FOREIGN EXCHANGE MARKET

1. Define foreign exchange market, foreign exchange rate, and foreign exchange
risk.
● Foreign exchange market
The foreign exchange market (also known as forex, FX, or the
currency market) is an over-the-counter (OTC) global marketplace that
determines the exchange rate for currencies around the world.
Participants are able to buy, sell, exchange, and speculate on
currencies. Foreign exchange markets are made up of banks,forex
dealers, commercial companies, central banks, investment
management firms, hedge funds, retail forex dealers, and investors.

In terms of trading volume it is, by far, the largest financial market in

the world. Aside from providing a venue for the buying, selling,
exchanging, and speculation of currencies, the forex market also enables
currency conversion for international trade settlements and investments.
Currencies are always traded in pairs, so the "value" of one of the
currencies in that pair is relative to the value of the other. This determines
how much of country A's currency country B can buy, and vice versa.
Establishing this relationship (price) for the global markets is the main
function of the foreign exchange market. This also greatly enhances
liquidity in all other financial markets, which is key to overall stability.

(Source: Akhilesh Ganti, 2020)

● Foreign Exchange Rate
A foreign exchange rate is the price of the domestic currency
stated in terms of another currency. In other words, a foreign exchange
rate compares one currency with another to show their relative values.
Since standardized currencies around the world float in value with
demand, supply, and consumer confidence, their values change relative to
each over time. (https://www.myaccountingcourse.com/accounting-
dictionary/foreign-exchange-rate
A currency's exchange rates may be floating (that is, they may
change from day to day or they may be pegged to another currency. A
floating exchange rate is dependent on the supply and demand of the
involved currencies, as well as the amount of the currency held in foreign
reserves. On the other hand, a government may peg its currency to a
certain amount in another currency or currency basket. For example, the
Qatari riyal has been worth 0.274725 dollars since 1980.
 An advantage to a floating exchange rate is the fact that it tends to
be more economically efficient. However, floating exchange rates tend to
be more volatile, depending on the particular currency. Pegged exchange
rates are generally more stable, but, since they are set by government fiat,
they may take political rather than economic conditions into account. For
example, some countries peg their exchange rates artificially low with
respect to a major trading partner to make their exports to that partner
artificially cheap.

(Farlex Financial Dictionary. © 2012 Farlex, Inc. All Rights Reserved)

❖ Types of Exchange Rates:

1.Free Floating

A free-floating exchange rate rises and falls due to changes in the

foreign exchange market.

2. Restricted Currencies

Some countries have restricted currencies, limiting their exchange

to within the countries' borders. Also, a restricted currency can have its
value set by the government.

3. Currency Peg

Sometimes a country will peg its currency to that of another nation.

For instance, the Hong Kong dollar is pegged to the U.S. dollar in a range
of 7.75 to 7.85.2 This means the value of the Hong Kong dollar to the U.S.
dollar will remain within this range.

4. Onshore Vs. Offshore

Exchange rates can also be different for the same country. In some
cases, there is an onshore rate and a rate. Generally, a more favorable
exchange rate can often be found within a country’s border versus outside
its borders. China is one major example of a country that has this rate
structure. Additionally, China's yuan is a currency that is controlled by the
government. Every day, the Chinese government sets a midpoint value for
the currency, allowing the yuan to trade in a band of 2% from the midpoint.

5.Spot vs. Forward

Exchange rates can have what is called a spot rate, or cash value,
which is the current market value. Alternatively, an exchange rate may
 have a forward value, which is based on expectations for the currency to
rise or fall versus its spot price. Forward rate values may fluctuate due to
changes in expectations for future interest rates in one country versus
another. For example, let's say that traders have the view that the
eurozone will ease monetary policy versus the U.S. In this case, traders
could buy the dollar versus the euro, resulting in the value of the euro
falling.

