Thus it is evident that hedging does minimise the exchange rate risk associated with the transaction however time constraint may be a factor in choosing the forward contract. Therefore the only constraint in choosing a forward contract is considering the time value of the contract.

1.2 Swaps

A currency Swap can therefore be utilised to transform a loan in one country to a loan in another country (Hull, 2011).It is usually the financial institution which enters the party in the case of the Swap of the currency loan.

For a future contract of £ 62500 in the months of

i.          September

The value of the future contract at the spot rate of $1.9045 the Dollar value of the contract is £62500 x 1.9045 is $119031.25 it is advisable to swap the loan US it offers a lower interest rate of 4% for up to 6 months

Therefore for a principal amount of 119031.25 x 0.02 = 2380.62 dollars

However raising the same loan amount in the UK at the rate of 5% would prove to be more expensive as 119031.25 x .0277 =3273.35

Therefore the cost of borrowing is higher therefore it is advisable to Swap the risk to a lower interest rate country.

ii.          December

However when the exchange rate is lower and reduces to 1.89 then it is not advisable to invest or borrow in the expensive country £ 62500 x 1.89 = $11812.5 in this case value of the future contract has already been reduced because of lower exchange rates therefore it is advisable to Swap the contract. To rise the cash on the higher investment rate available in the U.K.

1.3 Option Pricing

Net Payments = £ 643.2

If however no hedging technique is adopted by the corporation at the current spot rate of $ 1.9210 the company will have to pay £643.2 x 1.9210 which is $ 1235.58 or 1236 approx.

The company wants to hedge the risk between the time of making the contract and finally settling the contract.

For this the first step is to find out number of contracts required 643.2/31250 = 2 contracts

Therefore the option which provides the maximum return to the corporation should be exercised.

1. The option strike price of $ 1.88 or 188 cents. For a contract size of 31250 the value is (31250 x 0.0188 ) $587.5 per contract

Thus the value for 2 contracts is 587.5 x 2 = $1175

1. The option strike price is of $ 1.90 or 190 cents. For a contract size of 31250 the value is (31250 x 0.019) $ 593.75

Thus the value for 2 contracts is 593.75 x 2 = $ 1187.5

3.  The option strike price $1.92 or 192 cents. For a contract size of 31250 the value is (31250 x 0.0192) $ 600

Thus the value for 2 contracts is 600 x 2 = $ 1200

The option with a strike price of 1.88 should be exercised as it minimises the risk associated with contract as the closing spot rate is $ 1.9210 .Thus the maximum risk the exercised at the strike price of 1.88 therefore this option should be exercised.

Thus from the above it can be concluded that options if the most effective instrument to minimise risk of the Bath plc. However futures are at a 2^nd close in terms of providing hedging against exchange rate exposure.

2. Exchange Rate Systems

2.1 Introduction

The exchange rate systems have undergone large scale changes and have evolved from the Bretton woods era to a more modernized form. Under the Bretton woods central banks of all countries except the United States were given the responsibility to determine their exchange rate to the dollar. This system was however largely flawed because if the value of a country’s currency was determined lower to the dollar the country would buy their currency thus driving the exchange rate prices up. The system was too simplistic a flawed it did not take into account important aspects like inflation, economic performance or trade concerns. Eventually with differences of opinions arising with economists of many countries the Bretton woods system finally collapsed in 1973 with countries like the United stated allowing the exchange rate the ‘float’. It was from this period onwards that the concept of floating exchange rate emerged and eventually moving on to managed float.

(Reinhart and Rogoff, 2004)

The collapse of the Bretton woods was attributed also to the inability to maintain gold standards against the dollar. With the collapse of the Bretton woods three major systems emerged which were largely determined by the politics of the particular country. These were

1. A managed floating exchange rate

2. A fixed exchange rate linked a basket of currencies

3. A fixed exchange rate backed by a currency board

2.1.1 A Managed floating exchange rate

The discussion on the exchange rate systems has been largely focussed on providing efficiency in industrialised and developing countries. Exchange rate efficiency is an extremely important factor crucial to the development in developing countries. Exchange rate efficiency enables these economies to effectively align themselves with the global economy and participate in the free trade globally. However most of the countries also have some individuals concerns to protect their domestic economy and industry from external economic threats thus some have adopted a system of the managed float ( Rangarajan and Ahluwalia,2011).

A managed floating exchange rate aims to the keep the exchange within a certain band. The main advantage of such a system is to insulate the economy from inflation and thus maintain price stability. Adjustments to the band are made based on the aggregate demand and supply decision as well as employment concerns. The main priority of the central banks of countries with such a system is to maintain low inflation as well as maintain efficient output- employment levels in the economy. The countries following the model of the managed float are Singapore which adopted the system after the East Asian financial crisis in the early 90’s.The latest entrant to the group is China that has also adopted the managed exchange rate regime (Mc Cullum, 2005).

