If the new exchange rate would go up to 2%. Then, the new EURUSD would be:
Existing EURUSD: 1.1
New EURUSD: 1.1+ [1.1*2%] =1.1220
Hence, the Four decimal places in New EURUSD is .1220
(b):
We have given,
1 Euro = $1.1043
1 GBP = $1.2970
And we want to calculate one unit of GBP in terms of Euro, for this we have to apply following formula –
One unit of GBP in terms of USD
One GBP = _______________________________
One unit of EURO in terms of USD
1.2970
GBPEUR Rate = __________
1.1043
= 1.1745(EURO)
For understanding relationship between answer to part b of this question (stated above) and triangular arbitrage, firstly, we have to understand the meaning of triangular arbitrage.
Triangular Arbitrage: It is a process of finding an arbitrage opportunity from three different currencies in the foreign exchange market due to price difference in these currencies. It is also referred as cross currency arbitrage or three-point arbitrage (Reynolds, et. al., 2018).
Process of Triangular arbitrage: In this process we simultaneously convert one currency into another and so on and reach back with original currency which we have convert first. There are two ways to initiate this process which are –
1.Clockwise Arbitrage
2 Anticlockwise Arbitrage
Relationship between answer to part b of this question and triangular arbitrage: In both our answer and triangular arbitrage, there are 3 currencies involved. In our answer we calculate exchange rate through cross currency rate formula and also this formula is required to convert one currency to other (Reynolds, et. al., 2018).
Therefore, process used in answer to part b is same in all aspect as used in triangular arbitrage.
Home currency is US Dollar
Foreign currency is EUR
December 2017 1 EUR=1.144 US$
In accordance to Purchasing Price Parity assumption, there is only one price across the world and difference between exchange rate of different countries is due to difference in inflation rate of those countries (McKinnon and Ohno, 2016).
As exchange rate of US$ of December 2017 is higher than the exchange rate of January 2017 as compare to EUR that means that EUR is at forward premium.
By applying Purchasing Price Parity assumption in the given problem, it can have concluded that difference in exchange rate is due to inflation and inflation rate of EUR is higher than the inflation rate of US$ in year 2017 because for purchase of 1EUR it required 1.1US$ in January
2017 and for purchase of 1EUR it required 1.144US$ in December 2017.
Difference between forward and spot rate *100 * 365
Rate of inflation= _________________________________ __________
Spot Rate No. of days
1.144-1.1
Rate of inflation= ________ *100 =4% per annum
1.1
Exchange rate of January 2017 is 1EUR=1.1US$
If inflation rate of US is taken 3% higher than the euro, then real value of dollar will be calculated as follows:
Assume inflation rate of euro be 5%p.a.
Therefore, inflation rate of US will be 5+3= 8%
1+inflation rate of domestic country
Forward Rate= ___________________________________ * Spot Rate
1+inflation rate of foreign country
1.05
Spot Rate =_________ * 1.144 = 1.1122
1.08
Therefore, real value of dollar will be 1EUR=1.1122 US$
Change in Real value=1.1122-1.1=0.122
Change in Real value (%)=.0122/1.1*100=1.109%
(c)Change in real exchange rate can affect the currency in two ways: –
1.Positively-If home currency is appreciated as compare to foreign currency then it will increase the value of home currency in foreign exchange market.
2.Negatively-If home currency is depreciated as compare to foreign currency then it will decrease the value of home currency in foreign exchange market.
The foreign exchange rate can be increase or decrease due to following factors-
1.Rate of inflation- If inflation rate of a country increases as compare to other country then exchange rate of first mentioned country will decrease. Higher the inflation rate lowers the exchange rate (Hodrick, 2014).
2.Interest Rate- If interest rate of a country increase then it will allow more inflows of foreign investment in the country which will increase the value of foreign exchange. But when we repay the invested amount then our currency will have depreciated (Cairns, 2018).
3.National Income- If national income of person in a country increase then it will result in outflows of home currency it will negatively impact the home currency and home currency will depreciated (Blanchard and Johnson, 2017).
4.Balance of payment-If total receipt of foreign currency exceeds total payment of foreign currency during the year then it will have positive impact on home currency
5.Speculation- It can affect in both positively and negatively
6.Scarcity of resource- If there is scarcity of any resource in a country then it will result into outflows of home currency and therefore depreciate the home currency.
