The Effects of Varying Exchange Rates on Businesses - Research Proposal Example

the effects of varying exchange rates on businesses al Affiliation) Key words: Exchange rate, Revenue Contents Contents 2 2 Executive summary 2 Introduction 4 Purpose 4 Scope 5 Method 5 Limitations 5 Assumptions 6 Background 6 Findings 7 Calculations 8 Decisions in USA Super Cars 9 Recommendations 10 Conclusion 11 References 12 Executive summary The aim of the report was to investigate how the volatility of exchange rates affected the revenues of both businesses and financial institutions over periods of time. The exchange rate system of a country is governed by the financial laws. The exchange rate has a direct influence on the operation and decisions made by financial institutions. Through trading the currencies, a market for foreign exchange is formed and businesses that trade globally participate in the foreign exchange market .Such companies need to purchase and sell currencies regarding on the terms of agreement of the sale. Differences in values of the different currencies can be explained by looking at the sum differences between the export and import levels of a country. Deficits reflect unfavorable balance of payments while surplus balance of balance of payments, reflect a favorable balance of payments and therefore better exchange rates at the foreign exchange market. There are a number of factors that cause the volatility of the exchange rates and include:- The inflation levels of a country Amount of trade conducted Interest rates Natural disasters Political insecurity among others. Factors that would increase exchange rate values are; high inflation levels, high interest rates, occurrence of natural disasters and political insecurity while the converse is true regarding decreased levels of exchange rates (“The Effects of Changes in Foreign Exchange Rates” 2000). . The report therefore, analyzes an American company, USA Super Cars, which sells luxury sports cars globally to customers in 5 different countries; UK, Japan, Canada, USA and South Africa. The company under analysis, had just signed a contract to sell the cars in a year’s time. In order to cope with the varying exchange rates, acceptable standard deviation estimates have been assigned to the various currencies that the company is transacting in together with their corresponding exchange rates. Also provided are the number of cars to be provided to each customer and their selling prices. This will enable the calculation of the expected revenue levels using the mean average exchange rate values provide by the Bank of America. The standard deviation estimates provided by the bank ,will ensure the additional calculation of the highest possible revenue amounts collectable and the minimum amounts of revenue that the company, USA Super Cars can expect to obtain in the financial year. Ideally, the company would want to maximize its profits, which can be achieved when the exchange rates are low. Very volatile exchange rates can affect a company very adversely and curtail expected profits. Introduction Purpose The main purpose of the report is to investigate how the volatility of the exchange rates affects the revenue of businesses that transact globally. Other purposes of the report are:- Investigate the other risks that a financial institution undertakes due to the uncertainty of the exchange rates. Measures that can be used by businesses to curb erratic exchange rate fluctuations. Fiscal and monetary measures used to control exchange rates of a country. Find measures to be undertaken to curb the adverse effects of exchange rate volatility. Scope The exchange rates provided by the Bank of America have a set minimum and maximum level. The standard deviation highlights the maximum possible amount that the exchange rates can fluctuate while a minimum amount is also calculable. To calculate for a maximum value, the prevailing exchange rate value is summed up with the standard deviation. A reduced exchange rate value is achieved through deducting the standard deviation value from the mean exchange rate value. Method The investigation used the American company that sells luxury sports cars, USA Sports Cars and the Bank of America as sources of information with set exchange rates and their corresponding exchange rate standard deviations to highlight the extent of fluctuations. The fluctuations could either be increasing or decreasing. A table is drawn reflecting the various customers from Japan, UK, Canada, USA and South Africa with their corresponding quantity of cars sold. The various exchange rates are regressed on a linear model against variables like quantities of the luxury cars bought, the total average revenue to be generated and the adjusted revenue levels as a result of the standard deviations. Limitations There lacks coordination between various transacting