Impact of Foreign Exchange rate on International Investment

With the ramified economic changes and changes international economic factors, there is seen the high amount of financial and economic risk faced by international investors. The investment decisions of the investors are highly influenced by the foreign exchange risk, purchasing power parity and changing economic factors on the international level.  The main topic of this report is purchasing power parity and foreign exchange rate. It is observed that the foreign exchange rate is the rate at which the currency of the country is valued in the international market. However, due to the strengthening US Dollar on international level, several business organization have faced loss in their investment due to decrease in their cash inflow value  It is evaluated that purchasing power parity is defined as economic theory which reflects the exchange rate between two countries which are determined to equal to ratio of currencies’ respective purchasing power. The purchasing power parity is ideally used to determine the currency value of one country with respect to another. It determines the amount of loss and gain of the investor in the international transactions when one currency is converted into another. However, there are several derivatives tools such as forward contract, futures contract, call option and put options which could be used by international investors to overcome the foreign exchange risk from the expected change among the exchange rate of two currencies. This study has been conducted in such a way which focuses on identifying the foreign exchange rate risk and how investors could mitigate foreign exchange exposure risk and purchasing power parity of the people.

The macroeconomics relies on various methods and metrics to compare the economic productivity and standards of living between countries. The main economic factors to measure the foreign exchange risk exposure and currency value is purchasing power parity.  It is the economic theory which is designed to evaluate the different countries ‘currencies through a basket of goods approach. However, the main issue in using the purchasing power parity is based on the collection of the international data, determining the discounting model and compare the prices of the goods across countries that hold different values. The PPP is the alternative to the market exchange rates which is used to establish the relation between two currencies to buy goods and services.  Firstly, there is need to identify the purchasing power of one currency to buy the number of particular goods and services. After that currency value of each and every country will be compared by analyzing the purchasing value of each currency to buy particular stocks. The purchasing power is determined on the basis of the relative cost of living and inflation rates. The Big Mac index could also be used to assess the purchasing power of one country with another. However, it becomes complex to evaluate the actual purchasing behaviour of one country with another. There are several uncertain factors to determine the purchasing power parity such as government intervention, inflow, and outflow of the goods selected in a basket, the balance of trade in a particular economy. In addition to this, there are several foreign exchange risk exposure which is faced by investors while investing money on the international level such as transactions risk, translation risk, and economic exposure. Investors could manage these risks by using proper derivative contracts and future contracts hedge the possible international risk in their investment decisions.

Purchasing Power Parity: Definition and Use

There are several factors which impact the purchasing power parity of county to buy certain goods and services on an international level in context with other country’s currency value. However, in order to exhibit the study on the purchasing power parity and foreign exchange risk exposure, international Fisher effect and PPP have been analyzed in this literature review.  The purchasing power parity divulges the relation between the two and more currencies to buy certain goods and services. On the other hand, foreign exchange risk exposure of one currency is determined by considering several international financial risks such as transactions risk, translation risk, and economic exposure. These are the risks which are faced by the investors and companies while investing on the international level or accepting the cash inflow and outflow from one country to another country (Balassa, Bela,  584-596).

With the changes in international factors, there is several foreign exchange risk faced by the investors while investing capital on the international level. As per the perception of Gabaix, Xavier, and Matteo Maggiori, (1369-1420), it is reflected that  The international Fisher effect is the economic theory which states the expected changes among the two currencies which are equivalents to their countries’ nominal rates.  The international fisher effects show the changes in the foreign currency rate as compared to another country.  It also reflects how monetary policy of country could put the impact on the currency value of another country on the international level. In the recent times, due to the financial crises of the Euro currency, the value of Euro has gone down as compared to the currency value of other countries. It has resulted in high financial investment loss to international loss due to transaction risk, translational risk. The international fisher effect theory focuses on the concept that real interest rates of the foreign currency are independent of other monetary variables such as foreign currency exchange rate, monetary policies, and international policies rate.  The IFE provides assumption regarding the countries with the lower interest rates will have low inflation rate and company with the higher interest rate and purchasing power parity will have high inflation rate.

As per the perception of Cenedese, et al., (302-313),  it is reflected that after analyzing the above given international Fisher effect, it could be inferred that international financial market is highly volatile. The economics of particular country having high purchasing power parity is based on the foreign exchange rate and balance of trade. This balance of trade is positive when the foreign currency inflow is more than the foreign currency outflow of cash.

