(A case for a parent firm in a net oil exporting country with subsidiaries in a net importing country that has free market economy, politically stable, positive currency speculation and possibility of government defaulting on its debt)
Oil Prices and Exchange Rate
Oil price dynamics have a bearing on the ability of multinational to precisely model the future exchange rates. In most instances, in order to manage the foreign exchange rate risk that the firm is exposed in the international business arena, most multinational will hedge against the risks that are associated with exchange rate fluctuations. As a result, these multinationals minimize the possible negative effect that a firm may experience (Jain, 2007). In managing foreign exchange risk, the firm attempts to guard itself against detrimental trend but not limit the firm from optimizing gains on foreign exchange. Therefore, in order to take a position in hedging facilities such as currency futures that is in line with the firm’s aim, the firm must first understand the trend of the foreign exchange pair.
Oil price is one of the factors that will affect the trend of a currency pair. Various studies have shown that various currencies have a varied degree of relationship between oil prices and the value of their currency. The relationship is measured through a correlation analysis where a positive correlation means that the currency value will improve when the oil prices improve and decline when the oil prices decrease. Similarly, a currency that is negatively correlated to oil prices will appreciate in value when oil prices are declining and vice versa. Finally, there are currencies that are independent of the oil prices meaning that the changes in oil prices do not affect the value of the currency (Dzulkafli, 2007: Jain, 2007).
The first step in managing exchange risk is to understand the nature of the currencies in question. According to various econometric studies, net exporting nation’s currencies tend to be positively correlated to the prices of oil while net exporting countries’ currencies tend to be negatively correlated to the oil prices (Dzulkafli, 2007). Therefore, the multinational have to categorize the home country to either a net exporter or a net importer in order to understand the trend of the pair thus make an informed decision on how to hedge against exchange risks.
For this case, assume a multinational whose home currency is positively correlated to the oil prices and its subsidiaries located in countries whose currencies are negatively correlated with oil price movement. In a period when the oil prices are falling, it means that the value of the home currency will be depreciating against the currencies in the countries where the subsidiaries are located (Gillespie, 2001). If the analyst in the multinational expects that the falling prices will persist, the analyst is better taking a hedging instrument that will protect the firm from extreme losses in foreign exchange trend since there is a pre-determined exchange rate. However, if the period experiences a rising trend in the oil prices which is expected to keep increasing, it means that the firm will expect to gain. Therefore, although the firm may still hedge, the hedge is not that necessary since the conditions show a situation in which the gain of foreign exchange can be maximized since the maximum exchange rate will not be bound to any pre-determined price.
Inflation and Exchange Rate
Numerous studies have found a positive correlation between the rate of inflation and oil prices. Many of these studies have attributed the cause and effect relationship between these two items to the fact that oil is a major input in the production process. Therefore, as the oil prices increase, the rate of inflation should be expected to follow the same trajectory (Hunt, Isard & Laxton, 2011). As a result, this will lead to the transfer of increased oil prices effect to the consumers thus pushing the consumer price expenditure index downwards. However, over the years, the level of correlation between oil prices and the rate of inflation has been declining. Notably, these studies focused on the oil price fluctuation in the 1970s where the correlation was very high compared to the studies that focused on the fluctuation in the 1990s and early 2000s where the rate of correlation had reduced significantly (Dzulkafli, 2007). Many researchers have attributed the reduction in the rate of correlation to economic diversification thus reducing the effect oil has on the overall economy. Nonetheless, oil is still a major component of the economy whether the economy is a net importer or net exporter. As such, oil still has a significant effect on the country inflation.
Inflation is one of the deterrents of economic growth. Therefore, when the overall economy is negatively affected, it means that the individuals firms will also be negatively affected. The detrimental effect is due to an increase in production costs and reduced revenues due to reduced sales courtesy of reduced demand (Hunt, Isard & Laxton, 2011). In such situations, due to the falling purchase power, the firm will not prefer to increase its prices to compensate for the lost revenue in an attempt to match the rising costs since this will adversely affect the business. Therefore, the subsidiary is expected to remit a reduced profit to the parent firm. The situation shows that understanding inflation is useful to multinationals since it will benefit the parent firm in improving future projection of the entire firm through making realistic forecasts on the remittances from subsidiaries. Moreover, high inflation rate will have a negative effect on the country currency. Consequently, the firm should consider a hedging tool in order to cushion the parent firm from excessive loss associated with such market condition. The situation will be worse if there is a period of increasing oil prices because an increasing trend in oil prices will further weaken the subsidiary currency. The observation reinforces the need of a hedging instrument that will be used by the firm to manage the extent of loss in foreign exchange.
