Modeling Exchange Rates
Oil price dynamics will have a bearing on the ability of multinational to precisely model the future exchange rates of the foreign exchange in the countries that they operate. In most instances, in order to manage the risk that the firm is exposed in the international business arena, especially on the foreign exchange rate, most multinational will hedge against the risks that are associated with fluctuations in the exchange rate thus minimizing the possible negative effect that a firm may experience (Jain, 2007). Therefore, in order to take a position in hedging facilities such as currency futures, the firm must first understand the trend of the foreign exchange pair in order to guard the firm against detrimental trend but not limit the firm from optimizing gains on foreign exchange.
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 the 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 when the oil prices improve and decline when the oil prices decrease. Similarly, a currency that is negatively correlated to the oil prices will appreciate in value when the 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 multinational will need to understand the category of the currencies in question namely independent of oil prices, positively correlated or negatively correlated to oil prices. According to various econometric studies, net exporting nations currency 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 foreign exchange rate risks.
Considering 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 multinational 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 and the multinational analysts expect the trend to persist, 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 price will not be bound to any pre-determined price. The same observation holds when the subsidiary host country is independent of oil price movement. However, the converse is true when the host country is negatively correlated and the subsidiary host country is positively correlated.
Oil Price and Inflation
Numerous studies have found a positive correlation between the rate of inflation and oil prices. Many 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 the effect of the increased oil prices to consumers thus pushing the consumer price expenditure index upwards. However, over the years, the level of correlation between oil prices and the rate of inflation have found that the correlation has been declining over the years. 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. 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 the fact inflation depletes the purchasing power of the consumers thus lowering the firm sales revenues due to reduced sales. Also, inflation makes production costs to increase (Hunt, Isard & Laxton, 2011). In such situation, due to the falling purchase power, the firm will not prefer to increase its prices to compensate for the lost revenue to match the rising costs since this will adversely affect the business. As such, if a subsidiary is in such a country, it means that the subsidiary will register reduced profits thus lower its remittances to the parent firm. The factor is useful to multinationals since it will benefit the parent firm in undertaking future projection of the entire firm through making a realistic forecast on the remittances from subsidiaries in such countries. However, as noted, inflation undermines economic growth thus weaken of the currency. As such, a high inflation rate will have a negative effect on the country currency thus weakening it. Although the firm may experience reduced earnings in subsidiary currency, due to weakness of that country currency, the parent may receive the projected remittance. The firm may take advantage of inflation and delay the remittance until such a time when the inflation is declining thus limiting negative effect of inflation on exchange rate. As a result, this shows that inflation is another factor that the multinational will need to consider when seeking to create foreign exchange prediction models that will be used to determine the hedging instrument or tactic to be used to limit the effect of foreign exchange risks.
Oil Prices and Interest Rates
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). As such, the inflation depletes the consumer purchasing power thus lowering the consumer demand. The low demand leads to lower profit thus reduced remittances. As such, high-interest rates will be as a result of inflation that is caused by rising oil prices through an increase in inflation. Note that this is an argument in relation to a subsidiary located in a nation where oil prices and exchange rate are correlated. As such, the converse holds for a negatively correlated nation. In modelling exchange rates, the parent company will need to consider the effect of interest rates on the exchange rate. In theory, the high-interest rate will tend to attract foreign capital in that country thus causing the domestic currency to appreciate due to increasing foreign exchange supply but 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.
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). If the country uses a fixed policy, the multinational will need to examine the factors that the country considers in setting the exchange rate and speculate on the future direction of these factors thus determining the manner in which they will affect the exchange rate. Therefore, this helps understand the firm in making risk management decision with regard to exchange rate. In countries that use the mixed process of determining the exchange rate, a combination of considerations will be needed drawing from the consideration made in countries with a free market exchange rate and those that fix the exchange rate.
Conclusion
There is no one single factor that can be singled out to have the ultimate effect that determines the exchange rate. Therefore, each of the discussed factors plays a contributive role in determining the exchange rate. As such, in order to make meaningful predictive models relating to foreign exchange based on the movement of oil prices, the multinational will need to understand these factors and then combine them to get their aggregate effect on the exchange rate thus creating an effective predictive model (Gillespie, 2001). Having created a robust model, the multinational firm will use it to make foreign exchange prediction thus improving the effectiveness of foreign exchange risk management since it enables the management to use the most suitable hedging instrument.
References
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.
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.