6.Quotation

Typically, an exchange rate is quoted using an acronym for the

national currency it represents. For example, the acronym USD represents
the U.S. dollar, while EUR represents the euro. To quote the currency pair
for the dollar and the euro, it would be EUR/USD. In this case, the
quotation is euro to dollar, and translates to 1 euro trading for the
equivalent of $1.13 if the exchange rate is 1.13. In the case of the
Japanese yen, it's USD/JPY, or dollar to yen. An exchange rate of 100
would mean that 1 dollar equals 100 yen.

Source: https://www.investopedia.com/terms/e/exchangerate.asp
Foreign Exchange Risk
Foreign exchange risk refers to the losses that an international financial
transaction may incur due to currency fluctuations. Also known as currency risk,
FX risk and exchange-rate risk, it describes the possibility that an investment’s
value may decrease due to changes in the relative value of the involved
currencies. Investors may experience jurisdiction risk in the form of foreign
exchange risk.
Foreign exchange risk arises when a company engages in financial
transactions denominated in a currency other than the currency where that
company is based. Any appreciation/depreciation of the base currency or the
depreciation/appreciation of the denominated currency will affect the cash flows
emanating from that transaction. Foreign exchange risk can also affect investors,
who trade in international markets, and businesses engaged in the import/export
of products or services to multiple countries.
The proceeds of a closed trade, whether it's a profit or loss, will be
denominated in the foreign currency and will need to be converted back to the
investor's base currency. Fluctuations in the exchange rate could adversely affect
this conversion resulting in a lower than expected amount.
An import/export business exposes itself to foreign exchange risk by
having accounts payable and receivables affected by currency exchange rate.
This risk originates when a contract between two parties specifies exact prices
for goods or services, as well as delivery dates. If a currency’s value fluctuates
 between when the contract is signed and the delivery date, it could cause a loss
for one of the parties.

❖ Three types of foreign exchange risk

1. Transaction risk

This is the risk that a company faces when it's buying a product from a
company located in another country. The price of the product will be
denominated in the selling company's currency. If the selling company's
currency were to appreciate versus the buying company's currency then
the company doing the buying will have to make a larger payment in its
base currency to meet the contracted price.

2. Translation risk

A parent company owning a subsidiary in another country could face

losses when the subsidiary's financial statements, which will be
denominated in that country's currency, have to be translated back to the
parent company's currency.

3. Economic risk
Also called forecast risk, refers to when a company’s market value is
continuously impacted by an unavoidable exposure to currency
fluctuations.
Companies that are subject to FX risk can implement hedging strategies
to mitigate that risk. This usually involves forward contracts, options and other
exotic financial products and, if done properly, can protect the company from
unwanted foreign exchange moves.

(Source: Akhilesh Ganti, 2020)

https://www.investopedia.com/terms/f/foreignexchangerisk.asp

2. Describe the background and history of foreign exchange markets.

Foreign exchange dates back to ancient times, when traders first began
exchanging coins from different countries. However, the foreign exchange itself is
the newest of the financial markets. In the last hundred years, the foreign exchange
has undergone some dramatic transformations. The Bretton Woods Agreement, set
up in 1944, remained intact until the early 1970s. Trading volume has increased
rapidly over time, especially after exchange rates were allowed to float freely in
1971. In 1971, the Bretton Woods Agreement was first tested because of
uncontrollable currency rate fluctuations, by 1973 the gold standard was abandoned
by president Richard Nixon, currencies were finally allowed to float freely.
 Thereafter, the foreign exchange market quickly established itself as the financial
market. Before the year 1998, the foreign exchange market was only available to
larger entities trading currencies for commercial and investment purposes through
banks, now online currency trading platforms and the internet allow smaller financial
institutions and retail investors access a similar level of liquidity as the major foreign
exchange banks, by offering a gateway to the primary (Interbank) market.

FOREX refers to the Foreign Currency Exchange Market in which over

4,600 International Banks and millions of small and large speculators participate
worldwide. Every day this worldwide market exchanges more than $1.7 trillion in
dozens of different currencies. With the current growth rate the market is projected
to grow to more than $1.9 trillion per day by the year 2006. With such volume, one
can assume that the forex market is extremely volatile, changing at a moment’s
notice, depending on conditions within that country.