Interest Rates and Exchange Rate
Numerous studies have shown a slight positive correlation between oil prices and the rate of interest rates. However, many researchers have argued that correlation is not exclusive. However, from economics, it will be understood that one of the monitories policies that governments will use to counter the effect of inflation is altering interest rates. Therefore, an increasing trend in inflation rate will most likely lead to an increasing trend in the level of interest (Gillespie, 2001). In theory, the high-interest rate will tend to attract foreign capital in that country thus causing the domestic currency to appreciate as a result of increasing foreign exchange supply while the demand remains constant. Factoring this element in modelling foreign exchange rates enables a multinational firm to makes a better decision in hedging against foreign exchange risks it faces. Moreover, the underlying principle defining the relationship between interest rate and value of currency is inflation. As earlier observed, inflation will lead to depreciation of a currency. On the other hand, the resultant effect of interest is attraction of foreign currency which affects the currency positively. Since the underlying effect and the resultant effect are pushing the subsidiary’s country currency value in different direction, the analyst must study the effect and determine the aggregate effect the two forces have on the value of the currency thus benefit the multinational foreign exchange initiatives.
Governmental Influence on Foreign Exchange
Various governments maintain various economic policies. Some have a free market economy where the foreign exchange rate is set by the forces of demand and supply while others prefer to fix the exchange rate (Madura, 2015). Others use a combination of the two. A multinational will need to evaluate the subsidiary host country policies in order to make informed decisions. In relation to free markets, market efficiency is a major factor. Therefore, in modelling the projected exchange rates, the firm must understand the extent of market perfection. The consideration will involve examining elements such as the effectiveness of the government policies and the monetary policies since some of these policies will have an effect on the exchange rate (Mankiw & Hakes, 2004). Therefore, if the country has a high efficiency rate, it means that the subsidiary country will capture the effect of the changes in oil prices and other macroeconomic factors that affect the value of the currency. As such, this increases the ability to make accurate prediction regarding the currency movement thus improving the foreign exchange model accuracy and facilitate informed decisions regarding the right hedging instrument.
Current Account and Exchange Rate
A nation current account reflects the country’s earnings on investment and the balance of trade. The account is founded on currency inflow and outflow relationship. As such, when the outflows are larger than the inflows, the country is said to be having a deficit account. The converse is true. According to economic theory, to establish the relationship between the current account and the value of that country currency, in the event that the account registers a negative balance, the value of that country currency will be depreciating (Pilbeam, 2006). The situation will worsen in the event that the oil prices are rising since the rising oil prices will cause further depreciation on the subsidiary country currency. Therefore, in such conditions, the multinational is better protected from the exchange rate fluctuations by taking a hedging instrument to limit the loss on foreign exchange.
Government Foreign Debt and Exchange Rate
Government debt is a key player in determining currency exchange value movement. The influence of government debt on the country’s currency value arises through the probability of the government defaulting on its debt obligation (Eun and Resnick, 2007). As such, if the government where the subsidiary is stationed is expected to default, it follows that the investors will sell the government securities. Consequently, the value of the defaulting government currency will lose its value due to large volume of capital flight. The situation will be worsening in the event that the oil prices are increasing. The phenomenon influences multinational foreign exchange risk practice since the multinational will need to constantly monitor the government action to determine whether the government, where the subsidiary is located, has the capability to continually meet its debt obligation. In case there is a realistic chance that this government can default, the parent firm should always have a hedging tool to cushion the firm against such eventuality.
Exchange Rate Speculation
The foreign exchange movement does not always reflect the underlying economic fundamental. At times, the movements could be as a result of the financial markets sentiments. There are various activities that trigger market sentiments such as speculation on the action of a country’s central government monetary committee with regard to raising or lowering the interest base rates. In the event that the market players expect the value of currency of the country where the subsidiary is located to appreciate, investors will buy this currency (Eun and Resnick, 2007). As such, the increased demand will cause the value of the bought currency to gain in value and vice versa. Therefore, the parent firm does not require a hedging instrument since it stands to gain from this market condition with the gain receiving a boost from decreasing oil prices.
Political Stability and Exchange Rate
Not only does Political stability affect the level of economic activity but also the amount that flows into the country in form of foreign currency. As such, political factors influence both internal and external factors that, in turn, influence the value of the currency. Consequently, when a country has a stable political regime, the country is in a position to attract high foreign capital injection and increased local economic activities thus strengthening the local currency value (Catalan-Herrera, 2014). As such, when the subsidiary is located in this country, the currency is likely to be appreciating in value thus lowers the need of seeking a hedging instrument to avoid capping foreign exchange gains. Also, the exchange gains are improved if the oil prices are decreasing.
References
Catalan-Herrera, J. C. (2014). Foreign exchange and monetary policy essays from a developing country perspective. ABC-CLIO.
Dzulkafli, Z. (2007). The impact of oil prices on interest rates, exchange rates and prices a comparison between discrete and continuous time models. Colchester: University of Essex.
Eun, C. S., & Resnick, B. G. (2007). International financial management. Boston: McGraw-Hill/Irwin.
Gillespie, A. (2001). Advanced Economics through Diagrams 2ed (Oxford Revision Guides). Oxford, UK: Oxford University Press.
Hunt, B., Isard, P., & Laxton, D. (2011). The macroeconomic effects of higher oil prices. Washington, D.C.: International Monetary Fund, Research Dept.
Madura, J. (2015). International financial management. Cengage Learning.
Mankiw, N. G., & Hakes, D. R. (2004). Principles of economics study guide. Mason, OH: Thomson/South-Western.
Pilbeam, K. (2006). International finance. Houndmills, Basingstoke, Hampshire: Palgrave Macmillan.
