Finance Report: Hedging Operating Exposure in Finance

This finance report delves into the intricacies of the international monetary system, elucidating its standards and rules for facilitating global trade and capital reallocation. It examines the impact of this system on business operations, highlighting how government policies and global events can influence currency exchange rates and trade balances. The report then explores the relationship between interest rates, inflation, and exchange rates, offering insights into how these factors affect currency values and providing crucial implications for business managers. Finally, the report evaluates the extent to which a firm's operating exposure can be hedged, detailing various strategies such as matching currency cash flows, parallel loans, and currency swaps, to mitigate financial risks associated with currency fluctuations. The analysis provides a comprehensive understanding of international finance and its implications for businesses operating in a global environment.

Running head: FINANCE
Finance
Name of the Student:
Name of the University:
Author’s Note:
Course ID:

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Table of Contents
Answer to Question 1:.....................................................................................................................2
Answer to Question 2:.....................................................................................................................2
Answer to Question 3:.....................................................................................................................2

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Answer to Question 1:
International monetary system denotes a system, which develops standards and rules in
order to facilitate global trade among the nations. It assists in reallocation of capital and
investment from one country to another. This is the international network of financial institutions
and the government, which ascertains the exchange rate of various currencies for global trade.
Thus, international monetary system is a governing body with the help of which various
countries are involved in exchanging currencies with each other.
With the increasing issues in financial market and global trade, it is necessary for the
international monetary system to allocate standard values of the global currencies. However, the
stand of the government might influence the decision-making process of the global monetary
system. For example, any modification in trade policy might influence the global trade of
products and services. International monetary system motivates and boosts the nations for
involving in global trade to enhance their balance of payments along with minimising the trade
deficit. It has developed over time in the form of architectural body with a vision of integrating
the global economy. The international monetary system has made some global achievements that
include the World Bank and the International Monetary Fund.
The impact of international monetary system is to minimise the exchange rate, strengthen
the current account and reduce the financial account. However, if the monetary system is
restrictive, the power of the financial account and the exchange rate would increase, while there
would be decline in current account. By assuming that the monetary policy is not restrictive, the
international monetary system would result in the following in relation to the income effect:
 There would be increase in domestic gross domestic product (GDP).

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 The increase in domestic GDP would increase the overall demand for imports. When
there is increase in imports purchased, it is obvious that there would be deterioration in
current account.
 With the rise in imports purchased, there would be requirement to transfer domestic
currency to foreign currency. As a result, there would be decline in the rate of exchange
of the domestic currency.
 In the absence of governmental intervention, the financial account would move towards
surplus, since the current and financial accounts should be nil in combination. Owing to
the rise in imports, the foreigners would enjoy a surplus of the currency of the nation. In
case; the foreigners do not utilise the currency for buying the exports of the nation that
would enhance the balance of the current account, then the currency needs to be invested
in the assets of the domestic nation. This clearly explains the reason that nations like
Japan and China undertake huge investments in assets like US treasuries. The US
currency holders are required to place it to work in other areas. However, it is noteworthy
to mention that the foreign investors often receive increased rates of return compared to
the disclosures, since the value of the domestic currency is declining in relation to their
own currency.
Answer to Question 2:
When the interest rates in a nation are high, the value of the currency of that nation
increases compared to the countries providing lower rates of interest. However, in reality, this
does not occur in case of foreign exchange. Despite the fact that interest rates could be a
significant factor affecting exchange rates and currency value, the ultimate ascertainment of the