(Source: Violeta Gaucan, Titu Maiorescu University, Bucharest, Romania,

INTRODUCTION TO THE FOREIGN EXCHANGE MARKET)

http://www.scientificpapers.org/wp-
content/files/1120_Introduction_to_the_foreign_exchange_market.pdf ·

3. Enumerate ways that financial institutions can use to hedge foreign exchange risk.
Financial institutions can use foreign exchange derivatives to hedge their
exposure to foreign exchange risks.
❖ Popular foreign exchange derivatives
1. Forward contract is a customized derivative contract obligating
counterparties to buy (receive) or sell (deliver) an asset at a
specified price on a future date. Since the terms of the agreement
are customized when the contract is executed, a forward contract is
not subject to price fluctuations.
2. Currency Futures Contracts is a standardized contract that
specifies an amount of a particular currency to be exchanged on a
specified date and at a specified exchange rate. A firm can
purchase a futures contract to hedge payables in a foreign currency
by locking in the price at which it could purchase that specific
currency at a particular point in time.
3. Currency swap is an agreement that allows one currency to be
periodically swapped for another at specified exchange rates. It
essentially represents a series of forward contracts. Commercial
banks facilitate currency swaps by serving as the intermediary that
links two parties with opposite needs.
4. Currency option provides the right to purchase a particular
currency at a specified price (called the exercise price) within a
specified period. This type of option can be used to hedge future
 cash payments denominated in a foreign currency. If the spot rate
remains below the exercise price, the option will not be exercised
because the firm could purchase the foreign currency at a lower
cost in the spot market. However, a fee (or a premium) must be
paid for options, so there is a cost to hedging with options even if
the options are not exercised.

4. Identify the role of financial institutions in foreign exchange transactions

Financial institutions are increasing their use of the foreign exchange
markets to exchange currencies. They are also increasing their use of foreign
exchange derivatives to hedge their investments in foreign securities.
Specifically:
a. Commercial banks
● Serve as financial intermediaries in the foreign exchange market by
buying or selling currencies to accommodate customers.
● Speculate on foreign currency movements by taking long positions
in some currencies and short positions in others.
● Provide forward contracts to customers.
● Some commercial banks offer currency options to customers;
unlike the standardized currency options traded on an exchange,
these options can be tailored to a customer’s specific needs.
b. International mutual funds
● Use foreign exchange markets to exchange currencies when
reconstructing their portfolios.
● Use foreign exchange derivatives to hedge a portion of their
exposure
c. Brokerage firms and securities firms
● Some brokerage firms and securities firms engage in foreign
security transactions for their customers or for their own accounts.
d. Insurance companies
● Use foreign exchange markets when exchanging currencies for
their international operations.
● Use foreign exchange markets when purchasing foreign securities
for their investment portfolios or when selling foreign securities.
● Use foreign exchange derivatives to hedge a portion of their
exposure.
e. Pension funds
● Require foreign exchange of currencies when investing in foreign
securities for their stock or bond portfolios.
● Use foreign exchange derivatives to hedge a portion of their
exposure.
5. Reflect on the reasons why companies expand to other countries.
There are several reasons why companies expand to other countries. It is
to improve their prospects for growth as it offers a chance to explore markets and
gain access to millions of customers, thus increasing sales. Also, to diversify
which results in a more stable revenue. Thus, they will not be dependent on a
single economy. So if the domestic market is slowing down, having the
advantage of a global market will help cushion the companies during slower
economic times