(d) Concept and effect of interest rate in foreign exchange can be understand with the help of Interest rate parity theory:
According to Interest Rate Parity, the forward rate of one currency will contain a premium (or discount) that is determined by the differential in interest rates between the two countries. As a result, covered interest arbitrage will provide a return that is no higher than a domestic return.
And higher interest rate increases the value of a country ‘s currency. Higher interest rates tend
to attracts foreign investments, increasing the demand for and value of home country ‘s currency. Conversely, lower interest rates tend to be unattractive for foreign investment and decrease the currency ‘s relative value (Du, et. al., 2018).
Effect on foreign exchange rates due to change in interest rate can be understand by following steps: –
Step1. Increase in US interest rate.
Step2. Better return on US saving account
Step3. ‘Hot Money Flows’ in to take advantage of high interest rate.
Step4. Increased demand of US $
Step5. Appreciation in value of US$
Therefore, it can be concluded that if the interest rate of US (Home Currency) is higher than Euro area (Foreign
Currency), then the value of US currency will also be in increased so it always be expected that interest rate of US
currency will increase so that value of US currency will be increased as compare to EURO.
(e) In European counties rate of interest of government bond is determined by the European Central Bank and national government which are same with other countries of Europe. But due to following factors practically the interest rate of government bond is different: –
1.The government directives to the central bank to accomplish the government’s goal
2.The currency of the principal sum lent or borrow.
3.The term to maturity of the investment.
4.The perceived default probability of the borrower
5.The supply and demand in the market.
6.Interest rate can fluctuate accordance to status of economy.
For understanding comparison between country risk and exchange rate volatility, we have understood the following terms –
Country Risk: Country risk is a risk related to country’s economic and/or political risk which may affect the businesses and investment opportunities. For example, investment in one country, let us say, in United States is not same as investment in Australia, because of separate risks which are depending country to country (Brooke, 2016). It can be divided into two major groups, which are –
1.Political Risk
2.Economic Risk
Political Risk: Risk which is associated with country’s political environment, their politicians and impact of political decisions on businesses. For example, desperate politicians may impose a risk to investors in certain strategic industries because of supportive nature for nation (McKellar, 2017).
Economic Risk: It is a risk which is associated with country’s financial condition and country’s ability to repay its debt. For example, high debt-to-GDP ratio of a country may not easily allow to a country to raise funds(money) in international market and this makes a country risky for its domestic economy (Lin, et. al., 2018).
For understanding the exchange rate volatility, firstly we should understand the following term –
Exchange Rate: It is a rate at which one currency can be converted into another currency. Exchange Rate allows us to determine how much of one currency is required to gain another currency (Boon and Hook, 2017).
Exchange Rate Volatility: Exchange rate volatility refers to the tendency for foreign currencies to appreciate or depreciate in value, thus affecting the profitability of foreign exchange trades. The volatility is the measurement of the amount that these rates change and the frequency of those changes. There is a vast amount of studies on the impact of exchange rate volatility on international trade, as a result we may consider that volatility in exchange rate for short period of time has no such impact on the international trade but exchange rate volatility in long period of time has very vast impact on international trade (Brooke, 2016).
Why there is a change in Exchange Rate? This is very important question and this is depending on following factors –
Interest Rate: There is a positive correlation between country’s interest rate and its exchange rate. This mean if interest rate of one country is more in relation to other country than its currency is appreciated as compared to other currency higher interest rates provide higher rates to lenders, thereby attracting more foreign capital, which causes a rise in exchange rates (Hajilee and Al Nasser, 2014).
Inflation Rate: Changes in market inflation cause changes in currency exchange rates. A country with a lower inflation rate than another, will see an appreciation in the value of its currency. The prices of goods and services increase at a slower rate where the inflation is low. Relationship between inflation rate and exchange rate can be understand through purchasing power parity (PPP) (Brooke, 2016).
Balance of Payment: It means country’s current account balance. In other words, it reflects balance of trade & investment in foreign countries. If a country spends its currency more on imports than compared to exports, then it results in decline in its own currency. Balance of payments fluctuates exchange rate of its domestic currency (Gibson and Thirlwall, 2016).
