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EXCHANGE RATE THEORY & MEXICO.
Term Paper ID:24541
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Examines theory (risks & benefits, free & managed currencies, reserves, stability, hedges) in context of multinational entering Mexican market.... More...
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Paper Abstract:
Examines theory (risks & benefits, free & managed currencies, reserves, stability, hedges) in context of multinational entering Mexican market.
Paper Introduction:
Introduction
Today's economy is a global economy with companies based in the United States selling products in Europe that were manufactured in Mexico. Where international marketing was once the exclusive domain of large conglomerates, computer technology and telecommunications now make it possible for even small companies to enter the international marketplace. Another key factor in the growth of international marketing is the ability of financial institutions to be able to handle transactions conducted in various currencies, which facilitates international trade, but which also exposes companies to greater risk than if they dealt in a single strong currency. Today's international competitors must be concerned not only with the marketing potential of the product, but with the financial situation of the d
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Unforeseen factors can affect the nominalexchange rate, and speculators can suffer extreme losses at the same timethat they stand to make high levels of profit. Multinationals received some concession from the Financial AccountingStandards Board (FASB) in 1981 when FASB 52 replaced FASB 8 with regard totranslation risk, minimizing the effects of translation on financialstatements. Thusan American multinational might have a subsidiary in the United Kingdom,and an English multinational might have a subsidiary in the United States.With back to back loans, each multinational loans an agreed upon figure, inthe home currency, to the subsidiary of the other multinational at thecurrent exchange rate. Zhou, Su. The Economist, pp. This is what caused Mexicoto abandon the peso in 1994 and what led to the rapid devaluation of thatcurrency ("Just What," 1997, p. (1994, June 7). Thisis in contrast to noting them as they occur, which can be particularlyvolatile in some economies and representative of "paper" profit or losses. Generally, when the domesticmoney supply expands faster than the foreign money supply, the nominalexchange rate may not keep pace with the changes because of the delay inthe market's ability to react. Smith, David. Companies which decide to participate in the Mexican economy can do sowithout taking aggressive action to hedge the foreign exchange risks theyare taking, but only the most naive international financial managers wouldconsider this approach. (1994, August). Some of the same hedging techniques used in transaction riskmanagement can be applied to translation risk management, but there areother techniques that are generally more favorable. For example, an American multinational might agree to sell $1 millionin goods to an importer in Mexico and the current exchange rate might be 5pesos to the dollar. Inthe above example, the American company might borrow 5 million pesos from aMexican bank on the same day that the sale is completed and invest thosefunds for the 18 -day period. M. (1995, July 6). 1176). CDA-Investnet Insiders' Chronicle, p. The fixed and the flexible. The argument was that for countriesto successfully operate market-determined exchange rates, they would needvery sophisticated financial structures, including forward and futuresmarkets, that were often lacking in developing countries. 1. (1996, March). If the rates move so that the peso loses againstthe dollar, moving to perhaps 6 to the dollar, the American company willreceive only $833,333 rather than the $1 million it expected. The Mexicaneconomy has benefitted from the North American Free Trade Agreement (NAFTA)as well as from other economic policies and practices in recent years tothe point that GDP has increased in both 1995 and 1996, while inflation hasremained well under control during that same period (Background Notes,1997, p. 429-439. Nonetheless, the peso remains a floating currency which couldsuffer again in the wake of a serious loss of investor confidence. A forward hedge is essentially a derivative contract with thecurrencies in question serving as the measure of the contract. Avsar, Serdar A. The choice of an exchange rate regime cannot be divorced frompolitical considerations. Some managed currencies are managed within a "band;" the currenciesfloat within a predetermined price range (the band), but the governmentwill intervene to prevent the currency from either rising or fallingoutside the band's parameters. Taylor, Stephen J. Since global trade is now the norm, maintaining astrong export trade is particularly important to most governments(Erlanger, 1995, p. An examplecan be provided by a multinational company which sells goods to a foreignimporter. High domesticspending on nontraded goods may raise the relative price of the commodityand thus help the currency appreciate. Free currencies are not subject to direct government interventionand because there are literally billions of units of the money availablefor trade by buyers and sellers. (1997, June). Any number of factors can affect currency rates: productivity, oilprices, domestic and foreign government spending, and monetarydifferentials (Zhou, 1995, p. 94 ), but it needs to betaken into account since short-term effects can greatly affect the fortunesof companies and traders in this market. 72). This comes about as the nominalexchange rate is multiplied by the ratio of the price index of a highlyproductive nation compared to a less productive nation. Macroeconomic instability is another reason that countries may opt fora floating rather than fixed rate. Such companies would recognize thatMexico has enjoyed a strong recovery since the 1994 currency crisis, andthat the nation has taken steps to encourage foreign investment (see theattached exhibits for details regarding the nation's foreign exchangepartnerships and growth). 