6. Discuss the major factors that complicate financial management in multinational

firms.
There are factors that complicate financial management in multinational
firms. These are the following:
1. Different currency denominations
Cash flows occur in various currencies. Hence, exchange rates
must be included in all financial analyses.
2. Political risk
Nations are free to place constraints on the transfer or use of
corporate resources, and they can change regulations and tax rules at any
time. They can even expropriate assets within their boundaries. Therefore,
political risks occur in many forms and they must be addressed explicitly in
any financial analysis.
3. Exchange rate fluctuations
A multinational corporation’s consolidated reported earnings will be
affected by exchange rate fluctuations even if the company’s cash flows
are not affected. A weaker dollar tends to inflate the reported earnings of a
company’s foreign subsidiaries.
7. Discuss what exchange rates and cross exchange rates are.
An exchange rate is the value of a nation’s currency versus the currency
of another nation. Simply, it is the current rate at which one currency can be
exchanged for another. An exchange rate has two components, the domestic
currency and foreign currency, and can be either directly and indirectly quoted.
The US dollar (USD) is the currency against which all other currencies are
priced. In some instances, however, the exchange rate between two nondollar
currencies is needed. Any exchange rate that does not involve the USD is
considered a “cross rate” or cross exchange rate. The idea of cross rates implies
two exchange rates with a common currency, which enables you to calculate the
exchange rate between the remaining two currencies.

8. Differentiate direct from indirect quotation.

 In a direct quotation, the price of a unit of foreign currency is expressed in
terms of the domestic currency; 1 foreign currency unit = x home currency units.
In an indirect quotation, the price of a unit of domestic currency is expressed in
terms of the foreign currency; 1 home currency unit = x foreign currency units. In
a direct quotation, the home currency will always be in the numerator while the
foreign currency will always be the denominator and indirect quotation is on the
contrary. Like for example from a Bangladesh perspective (the currency is BDT
or Bangladeshi Taka) a direct quote is expressed as BDT/US$ and an indirect
quote is expressed as US$/BDT. So when in a direct quote BDT 83/US$; under
the indirect quote it would be $0.012/BDT. Hence, the relationship between direct
and indirect quote is one is the reciprocal of the other.

9. Derive direct quotation from indirect quotation and vice versa

● An indirect quote can be derived from a direct quote using this formula:

Indirect Quote= 1/Direct Quote

Example: If direct quote is Rs (Indian Rupee), *45/ US $, how can this exchange
rate be presented under indirect quote?

* which means 45 Indian Rupee will buy 1 US$

Indirect Quote=1/Rs. 45/ US$ (Simply dividing 1 by 45)

= US $ 0.0222/Rs

This means that 0.0222 US$ will buy 1 Indian Rupee

● A direct quote can be derived from an indirect quote using this formula:

Direct Quote= 1/Indirect Quote

Example: If indirect quote is US $ 0.018/Rs, how can this exchange rate be

shown under direct quote?

Direct Quote= 1/US $ 0.018 (Simply dividing 1 by 0.018)

= Rs. 55.55/US $
This means that 1 US dollar could be exchanged for 55.55 Indian Rupee

10. Compute cross exchange rates given that three or more currencies are involved.

There are two cases in computing cross exchange rates:

a. Two foreign exchange quotes where the order of the currencies is the
same. It means that in both quotes the common currency is the
denominator. For example, you have quotes for JPY/USD (yen/dollar)
and EUR/USD (euro/dollar). You want to find out the JPY/EUR. This
can be solved by dividing the first rate by the second:

JPY/USD ÷ EUR/USD = JPY/EUR

Because the denominator, a common currency (in this case the dollar), is
the same, you can cross- cancel it.

Example: Given the following exchange rates:

76.25¥/$
0.7850€/$
What is the exchange rate in between Euro and Japanese Yen?

The cross rate is:

(76.25¥/$) ÷ (0.7850€/$) = 97.13 ¥/€

b. Two foreign exchange quotes where the order of currencies is different.

Let’s stick with the currencies from the previous example. This time you
have quotes for USD/JPY and EUR/USD. You still want to find out the
JPY/EUR. This can be solved by finding first the reciprocal of a fraction to
get the common currency which is the USD:

1 ÷ USD/JPY = JPY/USD

Once you’ve done this, line your quotes up and do the same as before,
dividing the first rate by the second:

JPY/USD ÷ EUR/USD = JPY/EUR

Example: Given the following exchange rates:

0.0096$/¥
0.85€/$
What is the exchange rate in between Euro and Japanese Yen?