Government Debt: Govt. debt means national debt owned by central government. If the market predicts government debt within a certain country, then investors will sell their bonds in the open market. This results in a decrease in the value of its exchange rate will follow (Greenwood, et. al., 2015).
Political Stability & Performance: A country’s political state and economic performance can affect its currency strength. If there is a stability in political environment of a country, then it is more attractive to foreign investors, as a result, drawing investment away from other countries and invest with more political and economic stability. Increase in foreign capital, in turn, leads to an appreciation in the value of its domestic currency (Tunc, et. al., 2018).
Techniques for hedging exchange rate volatility risk: These can be categorised in two groups which are –
Invoicing
Netting
Leading & Lagging
Outsourcing
2.External Technique:
Forward Contract
Money market Cover
Futures
Options
Comparison Between Country Risk Analysis and Exchange Rate Volatility: It is very important to analysis the country risk to identify the related aspect which are necessary for determination of exchange rate volatility. If there is more country risk, then there should be more volatile exchange rate (Brooke, 2016). It can be summarised in following points –
If there is no political stability, then there is more country risk. As a result, there should be more volatile exchange rate
In country risk analysis, we analysis the risk as a whole related to nation but in exchange rate volatility, we consider the risk related to volatility of exchange rate which is covered only in forex market (den Bossche, et. al., 2017).
In analysis of country risk, we take various measurement to overcome from more country risk which negatively affect the country but in exchange rate volatility, there are various techniques which are used to hedge currency risk exposure (Alper, 2017).
If there is an appreciation in the currency due to positive exchange rate volatility, then it means that there are less country risk in that aspect (Hirst, et. al., 2015).
Exchange rate volatility has a positive impact on one currency and negative impact on other currency. It means that one country has low risk as compared to other country (Matsushita, et. al., 2015).
The exchange rate is of great importance and can affect the overall growth and development of the country’s trade and economy. Thus, the country should try to make their currency strong and try to stabilize their exchange rate so as to improve the country’s trade and economics. As a result, there should be stable political and economic condition in the country (Boon and Hook, 2017).
When a country experiences a recession, its interest rates are likely to fall, decreasing its chances to acquire foreign capital. As a result, its currency weakens in comparison to that of other countries, therefore lowering the exchange rate. Recession is a country risk, we should analysis this to overcome from this situation (Tunc, et. al., 2018).
Globalization is the speedy segregation of the entire economy which helps the companies in creating the interlinks in several ways. Globalization enhances betterment in the international trade practices and communication of different countries. Since last 25-35 years there is the marvellous increment in the globalization accordance with the increment in number of multinational corporations which expands their businesses in several number of countries and operates from their home country (Steger, 2017). MNC’ s used to develop their production centres at different places in different countries but generally at those places where there is the availability of cheap labour, markets are close, where the government policies face later their interests, where there is availability of raw materials etc. this kind of places are beneficial for MNC’ s in order to reduce the costs of goods and for maximising the profits. After the production of goods in huge quantity the MNC’ s sells their products in different countries. This creates the interlinks between MNC’ s and different economies of different nations and promotes the globalization (Baylis, et. al., 2017).
The benefits for the developing interlink helps in “homogenization of global culture” as this statement is given by several authors in their articles. In present times due to increasing role of multinational corporations in the contemporary world economy, leads to availability of same products with the same logos, same movies, same brands for different items, everybody eats at the same restaurants and same drinks. In this scenario, the logos and brands efforts of MNC’ s symbolises the globalization across the different nations and throughout the entire world economy (Ashford and Hall, 2018). The multinational corporations ensure enhancement of the Foreign Direct Investment (FDI), the value-added activities in several countries are controlled and managed by these MNC’ s. In present time, the multinational corporations give the priority to manufacturing and services related with the extraction of raw materials and commodities. FDI scheme also beneficial for the funding form the international markets. These MNC ‘s focuses on the adaptation of the advanced technologies as it is essential for maintaining the quality of products and reducing the costs increasing the production within time and costs effective manner. This helps in maximisation of their profitability (Tarasenko, et. al., 2018).