countries due to conflicting adoption of financial systems. Some countries permit the use of balance of payment to influence domestic economic policies. The use of a fixed exchange rate system is an outdated form with unfavorable conditions. There are a lot of factors that can affect the exchange rates in a years’ time like political turmoil, insecurity, high interest rates. The probability of collusion of a few major corporations to suit their financial needs. The system, whether fixed or not, is actually a system of managed flexibility meaning likelihood of devaluation and of the local currency. Assumptions It has been assumed that the exchange rates remain constant even in their average levels.. The assumption that exchange rates in the domestic currency ($) remains fixed is also false. This is due to factors such as interest levels by banks that have a direct relationship with the exchange rate levels. The selling prices of the luxury cars remaining constant over the period of a year are not correct. Cars depreciate in value as time passes by coupled with the fact that better and newer models are manufactured and sold every day. There is an assumption that buyers of the luxury cars are rational. This is contrary to the actual events since they are mostly unaffected by variations in the global currency markets due to their enormous wealth. There is no government interference in the exchange currency markets especially on the domestic front in order to ensure better balance of payments. Background Companies that transact globally are heavily reliant on global currency markets that are very volatile and highly impossible to predict. The differences brought by different conversion rates can have both positive and negative effects (Barton & Roberto, 2003). They can result in heavy losses or even supernormal profits as they are entirely reliant on the global currency markets. In this case, USA Super Cars even through the intervention of the government is still under risk of being wiped out of the industry by the fluctuating currency levels in the market. The American company which transacts in the UK, South Africa, Japan and Canada can only hope that the balance of payments of their individual countries are not too unfavorable. This is because the sale of luxury cars is reliant on the fact the buyers are financially stable otherwise business revenue levels will take significant hits especially countries that are of a lower financial standing in the global currency markets. Deals entered before fluctuations might seem like worthwhile ventures only to result in losses due to the volatile exchange rates. In this case, the company traded in the sale of luxury cars all over the world over a period of one year. Projected revenue levels even with the adjustments provided in the form of standard deviation by the American Bank, might not curtail the risk to both the bank and the company. The following information was obtained from USA Sports Cars. Number of sports cars sold over the course of the year=27 Total Revenue (using the average selling price in dollars) = $2,219,855.3 Using assigned standard deviation (highest revenue) = $2,278,118.7 Using assigned standard deviation (lowest revenue) = $2,118,131.9 Findings The following information was obtained from USA Sports Cars. Number of sports cars sold over the course of the year=27 Total Revenue (using the average selling price in dollars) = $2,219,855.3 Using assigned standard deviation (highest revenue) = $2,278,118.7 Using assigned standard deviation (lowest revenue) = $2,118,131.9 Customer Quantity Selling price Exchange rate mean Exchange rate standard deviation($) Converted selling price ($) UK 12 £ 57,500 1.40300 2,375.5 80,672.5 Japan 1 5 Y 8,400,000 0.00912 3,780.0 76,608.0 Japan 2 3 Y 9,000,00 0.00912 4,050.0 82,080.0 Canada 1 1 CAD 97,00 0.82490 3317.4 80,015.3 Canada 2 3 CAD 100,00 0.82490 3,420.0 85,910.0 South Africa 2 R 4,100,00 0.02110 3,403.0 89,913.0 U.S.A 1 $ 100,000 1.00000 100,000.0 Calculations Using the linear model formula (y=a+bx) ∑y= na +∑xb ∑xy= ∑xa+∑ x^2 ∑y represents the total selling price of the luxury cars in dollars. ∑x represents the total number of cars. ∑xy represents the total revenue using the average exchange rate. n represents the total number of customers globally. The following results are obtained from the table above. Y=87,161.47-805.72x In the calculation of probabilities, the data below is used. Highest revenue $ Lowest revenue $ Average revenue $ 996,360.0 939,780.0 80,672.5 401,490.0 36,4140.0 76,608.0 258,930.0 23,4090.0 82,080.0 83,332.7 76,697.9 80,015.3 257,730.0 237,210.0 85,910.0 179,826.0 166,214.0 89,913.0 100,000.0 100,000.0 100,000.0 Total highest revenue=$ 2,278,118.7 Total lowest revenue=$2,118,131.9 Total average revenue=$2,219,855.3 The chart shows the relationship between the quantity of cars, their