The cross rate is:

1 ÷ (0.0096$/¥) = 104.17 ¥/$

104.17 /$ ÷ 0.85€/$ = 122.55¥/€

 11. Solve problems regarding profit or loss when selling and production locations are
different.
A foreign exchange profit/loss occurs when a company buys or sells
assets ( goods, services, or financial asset) in a foreign currency and that
currency fluctuates relative to home currency. Hence it can create a difference in
value in the monetary asset and liabilities which must be recognized until they
are ultimately settled.
If the value of the home currency declines after the conversion, the seller
will have incurred a foreign exchange loss. If the value of the home currency
increases after the conversion the seller of the goods will have made a currency
gain. Profit or loss in foreign exchange market can be computed as:

Profit/Loss= Value of currency at time of payment - value of currency at point of

sale

On November 1, 2020 US Technology Company sold 500 stocks to a Thai

Investor and is expecting to receive 30 000 000 Baht on December 1, 2020. The
current spot rate is TBH 30/$. At the time of payment unexpectedly the spot rate
moves to 32 TBH/$. Did the US Technology Company make a gain or loss on
the sale and by how much?

Profit/Loss= Value of currency at time of payment - value of currency at point of

sale
30 000 000TBH 30000 000 TBH
= −
32TBH /$ 30 TBH /$
= $937 500 - $1 000 000
Loss = -$ 62 500

12. Differentiate fixed from floating exchange rate system.

An exchange rate system, also called a currency system, establishes the way in
which the exchange rate is determined, i.e., the value of the domestic currency with
respect to other currencies. In currency markets we can talk about the 2 types of
currency systems which are the fixed and floating exchange rate system.

Fixed also called “pegged” exchange rate system is when some currency may be
pegged to another currency or a unit of account. The government sets and maintains
the fixed currency with the help of its central bank. To maintain the rate, the central
bank needs to have a high level of foreign currency reserves which will be used to
ensure an appropriate money supply and fluctuation in the market. This has lower
exchange rate risk because of the fixed rate. Floating exchange rate is a constant
change of currency depending on the supply and demand of foreign exchange and has
higher risk because of the fluctuation. Foreign exchange markets determine the rate.
This system has two types; dirty float and freely floating system. Dirty float is when the
rate set by the market is subject to some government intervention. Central banks
intervene mainly to maintain order and stability. Freely floating system is completely free
from government intervention. At present the Philippines is implementing the floating
exchange rate.

13. Differentiate currency appreciation from depreciation and differentiate currency

devaluation from currency revaluation.

Currency depreciation or appreciation are applied when there is a change in

value of the currency in a floating exchange rate because of the demand and supply in
the market force. Currency appreciation refers to an increase in the value of one
currency in terms of another currency. This happens when the demand of a currency
exceeds the supply of a currency for sale. In such a case the foreign exchange dealer
will increase the quoted price of that currency because of the shortage of such currency.
For example $1 falls from € 60 to € 45 because of the increased demand of European
goods and securities by Americans this means that euro currency becomes more
valuable and less of it is required to buy the US currency. In this sense appreciation
shows a rise in the price of one currency in relation to another currency. In the long run
appreciation will lead to an increase in imports from US countries as American goods
will become relatively cheaper now.

In contrast, currency depreciation refers to a decrease in the value of one

currency in relation to another currency. This happens when the supply for sale
exceeds the demand of such currency. Thus dealers will have to lessen the quotes
price to entice buyers of such exchange. For example European corporations begin to
purchase more U.S. goods and European investors purchase more U.S. securities, the
opposite forces will occur. There will be an increased sale of euros in exchange for
dollars, causing a surplus of euros in the market. The value of the euro will therefore
decline as $1 arises from € 40 to € 45.With the same amount of US currency more
European goods ang security can be purchased. Hence exports to the US will increase
as they will become relatively cheaper.