Derivatives Tools for Overcoming Foreign Exchange Risk

With the changes in international factors, there is several foreign exchange risk faced by the investors while investing capital on the international level. As per the perception of Gabaix, Xavier, and Matteo Maggiori, (1369-1420), it is reflected that  The international Fisher effect is the economic theory which states the expected changes among the two currencies which are equivalents to their countries’ nominal rates.  The international fisher effects show the changes in the foreign currency rate as compared to another country.  It also reflects how monetary policy of country could put the impact on the currency value of another country on the international level. In the recent times, due to the financial crises of the Euro currency, the value of Euro has gone down as compared to the currency value of other countries. It has resulted in high financial investment loss to international loss due to transaction risk, translational risk. As stated by Sarno, Lucio., it is reflected that this theory focuses on the concept that real interest rates of the foreign currency are independent of other monetary variables such as foreign currency exchange rate, monetary policies, and international policies rate.  The IFE provides assumption regarding the countries with the lower interest rates will have low inflation rate and company with the higher interest rate and purchasing power parity will have high inflation rate.

As per the perception of Cenedese, et al., (302-313),  it is reflected that after analyzing the above given international Fisher effect, it could be inferred that international financial market is highly volatile. The economics of particular country having high purchasing power parity is based on the foreign exchange rate and balance of trade. This balance of trade is positive when the foreign currency inflow is more than the foreign currency outflow of cash.

As per the perception of Rogers, John H, it is divulged that the purchasing power parity is defined as the value of the currency of one economy in context with it buying power. For instance, if a person could buy 2 apples by using USD $ 1 and at the same time, he uses 2 AED United Arab Emirates Dirham to buy same 2 apples then in this case, it could be inferred that the purchasing power of AED United Arab Emirates Dirham is less than the currency value of USD $. This relation is defined by using the purchasing power parity. The relation between the two currencies on the basis of their purchasing power is determined by using the purchasing power parity.

International Fisher Effect and its Impact on Foreign Exchange Rate Changes

As per the perception of Kaminsky, et al. it is divulged that the currency derivatives are the instruments which are used to control the foreign exchange risk exposure of two currencies. The hedging of the foreign currency risk is based on the financial instruments such as forward options, future contract option, call options and put options. By using the below-given case study, we could easily analysis the foreign exchange risk and mitigating the international Fisher effect and purchasing power parity of country

 As per the views of Bahmani-Oskooee, Mohsen, et al it is divulged that the value of EURO currency has gone down due to the EURO financial crises on the international level. It is evaluated that the purchasing power parity of the investors in Europe will be facing high financial loss due to the foreign exchange risk exposure.  The purchasing power parity of the EURO currency has decreased throughout the time. It is observed that investors could use several options such as derivatives contract like forwarding contract, future contract, call option and put options to lock the future contract at the stipulated rate irrespective of the changes in the foreign currency values. As stated by McKinnon, Ronald and Kenichi Ohno, (42) it is depicted that these contracts are used by investors to save themselves from the foreign exchange risk exposures. The derivatives contracts and other future options assist investors to create the shield against for maintaining the stable purchasing power parity.

In addition to this, investors could also use fair value hedge technique to make interest rate swap between two countries to set strong purchasing power parity. Sometimes, investors use this swap option to create arbitrage profit in their international foreign exchange transactions. It is observed that arbitrage profit is earned by the investors at the time when there is high volatility in the market. As per the views of Liu, et al, (1781-1785), it is divulged that it is created by using the foreign exchange rate offered by different banks to investors.  The foreign currency swap is the option which is based on the hedge funding

As per the views of Bahmani-Oskooee, Mohsen, et al it is divulged that the value of EURO currency has gone down due to the EURO financial crises on the international level. It is evaluated that the purchasing power parity of the investors in Europe will be facing high financial loss due to the foreign exchange risk exposure.  The purchasing power parity of the EURO currency has decreased throughout the time. It is observed that investors could use several options such as derivatives contract like forwarding contract, future contract, call option and put options to lock the future contract at the stipulated rate irrespective of the changes in the foreign currency values. As stated by McKinnon, Ronald and Kenichi Ohno, (42) it is depicted that these contracts are used by investors to save themselves from the foreign exchange risk exposures. The derivatives contracts and other future options assist investors to create the shield against for maintaining the stable purchasing power parity.