The managed float exchange rate provides the countries with the opportunity to have definitive exchange rate policies. Policies designed in a manner to protect the domestic industry. The policy has been extensively used in the Euro zone which follows a protective trade policy for member countries which promotes the growth of the domestic industry and the economy (Boffinger et al, 2003). Though the main advantages of a managed float accrue to the domestic industry however for a multinational sometimes it may affect their revenues .But it also helps them maintain steady revenues in these countries because if the home currency weakens it would imply a weakening of the revenues as well. But the subsidiaries in the countries with the managed float would provide stable revenues. China can be seen as an effective example. China is the world’s fastest growing economies which has a managed float system and yet continues to enjoy favourability of global companies as they want to part of the growth model.

2.2.2 A fixed exchange rate linked a basket of currencies

The pegging of the exchange rate system to a basket of stable currencies introduces the stability in the countries exchange rate systems as well. It provides government and the central banks to have a distinctive monitory policy. Some countries do not have the capability to absorb the large scale external shocks for these countries a strong peg protects interests (Rajan et al , 2002). Empirical studies have proven that a pegged exchange rate enables to value the currency at the correct values. The case is best explained seeing the model of Honk Kong that moved from being an undervalued currency to a strong currency is East Asia after the adoption of the peg.

However it is not the case like a fix exchange rate where there is complete inflexibility. But rather a currency peg aligns the country effectively with the world economies. As most of the countries in today’s economy have been pegged with the dollar, a dollar appreciation or depreciation would have impact MNC’s in both home as well as pegged countries. Pegging is somewhat effective in a modern day globalised era; it may not be a free float but is also not an inflexible system.

A pegged exchange rate enables free trade to some extent which is highly beneficial MNC and their operating subsidiaries as it enables expansion of global operations at the minimal risk ( Boffinger et al, 2003).

2.2.3 Fixed Exchange rate Regimes

The basic reason for the collapse of the Bretton woods system was the inherent inflexibility in the system. The basic problem arises in the maintenance of an external equilibrium. It leads to the loss of flexibility of the internal policy making. This implies different trends emerging in different countries some have different levels of inflation. These results in countries with high inflation becoming increasingly competitive while low inflation countries lose their competitive advantage. In a fixed exchange rate regime governments require to hold large reserves of foreign exchange to protect against the external shocks .This proves to be a costly affair for the governments and employees large amounts of resources in maintaining such reserves.

However fixed exchange rate systems also have some advantages, the system eliminates speculation in the market. A fixed exchange rate system also reduces risk in international trade as the governments and companies are completely aware of their cash inflows and outflows as the exchange rate is pre-determined. This creates investment opportunities for large corporations.

(www.bized.co.uk – accesed on 29/3/2012)

3. Conclusion

Thus weather the exchange rate is fixed or floating or a combination of both it is highly unlikely for an economy to insulate itself from external factors, the more dominant the economy the greater its impact on domestic policies of other countries.an ideal exchange rate system can only emerge from stable macroeconomic policies of industrial countries which have a positive impact on the dependant countries.

Thus the adoption of an exchange rate regime may be subjective to each economy but however one thing is clear that the fixed exchange rate regime has become almost redundant. This is largely because of globalization with economies interdependent on each other it is difficult to ignore external factors in economic policy making. Thus both for governments as well as international companies it is important to hedge them against the exchange rate risk exposure by using security market and derivative instruments. Hedging against the risk would reduce uncertainty and would lead healthy growth and development of the corporation globally.

4. References

• Reinhart, M, and K Roghoff. “The Modern History of Exchange Rate Arrangements: A Reinterpretation.” NBER Working Paper 8963 (2004): 1-48. nber.org. Web. 30 Mar. 2012.
• Boffinger, P, and Timo Wollmershäuser. “Managed Floating: Theory, Practice and ERM II .” Deutche Bank Research Worshop 1.1 (2003): 1-56. Print.
• Ahluwalia, M, and C Rangarajan. “The Exchange Rate System: Some Issues .” Planning Comission 1.1 (2011): 1-8. Print.
• Mc Cullum, T. “Monetary Policy in East Asia: the Case of Singapore .” IMES Discussion Paper Series 10 (2005): 1-24. Print
• Rajan, R, and R Siregar. “Choice of Exchange rate regime – Currency Board.” Research Papers – AdeladeUniversity 1 (2002): 538-556. Print.
• “Biz/ed – Advantages and disadvantages of fixed exchange rates – Further work – Foreign exchange market – Markets – Economics bank – Virtual Bank of Biz/ed | Biz/ed.” Business studies teaching and education resources: Biz/ed. N.p., n.d. Web. 29 Mar. 2012. <http://www.bized.co.uk/virtual/bank/economics/markets/foreign/further1.htm>.

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