Currency devaluation and revaluation applies in a fixed exchange rate system in

which the country's government or monetary authority decides to alter the home
currency value. Currency devaluation deliberate downward adjustment in the official
exchange rate reduces the currency's value.Devaluation exists when the interaction of
market forces and policy decisions has made the currency's fixed exchange rate
untenable. According to Global Financial Data when devaluation occurs investors were
advised to purchase securities rather than to sell securities in the market at a lower
price in that devalued currency. However this is a threat to corporations who have
foreign debt for they need more currency to pay their international debt which
sometimes will cause bankruptcy to a company. On the other hand a revaluation is an
upward adjustment in the domestic fixed exchange rate which increases the currency's
value. Thus domestic investors are advised to sell stocks and will lessen the financial
cost paid to foreign creditors.

14. Describe trading in foreign exchange and differentiate spot rates from forward rates.
Foreign exchange is a network of buyers and sellers, who transfer
currency between each other at an agreed price. This consists of a global
telecommunications network among the large commercial banks that serve as
financial intermediaries for such exchange. These banks are located in New
York, Tokyo, Hong Kong, Singapore, Frankfurt, Zurich, and London. Foreign
exchange transactions at these banks have been increasing over time. At any
given time, the price at which banks will buy a currency (bid price) is slightly
lower than the price at which they will sell it (ask price). Like markets for other
commodities and securities, the market for foreign currencies is more efficient
because of financial intermediaries (commercial banks). Otherwise, individual
buyers and sellers of currency would be unable to identify counterparties to
accommodate their needs.
A spot rate is the quoted price for a unit of foreign currency to be delivered
“on the spot,” or within a very short period of time. For an instance £0.8425/$, is
a spot rate as of the close of business on July 25, 2005. A forward exchange
rate is the quoted price for a unit of foreign currency to be delivered at a specified
date in the future. If today were July 25, 2005, and we wanted to know how many
pounds we could expect to receive for our dollars on January 25, 2006, we would
look at the six-month forward rate, which was £0.5740/$. Note that a forward
exchange contract on July 25 would lock in this exchange rate, but no currency
would change hands until January 25, 2006. The spot rate on January 25 might
be quite different from £0.5740, in which case we would have a profit or a loss
on the forward purchase.

15. Identify if the forward rate is trading at a discount or at a premium.

A forward rate is an interest rate applicable to a financial transaction that
will take place in the future. If the forward rate is lesser than the spot rate the
forward rate is trading at a discount and if the forward rate is greater than the
spot rate, the forward rate is trading at a premium. The spot rate is the current
rate of exchange.

16. Explain and solve problems regarding interest rate parity

● Interest rate parity is a theory to predict forward foreign exchange rates.
These foreign exchange rates are predicted based on the hypothesis that
the interest rate differential between two countries should offset the
forward exchange rate and the spot exchange rate.
 ● Interest rate parity describes an ideal situation where the spot and foreign
exchange rates of two countries are in equilibrium. This theory suggests a
strong relationship between interest rates and exchange rates.
● According to the Interest Rate Parity theory, there is a direct relationship
between the interest rates in two countries and the differences in the
exchange rate of those countries.
● This theory conveys that if the interest rates in two countries are different,
then the exchange rate of the currencies of those countries will also be
different in accordance with the interest rate of the countries after a
specific period of time usually taken as one year.

Or

F0 = S x (1 + ia / 1 + ib)

Where F is the forward exchange rate while S is the spot exchange rate. The
interest rates for Country A and Country B are represented by ia and ib
respectively.

