Foreign Exchange Market
The foreign exchange market is one of the most important financial markets. It affects the relative price of goods between countries and so can affect trade. It means that it affects the price of imports and so affects a country’s price level (inflation rate). It also affects the international investment and financing decision. In this project, we will try to find why exchange rate would give many risks to a company and how a company can hedge itself.
Definition of Exchange Rate
The price of one currency expressed in terms of another currency is called an exchange rate. With the price it is normal to quote them as the price for one unit of the good. The price of a jacket is how much you have to pay to get 1 jacket. The price of a car is how much you pay to get 1 car. The exchange rate between AUS and US from AUS’s point of view is how many AUS dollars you have to pay to get 1 US dollar. Since you have to pay about AUS$1.55 to get 1 US dollar the exchange rate between AUS and US is 1.55. In this case, the US dollar is the “commodity” currency and the AUS dollar is the “terms” currency.
We denote this SAUS/US=1.55. If a currency appreciates it becomes worth more and so you need less of it to buy one unit of another currency. This makes imports cheaper. For example, if the AUS dollar appreciates then SAUS/US will fall from 1.55. On the other hand, If a currency depreciates it becomes worth less and so you need more of it to buy one unit of another currency. This makes imports more expensive. For example, if the AUS dollar appreciates then SAUS/US will rise from 1.55.
Why does FX give risks to a company?
Every daily exchange rate is changing over time. It might fluctuate slightly or go up and go down sharply. On the diagram1 is the daily exchange rate between AUS dollar and US dollar from 4 January 1999 to 17 March 2000. It shows that it fluctuates over time and the spread is from 0.6018 to 0.6738. If we consider this point, we can see how important the exchange is. For example, if the yearly international sales are $10 million US dollars and if the exporter wants to convert US dollars into AUS dollars, he/she may need to hedge for himself/herself. If the exporter can buy a forward contract in a year time at SUS/AUS=0.6138 in 1 January 1999, he/she will receive $AUS16.3 million dollars in 1 January 2000. However, if the exporter does not do anything about it, the exchange rate is SUS/AUS=0.6583 and he/she will only receive $AUS15.2 million dollars. There is a large difference between those two strategies about $AUS1.1 million dollars. Thus, we can how large the difference is.
However, there are still many other effects to affect the exchange rates such as:
A country’s economic condition has a great effect on the exchange rate such as inflation rate, interest rate. From theory, it can be observed in the...