Use of Fair Value Hedge Technique for Creating Arbitrage Profit

In addition to this, investors could also use fair value hedge technique to make interest rate swap between two countries to set strong purchasing power parity. Sometimes, investors use this swap option to create arbitrage profit in their international foreign exchange transactions. It is observed that arbitrage profit is earned by the investors at the time when there is high volatility in the market. It is created by using the foreign exchange rate offered by different banks to investors.  The foreign currency swap is the option which is based on the hedge funding technique and forward contracts which allow investors to book the future transactions at the stipulated exchange rate (Liu, et al, (1781-1785),

technique and forward contracts which allow investors to book the future transactions at the stipulated exchange rate.

There is another example to define the purchasing power parity of the investors of the one country.

Foreign exchange risk could be defined in the following parts which are given as below.

Transaction exposure- As stated by De Broeck, Mark, and Torsten Sløk, (368-383), it is divulged that it is the international foreign exchange risk faced by investors or companies indulged in international trade and inflow and outflow of cash from one country to another. This risk is defined as volatility in the currency exchange rate which will change after the time when the company in actual entered into the transactions.

Translation foreign risk exposure- As per the perception of Iyke, et al. (89-102), it is revealed that it is the risk which is determined on the basis of changes in the value of assets, liabilities, and income of the company. The changes in these values arise due to the volatile exchange rate one currency to another. Tesco and BHP Company have faced translation foreign risk exposure.

As stated by Kakwani, Nanak, and Hyun H. Son, (173-184), it is revealed that the impact of changes in the foreign currency exchange rate could be evaluated by using the example of two companies. BHP Billiton and Tesco are two international companies that have entered into international transactions. However, the total revenue and share price of the company has highly impacted by the foreign exchange risk exposure.

As per the views of Bahmani-Oskooee, Mohsen, et al, (463-483.), it is divulged that Tesco Company has high vulnerability in its business due to high fluctuation in its share price. The foreign exchange risk exposure of USD $ to AUD $ have been analyzed by using the share price of the company.

Conclusion

Figure 8: Tesco Stock and Exchange Risk

As stated by Lothian, James, (5-21), after evaluating the above-prepared chart, it is observed that the share price of the company is highly influenced by the strengthen USD $ on the international level as compared to other currencies. It is evaluated that the purchasing power parity of the AUD $ is less as compared to USD $. Therefore, while exporting goods to the US, Tesco might face the decrease in its inflow value (Bloomberg, 2017).

Figure 9: BHP Billiton and Exchange Risk

The impact of foreign currency exposure of these two countries is high which have highly influenced the share price of BHP Billiton. The major reason behind these impacts is based on the fact that most of the total revenue of company comes from the USA (Tenti, Paolo, 567-580)

Economic exposure- As per the perception of McKinnon, Ronald , and Kenichi Ohno., (42), it is reflected that the economic exposure of foreign exchange risk is based on the economic factors and balance of trade and purchasing power parity of country to another.  International investors in Europe have faced high foreign exchange loss due to the high volatility of the EURO currency and decreased in the foreign exchange value on the international level. However, AED United Arab Emirates Dirham has increased its value on the international level which resulted to strengthen currency value as compared to another country. It has also resulted in increased purchasing power parity of the investors of United Arab Emirates.

Therefore, after evaluating all the foreign exchange factors and risk exposure of investors towards the investment decisions, it could be inferred that as compared to other countries Purchasing power parity of the USA is strengthen which shows negative impact to the investors of US at the time of cash inflow from other country (Rogoff, Kenneth, (647-668),. Due to the strengthening US Dollar, investors have to depreciate their amount of cash inflow received in other currency value at the time converting the same in USD $ (Blanchard, Olivier, and Gustavo Adler).

Conclusion

Investors are more inclined towards investing their money in the international market with a view to creating value on their investment and hedge the foreign exchange risk of their currency value with another country. In this report, purchasing power parity and foreign exchange risk of the investors have been analyzed which reflects that investors could easily create value on their investment by using the hedging funds and forward contracts to create the shield against the foreign currency risk exposure. There are several economic and international foreign exchange risk factors which have negatively impacted the foreign currency value of the one country to another. It is analyzed that many companies and investors have faced high foreign exchange risk in their investment decisions. It is observed that the purchasing power parity is determined between more than two countries and their currency value to buy particular goods. Nonetheless, the higher the purchasing power parity of one currency is determined on the basis of the inflation rate and economic value. Now, in the end, it could be inferred that purchasing power parity of the US is high as compared to other countries on the international level. There are given several examples which show that the value of one currency is based on several factors. Each and every investor should use proper derivatives contracts and forward contracts to mitigate the foreign exchange risk. The purchasing power parity and economic foreign exchange exposure have the direct link with each other which shows that investors by using derivatives and future contract to mitigate the foreign exchange risk exposure.

References

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