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exchange rate of a currency with other currencies is the outcome of a number of interrelated
components that represent the overall financial condition of a nation in relation to other nations.
From the general perspective, increased interest rates raise the value of currency of a
nation. When the interest rates are higher, there are chances of more foreign investments and
thus, the value of and demand for the home currency increases. On the other hand, lower rates of
interest do not tend to be attractive for foreign investment along with minimisation in the relative
value of a currency.
However, the interest rates alone do not ascertain the value of any currency. The factors
like the balance of trade between imports and exports of a nation could be a critical factor in
ascertaining the value of a currency. The reason is that increased demand for the products of an
organisation implies increased demand for the currency of the nation as well. Therefore, the
favourable figures like balance of trade and GDP are key numbers that the business managers
consider in analysing any provided currency.
The inflation rate in a nation could have considerable effect on the value of currency of a
nation and the foreign exchange rates with the currencies of the other countries. However, the
effect of inflation rate is generally negative than positive on the currency value and exchange
rates. A low inflation rate does not ensure favourable rate of exchange for a nation; however, a
high inflation rate is probable to affect the exchange rates of a nation with other nations
adversely. However, if a nation is found to be politically or economically not stable or if there is
considerable chance of a sudden devaluation or other change in the value of currency of a nation,
the investors tend to move away from the currency and they are reluctant to hold the same in big
amounts or significant periods. Therefore, the business managers need to keep these aspects
under consideration for protecting their business assets.

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The nations attempting to balance inflation and interest rates face issues owing to the
complex relationship between the two factors, which are difficult to be managed. The low rates
of interest increase spending of the consumers as well as economic growth and thus, the impact
on currency value is generally positive. In case; there is increase in consumer spending to the
point where supply is lower than demand, inflation might ensure and this might not result in
unfavourable outcome. However, foreign investments could not be attracted with lower interest
rates. The higher interest rates generally attract foreign investment, which is probable to raise the
demand for the currency of a nation.
Answer to Question 3:
The extent to which the operating exposure of an organisation could be hedged is
discussed as follows:
Matching currency cash flows:
An UK exporter could match the cash flow currency of its assets and liabilities. With the
assistance of this strategy, it is possible to develop a natural hedge for the organisation. The UK
exporter could undertake the below-stated activities:
 The organisation could issue or borrow debt securities in currencies denominated in USD
and YEN for using its export receivable in paying the principal and interest. By
conducting the same, the UK exporter could protect from Pound/Euro fluctuation.
 The UK exporter could pay to its Indian subsidiary in YEN or USD. By conducting the
same, the UK organisation could match its assets with its liabilities. However, there
would be shift in foreign exchange risk to the Indian subsidiary.

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With the passage of time, there are a number of organisations that have started to undertake
this position for managing operating exposure, which has not been feasible in the earlier periods.
Parallel loans:
In parallel loans, two organisations in different nations obtain offsetting amounts
from one another in the currency of each other. For instance, an Indian firm imports top cosmetic
products from UK and sells the same in India. It operates a branch office in UK for procuring
cosmetic products and exporting the same to India. The significant expenses of the Indian
importer are in GBP; however, earnings are in INR. The Indian exporter provides a loan of
£15,000 to the branch office of the Indian importer. The Indian importer provides an identical
loan amount in INR to the Indian exporter. The day when the loan was provided, the spot rate is
assumed to be INR 42/GBP. The Indian exporter provides a loan of £15,000 to the branch office
and the Indian importer provides a loan of INR 630,000 to the Indian exporter. Thus, it is
apparent that both organisations managed to obtain their FOREX requirement without visiting
the FOREX market.
Currency swap:
In currency swap, an organisation swaps its foreign currency denominated payments of
debt including principal and interest with a counter party. For instance, it is assumed that the UK
exporter has borrowed USD for financing its business operations. It has been expecting from the
sales proceeds that it would be able to settle its lender payments. However, with the rising
competition in the US market, it has started to concentrate on the domestic market and it expects
to earn maximum revenue in GBP terms. Therefore, the UK exporter is not found to be keen to
service USD denominated debt. The Indian exporter has two alternatives, which include either

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making prepayment of the USD debt or changing the debt of USD to GBP debt. The prepayment
of any debt comes with the own cost, which implies that the lender might charge a fee. In case of
the second option, the currency swap has been undertaken by using the services of a swap dealer.