The World Trade Organisation and the Organisation for Economies Cooperation and Development framed some rules and regulations for promoting the fair-trade practices throughout the entire world economy. Besides this, the World Trade Organisation also focuses on betterment of the role transportation and communications technologies that leads to reduction in costs incurred in managing the far-flung economic operations. The MNC ‘s promotes the advancement of the computing and telecommunication technologies, these technologies help in managing the operations of the business in different countries and in different time zones. As the main ordeals of globalization is distances, this all advancement in transportations and communications are made in order to reduce the effects of this obstacle (Light, 2018). There some advantages of the expansion of globalization or the ‘MNC’ s promotes the globalization is good for the entire economy” for supporting this statement some advantages are as follows.
Books and Journals:
Alper, A.E., 2017. Exchange Rate Volatility and Trade Flows. Fiscaoeconomia, 1(3), pp.14-39.
Ashford, N.A. and Hall, R.P., 2018. Globalization: Technology, trade regimes, capital flows, and the global financial system. In Technology, Globalization, and Sustainable Development (pp. 264-333). Routledge.
Atack, J., 2018. Estimation of economies of scale in nineteenth century United States manufacturing. Routledge.
Baylis, J., Smith, S. and Owens, P. eds., 2017. The globalization of world politics: an introduction to international relations. Oxford University Press.
Beck, U., 2018. What is globalization? John Wiley & Sons.
Blanchard, O. and Johnson, D.R., 2017. Macroeconomics. London usw.: Prentice-Hall International Inc.
Boon, T.H. and Hook, L.S., 2017. Real exchange rate volatility and the Malaysian exports to its major trading partners. In ASEAN in an Interdependent World: Studies in an Interdependent World (pp. 95-117). Routledge.
Brooke, M.Z., 2016. Handbook of international financial management. Springer.
den Bossche, V., Henry, P.L. and Zdouc, W., 2017. The Law and Policy of the World Trade Organization: Text, Cases and Materials. Cambridge University Press.
Du, W., Tepper, A. and Verdelhan, A., 2018. Deviations from covered interest rate parity. The Journal of Finance, 73(3), pp.915-957.
Gibson, H.D. and Thirlwall, A.P., 2016. Balance-of-payments theory and the United Kingdom experience. Springer.
Greenwood, R., Hanson, S.G. and Stein, J.C., 2015. A Comparative?Advantage Approach to Government Debt Maturity. The Journal of Finance, 70(4), pp.1683-1722.
Hajilee, M. and Al Nasser, O.M., 2014. Exchange rate volatility and stock market development in emerging economies. Journal of Post Keynesian Economics, 37(1), pp.163-180.
Hirst, P., Thompson, G. and Bromley, S., 2015. Globalization in question. John Wiley & Sons.
Hodrick, R., 2014. The empirical evidence on the efficiency of forward and futures foreign exchange markets. Routledge.
Light, A., 2018. The development of world trade organization law: Examining change in international law [Book Review]. Australian Year Book of International Law, 35, p.224.
Lin, S., Shi, K. and Ye, H., 2018. Exchange rate volatility and trade: The role of credit constraints. Review of Economic Dynamics.
Matsushita, M., Schoenbaum, T.J., Mavroidis, P.C. and Hahn, M., 2015. The World Trade Organization: law, practice, and policy. Oxford University Press.
McKellar, R., 2017. A short guide to political risk. Routledge.
McKinnon, R.I. and Ohno, K., 2016. 7 Purchasing power parity as a monetary. The Future of the International Monetary System: Change, Coordination of Instability? Change, Coordination of Instability? p.42.
Reynolds, J., Sögner, L., Wagner, M. and Wied, D., 2018. Deviations from Triangular Arbitrage Parity in Foreign Exchange and Bitcoin Markets.
Steger, M.B., 2017. Globalization: A very short introduction (Vol. 86). Oxford University Press.
Tarasenko, O., Yermakov, Y. and Pchelin, V., 2018. FORMATION OF COMPETITIVE ADVANTAGES OF ENTERPRISES IN TERMS OF GLOBALIZATION: COMPETITIVE DYNAMICS AND AN INTELLECTUAL COMPONENT. Baltic Journal of Economic Studies, 3(5), pp.469-473.
Tunc, C., Solakoglu, M.N., Babuscu, S. and Hazar, A., 2018. Exchange rate risk and international trade: The role of third country effect. Economics Letters, 167, pp.152-155.
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