939). Ifthe rate is set at a level far from equilibrium, the resulting effects maylead the authorities to reset the rate to rectify such errors, which inturn could undermine confidence and the clarity of signals of the directionof government policies in the early stages of reform. Foreign exchange markets withofficial rationing. While hedging has the effect of reducing profitswhen the hedge proves unnecessary (since the hedge effectively costscompanies some funds), such protection is necessary in a nation which hashad two serious financial crises in 15 years (Mexico suffered a currentaccount deficit correction and devaluation of the peso in the early 198 s,as well) (Thorne, 1997, p. Whereinternational marketing was once the exclusive domain of largeconglomerates, computer technology and telecommunications now make itpossible for even small companies to enter the international marketplace.Another key factor in the growth of international marketing is the abilityof financial institutions to be able to handle transactions conducted invarious currencies, which facilitates international trade, but which alsoexposes companies to greater risk than if they dealt in a single strongcurrency. However, themultinational could enter into a contract with a third party to sell 5million pesos to the party in exchange for $1 million in 18 days.Assuming that the hedge carries with it a premium of one percent (to coverthe buyer against changes in the rate), the multinational will receive$99 , in exchange for 5 million pesos. Thus a move by a large central bank to divestsome of its holdings in a given currency may, by itself, change the valueof that currency on the international markets. Lizondo, J. Many countries haveexperienced a decline in their gross official international reserves at thetime a floating currency is announced; in some cases, this decline was toless than three months' worth of imports (Lizondo, 1994, p. Inorder to cover the transaction risk, the multinational then may sell theagreed-upon amount to a third buyer, who sells the currency in question tothe importer at the same time. Many foreign investors choose to invest in portfolios ratherthan in equipment since the portfolios are easier to convert to cash in theevent of a problem. (1994, August). There is a substantial amount of risk in the exchange markets becauseof their free-floating nature. 76). Similarly, if the company has a strongfinancial manager who is familiar with hedging techniques and who has thepersonal contacts in Mexico necessary to make entering into transactionhedges and translation hedges possible, a Mexican investment should bepursued. The monetary differential is thought to be have only a temporaryeffect on real exchange rates (Zhou, 1995, p. This does not mean that speculators cannot make (and lose)large sums of money based on currency fluctuations, only that the magnitudeof the fluctuations tends to be less than originally forecast when theUnited States left the gold standard (Bartolini & Bodnar, 1996, p. Similarly, if reverse conditions are present,companies may want to delay payment for as long as possible in order totake full advantage of the exchange markets. Thus anincrease in oil prices would affect those countries which have a heavydependence less than those countries with less of a dependence. In most instances, developing countries are insuch poor economic condition that the authorities saw considerable merit inletting the market be responsible for the adjustment of the exchange rate;this automatically reduces the influence of lobbies and vested interests.In addition, for previously centrally planned economies, the shift tomarket-determined exchange arrangements was an important manifestation of afundamental change of economic policy (Erlanger, 1995, p. Alternatives A multinational company considering entering the Mexican market couldsimply decide that the foreign exchange risk is too volatile and refrainfrom participating in the Mexican economy. Indeed, a desireto stop importing inflation from Russia led Latvia and Lithuania to floattheir new currencies in the second half of 1992 (Erlanger, 1995, p. In addition, it is difficult for any country to try to determine asustainable equilibrium exchange rate under a fixed strategy, and the taskbecomes even more complicated if the country is undertaking extensivemacroeconomic and structural reforms (for example, privatization, reducingthe size of the state, and trade and foreign exchange liberalization). Washington, DC: U.S.Department of State. 1). Institutional Investor, pp. 79). This suggests that there are consumers in Mexico who have theability to purchase goods from a multinational organization. This has been evident in most of thedeveloping countries choosing a floating currency in the form of continuinghigh rates of inflation in the early stages of reforms or the absence ofsufficiently strong programs (Ajakaiye & Ojowu, 1994, p. The governmentsthus had little choice but to allow direct market determination of theexchange rate if they were to avoid a shift of foreign exchangetransactions to the parallel market, with its adverse consequences in taxevasion, criminalization, and loss of economic control. C7). So long as the American company is able tosecure higher returns than the interest rate on the loan, there isprotection against a decline in the currency rate. Companies must also consider the political risk of their product orservice, and whether they might be the target of political activists inMexico, who sometimes use violence to achieve their goals. "Rewards Available to Currency FuturesSpeculators." Economic Record 68 (June 1992): S1 5-S116. Meanwhile, increasing numbersof developing countries were moving to flexible exchange rates, whichcaused concern in the developing countries. "Efficiency in Currency Futures Markets." EconomicRecord 68 (June 1992): S13 -S134. This coincideswith anticipating the overall risk to the organization and whether thepotential return represented by the Mexican opportunity justifies therisks. (1997). Japan, forexample, is highly susceptible to fluctuations in the oil market, and theyen traditionally suffers against the dollar when such increases occur.Actions by the Japanese government sometimes work to weaken the yen furtheras it may raise the nominal exchange rate (Zhou, 1995, p. Today's international competitors must be concerned not onlywith the marketing potential of the product, but with the financialsituation of the destination country and the risks to which the companywill be exposed from a foreign exchange standpoint. 