Example:

Spot exchange rates between two currencies, the Great Britain Pounds (£) and
the United State Dollars ($) is given as below:

£1 GBP = $1.25 USD

$1 USD = £0.8 GBP

 The interest rate in the United Kingdom is 8% while the interest rate in the United
States is 12%. Assuming a company in the United Kingdom wants to borrow
£10,000 in the UK and invest it in the United States, the forward exchange rate
can be calculated first as:

This means that the future exchange rate in a year’s time will be £0.771 for $1
instead of £0.8 for $1. As suggested before, because the interest rate of the UK is
lower, the value of the GBP will rise in comparison to the US that has a higher interest
rate.

So instead the spot exchange rate is $1.25 for every £1, in a year’s time, due to
interest rate differences, it will be $1.30 ($1 / £0.771) for every £1.

This means that the company must first convert the £10,000 to USD, and will
receive $12,500. This $12,500 will make the company an interest income of $1,500
($12,500 x 12%) once invested. Therefore, the company will receive a total of $14,000
($12,000 + $1,500) in one year. After the year, when the company converts it back to
GBP, it will receive approximately £10,800 ($14,000 x 0.771).

However, if the same money were invested in the UK, it would have yielded an
interest income of £800 (£10,000 x 8%). This would have made the total amount of
£10,800 (£10,000 + £800) at the end of the year.

This is what interest parity suggests. The difference in the interest rates of
the two countries was offset by the difference in the spot exchange rate and the
forward exchange rate of the currencies of the two countries in a year.

https://www.cfajournal.org/interest-rate-parity/

17. Identify if currency is at a forward premium or at a forward discount.

The currency is at a forward premium when the forward or the expected
future price for a currency is greater than the spot price. It is an indication by the
market that the current domestic exchange rate is going to increase against the
other currency. The currency is at a forward discount when the forward or
expected future price for a currency is less than the spot price. It is an indication
by the market that the current domestic exchange rate is going to decline against
another currency.
https://www.investopedia.com/terms/f/forwarddiscount.asp

18. Explain and solve problems regarding purchasing power parity.

Purchasing Power Parity is an economic theory that compares different
countries' currencies through a "basket of goods" approach. According to this
concept, two currencies are in equilibrium—known as the currencies being at par
—when a basket of goods is priced the same in both countries, taking into
account the exchange rates.

Example

Let's take the example of purchasing power parity between India and the US.

Suppose an American visits a particular market in India. The visitor bought 25

cupcakes for Rs.250 and remarked that cupcakes are quite cheaper in India. The

visitor claimed that on an average 25 such cupcakes cost $6. Based on the given

information calculate the purchasing power parity between the two countries.

Given, Cost of 25 cupcakes in INR = Rs.250 Cost of 25 cupcakes in USD = $6

Therefore, the purchasing power parity of India w.r.t US can be calculated as,

Purchasing power parity = Cost of 25 cupcakes in INR / Cost of 25 cupcakes in

USD
= Rs.250 / $6

Therefore, the purchasing power parity ratio of the exchange for cupcakes is

USD1 = INR41.67.

Example

Let’s take another example to compute purchasing power parity between China

and the US. In January 2018, a McDonald’s Big Mac costs $5.28 in the US, while

the same Big Mac could be bought for $3.17 in China during the same period.

Based on the given information calculate the purchasing power parity between

the two countries.

[Exchange rate $1 = CNY6.76]

● Given, Cost of Big Mac in CNY = 3.17 * CNY6.76 = CNY21.43

● Cost of Big Mac in USD = $5.28

The calculation of Cost of Big Mac in CNY will be, Cost of Big Mac in CNY = 3.17

* CNY 6.76 = CNY 21.43

Therefore, the purchasing power parity of China w.r.t US can be calculated as,

Purchasing power parity = Cost of Big Mac in CNY / Cost of Big Mac in USD

= CNY 21.43 / $5.28

 Calculation of Purchasing Power Parity of China w.r.t US will be,

Purchasing Power Parity = CNY4.06 per $

Therefore, the purchasing power parity ratio of the exchange for Big Mac is

USD1 = CNY4.06.

