Changes in foreign exchange rates affect decisions made by businesses, investors, governments, and consumers. The rate of currency exchange between countries can impact the prices of goods and services, the supply and demand of financial assets, and interest rates. Additionally, fluctuations in foreign exchange rates can impact the bottom line of a business holding foreign exchange denominated investments. The significant impact exchange rates can have on the global economy suggests understanding how to forecast exchange rates is essential. There are several methods in which foreign exchange rates can potentially be predicted which are based upon parity conditions, balance of payments, and the asset market. After an evaluation of each of these methods, an assessment will be provided suggesting the best approach for financial managers to utilize as they attempt to forecast exchange rates. The law of one price suggests that identical goods sell for a single price regardless of the location of the market or the currency in which the good is denominated (Eiteman, Stonehill, & Moffett, 2010). When the prices across markets differ, arbitrage opportunities exist and arbitrageurs will buy and sell goods to return the market price to equilibrium (Bodie, Kane, & Marcus, 2011). Out of these arbitrage activities, various international parity conditions arise connecting exchange rates, interest rates, and price levels (Eiteman et al., 2010). The purchasing power parity (PPP) theory suggests that, given the law of one price, the exchange rate can be determined based on an “individual set of prices” (Eiteman et al., 2010, p. 165). It relates the pricing of goods to the movement in inflation rates between countries (Eiteman et al., ... ... middle of paper ... ...s. (9th ed.). New York, NY: McGraw-Hill/Irwin. Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2010). Multinational Business Finance. (12th ed.). Boston, MA: Pearson Education, Inc. Gharleghi, B., Shaari, A. H., & Shafighi, N. (2014). Predicting exchange rates using a novel “cointegration based neuro-fuzzy system.” International Economics, 137. http://dx.doi.org/10.1016/j.inteco.2013.12.001 Rogoff, K. (2009). Exchange rates in the modern floating era: What do we really know? Review of World Economics, 145(1), 1-12. http://dx.doi.org/10.1007/s10290-009-0006-5 Solnik, B. B. (1978). International parity conditions and exchange risk. Journal of Banking & Finance, 2(3), 281-293. http://dx.doi.org/10.1016/0378-4266(78)90017-1 Taylor, M. P. (1995). The Economics of Exchange Rates. Journal of Economic Literature, 33(1), 13-47. Retrieved from http://www.AEAweb.org
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Technology is a huge part of today’s society and it is helping the world come together in many ways. Because of technology, and what it is capable of, our world is becoming globalized. Because of globalization, multinational corporations are quickly changing how they do business and this is impacting how financial management is conducted. For a better understanding, this report will discuss the pro’s and con’s that technology has on the globalization of multinational corporations, as well as how it is changing MNC’s financial management. First, the definition of globalization.
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Purchasing Power Parity is a theory that assume in long-run it would cost the same to buy a market basket of goods between two currencies by using dollars on market exchange rate (Antweiler, 2011). Purchasing Power Parity reflect the reality purchasing power for one currency and help to minimize errors of GDP. For example, based on the data from World Bank Group, the Gross Domestic Product in China was worth 10360.10 billion US dollars in 2014 (Bank, 2015). This amount of GDP might be inferred to have higher real GDP if market exchange rates not reflect the real exchange rate. In other word, the amount of Yuan exchange to US dollars actually could buy more basket of goods than it is right now.
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Exchange rate and inflation: An appreciation of the exchange rate helps to control cost and price inflation in the economy. A fall in import prices means that it is cheaper to import raw materials, components, finished manufactured products leading to an outward shift in Short Run Aggregate Supply shown in diagram - this has a direct impact on the Retail Price Index Tougher for domestic companies to compete with cheaper imports - lower profit margins as businesses have to adjust (less pricing power in their markets) Slower growth of exports (leading to a slowdown in aggregate demand - possibly the emergence of a negative output gap where actual GDP A bigger trade deficit represents a net outflow of demand from the circular flow of income and spending - leading to less demand-pull inflation.
Other types of exchange rate risks are translation risk and so-called hidden risk. The translation risk relates to cases where large multinational companies have subsidiaries in other countries. On the financial statement of the whole group, the company may have to translate the assets and liabilities from foreign accounts into the group statement. The translation will involve foreign exchange exposure. The term hidden risk evolves around the fact that all companies are subject to exchange rate risks, even if they don’t do business with companies using other currencies. A company that is buying supplies from a local manufacturer might be affected of fluctuating foreign exchange rates if the local manufacturer is doing business with overseas companies. If a manufacturer goes out of business, or experience heavy losses, it will affect all the companies it does business with. The co...
Economists have long taken the view that economic fundamentals determine exchange rates. Nevertheless, in the early 1970s, after the collapse of fixed exchange rate regimes of the Bretton Woods system, excess volatility, nonlinear and disorderly movements in exchange rates became mysteries that traditional exchange rate theory cannot explain. Recent scholar concluded “no definitive evidence that economic variable can forecast exchange rate for currencies of nations with similar inflation rates" which is known as “the disconnect puzzle” from Meese and Rogoff’s studies (1983). Thus, this essay aims to explain why is it apparently so difficult to forecast exchange rate movements, and to provide evidence from the relevant literature and the reference of three popular fundamentals-based models, including Monetary Model and Mundell-Fleming Model.
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The foreign exchange market is one of important mechanism in the international business because foreign exchange is an intermediary for all nations in term of the growth of the economy. There are many functions of foreign exchange market in the global economy. In the international business, it uses the foreign exchange markets in four ways. First, the pay...