BFM208: International Finance Online Exam - Exchange Rates and Risk

This document presents a comprehensive solution to an online exam for the International Finance course BFM208. The solution delves into the advanced premium puzzle in monetary markets, exploring its relationship with interest rates, economic stability, trade-weighted indices, government bond...Read More

BFM208 - International Finance online exam

Contents
MAIN BODY..............................................................................................................................................3
Question 1...............................................................................................................................................3
Question 2...............................................................................................................................................5
REFERENCES............................................................................................................................................9

MAIN BODY
Question 1
The advanced premium paradox in monetary markets (also known as the Fama puzzle) relates to
the well analytical observation that national interest rates surpass international interest rates
while the local nominal ratings are estimated to be appreciated (Moran and Nono, 2018). The
theory assumes that if all the currencies were to be similarly volatile, shareholders will seek
higher interest rate levels on the currency that are anticipated to be of value. The theory is that, in
the event that they all are relatively sure, shareholders will demand higher inflation on currency.
The initial value puzzle is closely linked in the absence of exposed parity and the process of pre-
rate distortion. The puzzle is that the advance premium generally points in the opposite direction
in the spot price for the ex post movement. Discovered disparity of interest implies that forward
discount and thus the interest difference can be an impartial indicator of the ex post spot rate
adjustment, if covered disparity of interest occurs, implying realistic expectations. The puzzle of
the forward rate skew is that the forward rate does not give an uneven estimate of the potential
spot rate. To determine concepts and conditions, specify the advance rates at time s to be
included in a transaction k as Ft and the exchange rates t as St. In addition, the subjective
anticipation of the time spot rates t+k is defined as St+k ć depending on length t knowledge.
Assuming realistic expectations for the moment, viz.,) (And St+k).
Factors that have been included to explain its existence
Interest rates- With the rise in interest rates, higher mortgage payments are made from keeping
this nation's currency, providing more benefit growth prospects. The price of the tax obligations
among traders who want to buy this. Conversely, once the premiums fall, profit options are
deemed less desirable and the money is used, which causes individuals to want to sell. The price
of the currency declines with rising requests.
Economic stability- A stable economy, attracted by external investment, is seen as a low risk.
The cost of its currency is increased by this demand (Reed IV, 2019). In comparison, a weaker
economy causes investors to lose confidence and withdraw deposits, resulting in a decline in the
currency.

Trade-weighted Index- the TWI, a typical version of the effective currency index is a multilateral
currency value index. The trade-weighted effective currency index (TWI). It is compiled as a
total average domestic-foreign currency value, with a makes maintaining to the proportion of
trade per different nation. If exports are more important than imports, a 'trade surplus' is said to
exist in the economy which strengthens its stability. The exchange rate grows as foreign buyers
buy the export product currency.
In the opposite, an economy is facing a "trade imbalance" because imports are higher than
exports. In order to buy manufactured commodities, the nation must sell its own currency, which
would decrease the currency value.
Government bond- It can lead to better local infrastructure and innovative development.
Although it may result in currency rate depreciation if it is too high. As public debt is cut,
economic stability becomes stronger and the currency's value increases, attracting more investors
(Burnside, Eichenbaum and Rebelo, 2019). When government debt rises, it will issue more
currency and raise circulating volumes (known as quantitative easing). The new currency
reserves are diluted in value, allowing rates to plummet.
Terms of Trade- Trade terms are a proportion of a nation's export prices and its import costs.
When a country's export price rises more rapidly than its import rates, its trading conditions
change. As a consequence, higher sales, higher demand for the currency and the appreciation of
the currency are improved. This leads to the exchange rate increase.
Economic Performance- Political stability is one of the variables that affect a country’s economic
growth. A nation's political climate draws more foreign direct investment, and conversely.
Increased international investments leads to an increase in the price of the country's national
currency (Thornton, 2019). Such sustainability also has a strong effect on financial or trade
policies, removing any volatility in the currency's value.
Speculation- If the price of a nation's currency is projected to increase; investors demand more of
it in order to prosper in the near future. As a consequence of the increase, the country's currency
value increases. This, in particular, leads to an increase in the currency rate. Since there are so
many variables at play, exchange rates fluctuate, which can be very upsetting for people who
send money abroad on a regular basis. Though watching the prices of a currencies conduit will