https://www.wallstreetmojo.com/purchasing-power-parity-formula/

https://www.investopedia.com/updates/purchasing-power-parity-ppp/

19. Explain the relationship between inflation, interest rates, and exchange rates and
how one affects the others.
● Inflation is closely related to interest rates, which can influence exchange rates.
Countries attempt to balance interest rates and inflation, but the interrelationship
between the two is complex and often difficult to manage. Low interest rates spur
consumer spending and economic growth, and generally positive influences on
currency value. If consumer spending increases to the point where demand
exceeds supply, inflation may ensue, which is not necessarily a bad outcome.
But low interest rates do not commonly attract foreign investment. Higher interest
rates tend to attract foreign investment, which is likely to increase the demand for
a country's currency.
● The ultimate determination of the value and exchange rate of a nation's currency
is the perceived desirability of holding that nation's currency. That perception is
influenced by a host of economic factors, such as the stability of a nation's
government and economy. Investors' first consideration in regard to currency,
before whatever profits they may realize, is the safety of holding cash assets in
the currency. If a country is perceived as politically or economically unstable, or if
there is any significant possibility of a sudden devaluation or other change in the
value of the country's currency, investors tend to shy away from the currency and
are reluctant to hold it for significant periods or in large amounts.

20. Describe international money and capital markets.

● The international money market is a market where international currency
transactions between numerous central banks of countries are carried on. The
transactions are mainly carried out using gold or in US dollars as a base. The
basic operations of the international money market include the money borrowed
or lent by the governments or the large financial institutions.
 The international money market is governed by the transnational monetary
transaction policies of various nations’ currencies. The international money
market’s major responsibility is to handle the currency trading between the
countries. This process of trading a country’s currency with another one is also
known as forex trading.
International capital market is very helpful for reducing the risk of small
companies because in the international market, you can buy different countries'
shares, debentures and mutual funds.
● International capital market is that financial market or world financial center
where shares, bonds, debentures, currencies, hedge funds, mutual funds and
other long term securities are purchased and sold. International capital market is
the group of different country's capital markets. They associate each other with
the Internet. They provide the place to international companies and investors to
deal in shares and bonds of different countries.
Different countries have different business environments, so if any country is
facing loss and due to financial crisis, your investment in that country may suffer
losses but you can fulfill this loss from other country's investment. So, overall risk
will be reduced by this technique.

21. Describe multinational capital budgeting and recognize the additional risks
involved.
● Multinational capital budgeting, like traditional capital budgeting, focuses on cash
inflows and outflows associated with long-term investments. Multinational capital
budgeting techniques are used in foreign direct investment analysis.
● Operating a foreign market is a fascinating opportunity for a U.S hospitality
firm to engage in direct investment or market expansion. However, in spite
of being attractive, going into international markets can be fraught with a
number of unanticipated hindrances and risk. The major risk associated
with foreign capital budgeting can be viewed in three ways; exchange rate
fluctuation, political risk, and economic instability, specifically related to
inflation. These factors can be predominant obstacles in multinational
capital budgeting.

22. Enumerate and discuss the impact of multinational operations.

ADVANTAGES:

Conducting business on the multinational level brings with it a host

of benefits for the company's operating abroad. The most well-known
advantage is the ability to tap into low-cost labor markets, which
represents one method of cutting production costs. Raw material
resources may also be cheaper to extract and process outside of the
 company's nation of origin. An additional positive aspect of operating
multinationally is that it offers access to multiple markets for a company's
products. In essence, a multinational business offers a competitive edge
for companies that incorporate it in their business model against those that
do not.

DRAWBACKS OF MULTINATIONAL OPERATIONS

Critics of multinational operations say that setting up shop in a developing

nation is predatory by nature and exploits the desperation of the local populace.
Critics more interested in broader economic implications say that outsourcing
factory labor to developing nations damages the local economy of the company's
parent nation, creating a scarcity of middle-class jobs. While it may seem trivial
whether a single company outsources its workforce, the effect on a national
economy is cumulative and eventually portions of a national industrial base can
collapse.