a. Describe some policy examples that illustrate the use of fiscal, monetary, and balance of payment policies with flexible and fixed exchange rate systems.
Ans.
The government and the Central bank of a country control the supply of credit through efficient and effective credit policies and fiscal and monetary policies. They can strengthen management of liquidity and improve the conducting of monetary policy, in order to reasonably control growth in money supply and credit. They can implement wither expansionary or concretionary fiscal policies to increase or decrease the flow of credit in the economy.
(1) stabilized exchange rate fluctuations
(2) stabilized output fluctuations
(3) economic freedom
Fixed advantages
A fixed exchange rate should reduce uncertainties for all economic agents in the country. As businesses have the perfect knowledge that the price is fixed and therefore not going to change they can plan ahead in their productions. Inflation may have a harmful effect on the demand for exports and imports. To ensure that inflation is kept as low as possible the government is forced to take measurements, to keep businesses competitive in foreign markets. In theory a fixed exchange rate should also reduce speculations in foreign exchange markets. In reality this is not always the case as countries want to make speculative gains.
Fixed Disadvantages
The government is keeping the exchange rate fixed by manipulating the interest rates. If the exchange is in danger of falling the government needs to increase interest rates to increase demand for the currency. As this would have a deflationary effect on the economy the demand might decrease and unemployment might increase. A government has to maintain high levels of foreign reserves to keep the exchange rate fixed as well as to instill confidence on the foreign exchange markets. This makes clear that a country is able to defend its currency by the buying and selling of foreign currencies. Fixing the exchange rate is not easy as there are many variables which are changing over time if the exchange rate is set wrong it might be hard for export companies to be competitive in foreign countries. International disagreement might be created when a country sets its exchange rate on a too low level. This would make a countries export more competitive which might lead to a disagreement between countries as they might see it as an unfair trade advantage.
Flexible Advantages
As the exchange rate does not have to be kept at a certain level anymore interest rates are free to be employed as domestic management policies(Appleyard 703). The floating exchange rate is adjusting itself to keep the current account balanced, in theory. As the reserves are not used to control the value of the currency it is not necessary to keep high levels of reserves (like gold) of foreign countries.
Flexible Disadvantages
Floating exchange rates tend to create uncertainty on the international markets. As businesses try to plan for the future it is not easy for the businesses to handle a floating exchange rate which might vary. Therefore investment is more difficult to assess and there is no doubt that excursive exchange rates will reduce the level of international investment as it is difficult to assess the exact level of return and risk. Floating exchange rates are affected by more factors than only demand and supply, such as government intervention. Therefore they might not necessarily adjust themselves in order to eliminate current account deficits. The floating exchange rate might worsen existing levels of inflation. If a country has higher inflation rate than others this will make the export of the country less competitive and its imports more expensive. Then the exchange rate will fall which could lead to even higher import prices of goods and because of cost-push inflation which might drive the overall inflation rate even more.
While flexible exchange rates can ensure that the country achieves external balance, they do not ensure internal balance. In several situations the exchange rate change that reestablishes external balance can make an internal imbalance worse. If a country has rising inflation and a tendency toward external deficit, the depreciation of the currency can intensify the inflation pressures in the country. If a country has excessive unemployment and a tendency toward surplus, the appreciation of the currency can make the unemployment problem worse. To achieve internal balance, the country's government may need to implement domestic policy changes.
b.Describe some common risks associated with the operations of multinational corporations.
Ans.
Foreign Risks: International trade and investment requires dealing with foreign currencies, receiving the foreign exchange in the future or paying the foreign exchange in the future, which exposes a company/investor to currency risk, which is the risk of an adverse exchange rate movement.
Also, there are potential political Risks for multinationals making investments and doing business overseas. Building production facilities overseas is a long term investment. Political climate can change and present risks.Even there are primarily market and credit risks. Market risk represents the possibility that the value of the derivative instrument will change. A proper categorization is as under:
1) Economic risks
2) Business Risk or Management Risks
3) Financial Risk
4) Liquidity Risks
5) Political Risks
6) Management risks are most controllable by investor as it can change the persons managing or train them to work efficiently. Financial risk is controlled through varying the level of leverage.
c.Explain how multinational corporations can use various forms of hedging to minimize exchange rate risks.
Ans.
In the present state of economy, there is an imperative need for the corporate clients to protect their operating profits by shifting some of the uncontrollable financial risks to those who are able to bear and manage them. Firms can use hedging to protect themselves against this risk in the short term; for the long term, financing the project using local currency can minimize this risk. we use derivatives for hedging, the actual delivery of the underlying asset is not at all essential for settlement purposes. The profit or loss on derivative deal alone is adjusted in the derivative market. The various forms of hedging to minimize exchange rate risks are as under:
The important financial derivatives are the following:
i)Forwards
ii)Futures
iii)Options
iv)Swaps
Forwards are the oldest of all the derivatives. A forward contract refers to an agreement between two parties to exchange an agreed quantity of asset for cash a t a certain date in future at a predetermined price specified in the agreement. The promised asset may be currency, commodity, instrument etc.
Future contract is very similar to a forward contract in all respects expecting the fact that it is completely a standardised one. Hence, it is rightly said that a future contact is nothing but a standardised forward contract. It is legally enforceable and it is always traded on an organized exchange.
Options: In the volatile environment, risk of heavy fluctuations in the prices of assets is very heavy. Option is yet another tool to manage such risks. An option contract gives the buyer an option to buy or sell an underlying asset at a predetermined price on or before a specified date in future. The price so predetermined is called the ‘strike price’ or ‘exercise price’.
Swaps are yet other exciting trading instruments. In fact, it is a combination of forwards by two counterparties. It is arranged to reap the benefits arising from the fluctuations in the market- either currency market or interest rate market or any other market for that matter.