give a good understanding of when to make transactions, it is best to keep up to date on
exchange rates.
Current Account Deficits - The current account deficit is the overall economy between a nation
and its trading partners (Cardebat and Figuet, 2019). It represents the value differential between
goods and services traded with other nations. When a country imports more than it sells, the
trade balance is negative. It has a significant effect on the exchange rate because a nation would
need more international resources, reducing demand for local currency. Because of the surplus
availability of local currency, its value toward foreign currency falls.
Question 2
(a)
A domestic plc is a business in its home nation which conducts its business. A domestic
company also has to charge dues or taxes for goods that it purchases separately from a non-
domestic company (Thuy and Thuy, 2019).
Exchange rate- Specific or variable exchange rates may be fixed. Financial institutions of a
nation determine fixed exchange rates, while the system for domestic production and
consumption decides floating exchange rates. Some nations have confined exchanges to currency
within the boundaries of their nations. The country can even set its value to restricted currencies.
A change in the exchange rate will impact domestic companies on two separate networks. The
first is to have a direct impact through the marginal revenue stream, as the rate of exchange
altered the prices of imports. Proceeding with automotive industry of UK as an example, a higher
UK. Pounds decreases the marginal cost for the manufacture of automobiles in the United States
by purchasing medium-sized goods — such as vehicle parts, iron and tires.
For companies that supply more of their production from outside the world, this impact would be
increased. The latter, more indirect, is the marking channel. The stronger pound is also
economical in manufactured final products, for instance international vehicles (Bahmani-
Oskooee, and Nouira, 2019). Domestic car makers will also lower the price of cars
manufactured for the UK sector to hold the share of the market even though intermediate
components are not imported. That is, domestic finished goods rates could change solely when

competition prices changes – even though their fixed revenue does not change. This will lead to
lower markdowns for UK.
Second, major businesses are more vulnerable to domestic currency values than small
companies. For a few factors this is happening. Big businesses produce a higher proportion of
production from overseas than small companies; with exchange-rate fluctuations far more
affected their marginal costs. In the following table, the wider red bars for companies with a
larger market share can be seen. Moreover, big companies have greater competitive
complementarily and thus aggressively respond to the competition from abroad as seen by the
wider blue bars as we step towards the right of the table.

Substantial foreign exchange risks face domestic firms. In reality, on average, domestic
corporate exposure to currency risk is not significantly different from exposes in global firms.
Moreover, they show that with the time horizons used to calculate exposure, the number of
domestic firms with substantial foreign exchange exposures increases (Chang, Rajput and
Bhutto, 2019). In addition to this domestic business exposure levels are inversely correlated with
size, R&D investment levels, and in a lesser degree positively with financial leverages and
banking market ratio, inventory turnover, financial leverage and intensity in the sector. In other
terms, the greatest vulnerability to foreign exchange uncertainties is likely for small domestic
businesses with high equity leverage and debt levels and low asset turnover in extremely
competitive sectors. These findings are robust in different econometric financial theory and other
foreign currency estimation procedures.
(b)
Companies should monitor their FX risk exposures with a variety of approaches. In general, the
strategies can be divided into two classes - internally and externally. Internal solutions are
usually cheaper and simpler to arrange, but may not be applicable to all firms based on their
condition (Shetty, Manley and Kyaw, 2019). External approaches include negotiating with a 3rd
person (usually a bank or exchange) and are much more centralized than internal solutions and
usually include transaction costs. The best form of hedging depends on the risk you choose to
handle. For instance, is it a short-sighted exposure (e.g. investment risk from selling a sales
person in $) or more risk to a sales person in the United States (e.g., 10 year loans or UK
extension of £ sales and £ expenses), business circumstances. An additional factor is whether or
not the exposure is dependent. A contingent exposure might be anything like a GBP tender
which your company can not win, but might subject you to FX risk if it succeeds. For certain
threats, you would like a versatile way, that would not lock you into a particular transaction/rate
– usually in this case, an FX solution is being used, that we will address in depth at the end of the
FX risk range.
Internal methods of hedging are accessible. These should often be considered, since they can be
cost-effective and relatively simple, before using external approaches. However, it is likely that
certain firms cannot use all the tools. The examples involve internal hedging methods;