1). This question took on moreurgency in 1973 with the first oil price shock, and became important againin 1982 as the debt crisis began to unfold. This can prompt fears among managers that stockholders and othersinterested in the company's performance may conclude that management is notdoing its job because of the loss when the loss is not the result ofmanagement activities (necessarily) but instead is due to fluctuations inthe exchange rate. Economist, pp. New York Times, pp. Multinationals and earnings exposure. Synthesis When deciding whether to enter the Mexican economy, internationalfinancial managers must work together with marketing professionals todetermine if there is a ready market for the product or investment inquestion. Certainly the nation's rapid return to a realgross domestic product in excess of the pre-crisis level and maintenance ofa relatively low current account deficit ( .6 percent) indicates that thegovernment is serious about focusing on economic growth and prosperity(Thorne, 1997, p. Concepts Flexible exchange rates first found favor among industrial countriesin the early 197 s; the determination of the exchange rate arrangement andthe choice of the currency "peg" (measure) became major policy issues fordeveloping countries (Rothbard, 1994, p. (1996, April 29). There are two basic types of currencies which float: free andmanaged. S2-S3. S2). 8). S1 7). There had alsobeen a concern that floating the currency in the context of serious balanceof payments difficulties could lead to a steep fall in its value; this, inturn, could adversely affect price stability and output in the short run(Ajakaiye & Ojowu, 1994, p. World Development, pp. The transaction risk is now on themultinational company. S. 131). Rothbard, M. Traders who purchased dollars one day maysell them the next for yen, and so are not tied to any particular currencyfor themselves or those on whose behalf they may be working. Toprotect itself from this risk, companies can engage in various types ofhedging, including a forward hedge, a credit or money market hedge, or thecompany may choose to accelerate or delay payment. N. The importer agrees to pay the multinational 5million pesos in 18 days. 8A). Choosing the appropriate capital marketcan help companies find investors interested in their offering.Speculators also make use of the various international markets for the samereason: to maximize their return. References Ajakaiye, D.O., & Ojowu, O. The transaction (purchase or sale) carries a riskthat the currency value will change; hence the term transaction risk. Erlanger, S. 64). Just what the doctor ordered. This highly specialized form of managedcurrency has found particular favor among developing nations as a way tobalance the advantages of fixed currencies with the advantages of floatingcurrencies ("The Fixed and the Flexible," 1996, p. Are exchange ratesexcessively volatile? "How to Manipulate the Markets." Management Today,February 1995, 21. 72-95. They can use back-to-back loans to fundsubsidiaries, or they may choose one of the international capital markets,including New York, London, Zurich, or the Cayman Islands, among others.Each market offers particular advantages and disadvantages at any point intime, and the price and cost associated with one market vary widely bothwith other markets and over time. This research examinesone popular market for American goods, Mexico, considers the foreignexchange risk that companies face when doing business in Mexico, and offersrecommendations on how to minimize that risk. This increases the real money balance andmay cause interest rates to fall. C7). One of these includesback to back loans, where two multinational companies based in twodifferent countries have subsidiaries located in the other country. 1175-1182. Country Commercial Guide: Mexico. (1997, April). Managed currencies are subject to intervention by their governments;such intervention is normally undertaken when the government perceives thenational interest to be at stake. 1179). 63). One of the most common arguments against floating currencies is thatthey are more volatile than fixed currencies. The problem was that, untilrecently, there had been a widespread belief that freely floating rates indeveloping countries would not work. Russia will test a trading band for theruble. Relative price effectsof exchange rate depreciation in Nigeria. Butler, K., & Butler, C. Bartolini, L., & Bodnar, G. A credit or money market hedge involves borrowing against the amountin question in order to make a profit over the time period in question. Certainly this would appearto be the case since their prices are subject to market pressure and arenot "pegged" to a single measurement (such as the gold standard provided).However, there is little evidence to suggest that floating currencies aremuch more volatile than those that do not float (Bartolini & Bodnar, 1996,p. Government spending may also bring about a change in the real exchangerate, but here the direction of the change depends on whether thegovernment spending is on tradable or nontradable goods. 