respective selling prices in dollars, and the total revenue attainable under average exchange rate levels. Decisions in USA Super Cars (1)Mean of total revenue =Total revenue/total number of cars =2197855.3/27=$81,402.05 per car Standard deviation of total= [{(80,672.5) ^2 + (76,608) ^2 + (82,080) ^2 + (80,015.3) ^2+ (82,490)^2+ (86,510) ^2+ (100,000) ^2}-{7*81,402.05^2}]/7 =0.154 (2)Probability revenue will exceed $2,200,000=0.034 Probability revenue will exceed $ 2,250,000=0.012 (3)Probability revenue will be less than $2,160,000=0.9802 Probability revenue will be less than $2,130,000=0.9944 (4)The offer by HSBC is good for USA Super Cars because it is higher than the lowest possible revenue amount that can be collected through exchange rates. (5)The Sales Manager is more risk averse because he would rather avoid a potential loss (2,150,000-2,118,113.9) than a potential gain (2,278,118.7-2,150,000). (6)Other risks include the risks involving the gain or loss of unexpected incomes. (7)It would make a huge difference if the sum to be aid was in 3 months rather than a year’s time, due to factors such as inflation. The bank would prefer the payment to be made when the exchange rates are high so it can reap profits while the company would prefer payment when exchange rates are low. (8)Probability bank will incur loss=0.045 (9)Bank’s value at risk=0.05*58,263.4=$ 2,913.17 Bank’s expected profits=$(2278118.7-2219855.3)= $58,263.4 (10)The bank can decide to increase interest rates with a view of increasing the exchange rates through increased money supply in the economy. Recommendations Instead of waiting for the quarterly results to find out the effects of the fluctuating exchange rates, look at where the exposure lies. Analysis of risk is very important when dealing with foreign markets. This is a simple tactic that only involves monitoring the changes in the currency market (Edwards & Carlos, 1997). Through currency hedging. This comes in very many different forms such as exchanging the currency in tranches. When a person is not sure about whether an exchange rate is favorable, you can change it in parts instead of doing it wholly. Companies should use the forward contract method, which is a risk management tool. It allows for the management of currency requirements by agreeing an exchange rate on a material day and then buying or selling the currency in the future when it is most favorable. This is mostly lucrative when the exchange rate in the market favors you .More flexibility can also be afforded by paying a fairly low deposit amount usually of about 5%.It has the added advantage of reducing the risk brought by the volatile currency markets. Businesses can also manage their exposure by practicing some business practices. They can for instance for firms which are international, they can be able to recoup some of their losses from other beneficial currencies. In case there are contracts, clauses can be inserted in them to ensure that the business and the customer have limited exposure in case exchange rates go above the agreed upon levels Other options put forward propose the use of derivatives which is a very complicated method. However, it is a very effective tool because it exposes the volatility of exchange rates and provides a vivid outlook on how well a business’ operations are functioning. This has the added effect of removing redundancies and increasing the revenues of the business, Conclusion The management of currency is by nature very volatile and unpredictable but through prudent financial measures, a firm’s risk can be managed efficiently to prevent crippling losses. It is therefore the responsibility of every business to be vigilant on the exchange rates and adopt the appropriate measures at their disposal in order to be profitable (Mattoo & Prachi, 2012). From the findings, we can conclude that businesses, especially those of international standing are affected by exchange rates either positively or negatively. Positive results include higher profits while negative results include massive losses. However, a number of mechanisms can be adopted to combat the effects of exchange rates such as through forward contracts among many others. As earlier said, in order to deal with currency exposure you have to manage risk. References The Effects of Changes in Foreign Exchange Rates 2000. New York, N.Y.: International Federation of Accountants. Edwards, S. & Carlos A. G. 1997. Banks and Macroeconomic Disturbances under Predetermined Exchange Rates. Cambridge, MA: National Bureau of Economic Research. Barton, D. & Roberto, N. 2003. Dangerous Markets: Managing in Financial Crises. New York: John Wiley and Sons. Mattoo, A. & Prachi, Mi. 2012. Spillover Effects of Exchange Rates a Study of the Renminbi. Washington, D.C.: World Bank, Development Research Group, Trade, and Integration Team. Read More