 Does Nothing- Don't try managing the chance of FX. Exposes the enterprise to ups and
downs of FX prices (Héricourt and Nedoncelle, 2018). If a corporation is a big FX
business or is a small marginal business, it cannot be practicable. With this scheme,
business saves trade costs when there is no hedge.
 Leading and lagging- Cash flow control mechanisms from which the company can
attempt to sooner or later pay and collect foreign currency denominated
payments/receipts, based on anticipated FX rate moves. If a corporation with an FX client
expects to reject the currency due in the next three months, for instance, it will
automatically attempt to collect the payment. This will be done with an instant payment
discount. One theory here is that the corporation will fairly predict FX rate shifts.
FX risk exposure control consists of external techniques involving communicating with 3rd
parties (e.g. banks or transactions). There are various strategies in this category, including
forward, future, monetary markets, FX futures and currency swaps – all of which will be
discussed below:
 Forwards- Developed contracts offer one of the easiest external risk management
processes. The forward contract represents a specific transaction between a company and
a third party (usually a bank) by means of which a certain volume of money is to be
traded in the potential at a negotiated rate on a fixed date. The future rates are also rates
that are negotiated for some time to come today (Khan, 2019). With a forward market
lock at a certain FX rate, companies would be unable to benefit from any favorable FX
rate movements over the interim period. Many companies would use forward,
particularly exporting companies to the UK/US.
 Futures- Currency futures have a similar purpose to forward contracts by enabling a firm
to lock in advance a fixed FX rate. In comparison to future economies, though, future
deals are structured and exchanged in future markets. They would also have maturity
period and contract lengths, which do not accommodate a specific company.

REFERENCES
Thuy, V.N.T. and Thuy, D.T.T., 2019. The impact of exchange rate volatility on exports in
Vietnam: A bounds testing approach. Journal of Risk and Financial Management, 12(1),
p.6.
Bahmani-Oskooee, M. and Nouira, R., 2019. On the impact of exchange rate volatility on
Tunisia’s trade with 16 partners: an asymmetry analysis. Economic Change and
Restructuring, pp.1-22.
Chang, B.H., Rajput, S.K.O. and Bhutto, N.A., 2019. Impact of exchange rate volatility on the
US exports: a new evidence from multiple threshold nonlinear ARDL model. Journal of
International Commerce, Economics and Policy, 10(02), p.1950009.
Shetty, A., Manley, J. and Kyaw, N., 2019. The impact of exchange rate movements on mergers
and acquisitions FDI. Journal of Multinational Financial Management, 52, p.100594.
Héricourt, J. and Nedoncelle, C., 2018. Multi-destination firms and the impact of exchange-rate
risk on trade. Journal of Comparative Economics, 46(4), pp.1178-1193.
Khan, M.K., 2019. Impact of exchange rate on stock returns in Shenzhen stock exchange:
Analysis through ARDL approach. International Journal of Economics and
Management, 1(2), pp.15-26.
Cardebat, J.M. and Figuet, J.M., 2019. The impact of exchange rates on French wine
exports. Journal of Wine Economics, 14(1), pp.71-89.
Moran, K. and Nono, S.A., 2018. Gradual learning about shocks and the forward premium
puzzle. Journal of International Money and Finance, 88, pp.79-100.
Reed IV, J.R., 2019. The forward premium puzzle and Markov-switching adaptive
learning. Journal of Macroeconomics, 59, pp.1-17.
Burnside, C., Eichenbaum, M. and Rebelo, S., 2019. Replication data for: Understanding the
Forward Premium Puzzle: A Microstructure Approach.
Thornton, D.L., 2019. Resolving the unbiasedness and forward premium puzzles. Scottish
Journal of Political Economy, 66(1), pp.5-27.