63-64. International Monetary Fund Staff Papers, pp. When seeking to raise capital, multinational organizations have a widerange of options open to them. C1). The higher a nation's productivity,the stronger its currency tends to become. Governments have an interest in thevalue of their currencies because strong currencies make their exports moreexpensive and less competitive, while relatively weaker currencies improvethe outlook for exports. Transaction risks usually involve a receivable or payable denominatedin a foreign currency, and commonly arise from a transaction such as apurchase from a foreign supplier or a sale to a foreign customer (Butler &Butler, 1997, p. Thorne, A. The multinational company may accept that the importer will payat some future date the agreed upon amount in the agreed upon currency. Journal of Development Economics, pp. 76-77. 12 ). The lack of volatility might result from the currencies which arenormally traded: the American dollar, German mark and Japanese yen.Speculators and investors alike tend to trade in currencies of developednations rather than developing nations; these currencies are backed byrelatively stable economies which prevent large fluctuations in currencyprices: if there is too much movement one way or another, buyers willeither flock to or abandon the currency in question ("Multinationals,"1996, p. The nominal exchange rate can well be affected by the mere fact ofspeculation in a given currency. However, it is not realistic of companies to expect thatexchange rates will not change, although criticism that losses or gainsshould be noted only when actually realized is a legitimate concern. "The Response of Real Exchange Rates to Various EconomicShocks." Southern Economic Journal 61 (April 1995): 936-954. Multinational Finance. In this way, a company which has a given amount in a bank in a foreigncountry and who maintains that balance over the course of the year may findthat due to exchange rates, the balance falls when translated into dollars. (1996, March 16). (1996). Problem Definition The problem of foreign exchange risk in Mexico is not insignificant.The Mexican currency, the peso, is not strong relative to other majorcurrencies (including the American dollar, the German mark and the Japaneseyen); as a result, the value of the peso fluctuates in relation to theseother currencies, and sometimes with great volatility: events in 1994 and1995 led to a devaluation of as much as 54 percent, a situation whichproduced serious financial consequences in Mexico. Where transaction risk refers to the risk associated with changes incurrencies over the period of a single transaction, translation risk refersto the risk that multinational organizations take on when they must statetheir financial position in terms of a single currency, their "home"currency, on financial statements (Taylor, 1992, p. Without sufficient reserves, acommitment to defend a fixed exchange rate is not been credible and isquickly tested by the foreign exchange markets. When the loan comes due, it will be paid forwith the pesos due from the importer, and the proceeds from the investmentscan be used to pay interest. In thesecircumstances, fixed exchange rates could not be adjusted quickly enough tokeep up with price realignments and neutralize significant arbitragepossibilities against the parallel market exchange rate. In this way, thereal exchange rate is insulated somewhat from possible equalization throughinternational exchanges. Oil prices have an effect on the currency markets because of thedependence of the world's strongest economies on imported oil. (1997, July 26). 43 ). Washington, DC: U.S.Department of State. S2). The case against fixed currencies.Journal of Commerce and Commercial, p. Introduction Today's economy is a global economy with companies based in the UnitedStates selling products in Europe that were manufactured in Mexico. In this way, there is no currency exchange risksince the companies will repay their loans in the same currency as it wasreceived (Smith, 1995, p. Cincinnati,OH: Southwestern College Pub. 943). 8A. Recommendation If a company has other multinational operations which provide adiversified portfolio, this offers some protection against the risk thecompany would encounter in Mexico. Risk can be classified intofour types: transaction risk, translation risk, capital market risk andinvestment risk (Avsar, 1992, p. This isthe situation that faces international financial managers (CountryCommercial Guide, 1996, p. 21). Insufficient reserves provide one of the most conspicuous reasons fornations to implement a floating exchange rate. C1, C7. Companies could also enter the Mexican market, but do so with theknowledge that there are certain risks associated with the possibly largerewards of doing business in Mexico. An importer in a country whose currency is expected to depreciate interms of the currency of the supplier is motivated to purchase the foreigncurrency as soon as possible in order to get the most favorable rate ifpayment is due in the currency of the exporter. Since that time,however, the nation has taken steps to reinforce investor confidence bothin the nation as an attractive investment opportunity and specifically inthe peso. This has been one of the problems that Mexico has hadin attracting foreign investment ("Just What," 1997, p. Introduction: Is Mexico up for sustainedgrowth? Certainly a large number offoreign companies withdrew investment in 1994 and 1995 following theeconomic destabilization which occurred at that time; companies with lowlevels of risk tolerances could well pursue that alternative now. If, for example, a large bloc of currencyis bought (or sold), it may send ripples through the markets as investorsand speculators react to the transaction rather than to the foundations onwhich the currency is based. Background Notes: Mexico. An exporter who expectsthe currency of the purchasing country to drop would want payment as soonas possible if the currency of the importer is being used in order tominimize transaction risk.
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