2. Exchange Rate risk. Impacts of appreciation on profitability (Sony example).

Question

2. Exchange Rate risk. Impacts of appreciation on profitability (Sony example). 3. You will not have to draw a demand & supply graph; however, you should be able to analyze how various events will impact exchange rates. 4. How do countries "fix" exchange rates? What role does the central bank play? What are international reserves? 5. How can a central bank cause the value of its currency to appreciate or depreciate? 6. You should be able to explain how a Central Bank's manipulation of its currency impacts the money supply & consequently real GDP and inflation. 7. Currency Pegging. How it works. Advantages & disadvantages.

Explanation / Answer

2. Foreign exchange risk is the risk that the firm runs into when it does business transactions in a currency other than the domestic currency of the firm. If the domestic currency appreciates, then the earnings in foreign currency will value lesser and hence will be a loss to the firm when they convert profits to their domestic currency. Sony is a company that manufactures in various countries other than the US. Thus, it is exposed to foreign exchange rate risk. Hence the firm is into a lot of derivatives to reduce the risk of foreign exchange fluctuations.

3. Foreign exchange is the rate at which one currency is exchanged for the other. Now, it is determined by the demand and supply in the market. If the demand is more than the supply, the rate will increase. If the supply is more than the demand, the value will fall. The demand and supply for any currency is impacted by Imports, exports, foreign loans, etc., where money moves across nations.

4. International reserves are the reserves that a country holds like foreign currencies, gold, etc., Now countries may sometime face scenatios where the exchange rate falls down without a floor. To revive the rate in the market, the central bank of the country will buy their own currency by selling the international reserves. This will boost the demand and fix the rate fall. Also, when the rate shoots up, the central bank will sell its currencies to ensure that the rate is not beyond its band.

5. The central bank has the power to make the value of the currency appreciate or depreciate as it has the custody of the international reserves. To appreciate the currency, it will buy the domestic currency increasing the demand. And to depreciate the value, it will sell the domestic currency thereby reducing the gap between demand and supply.

6. When the central bank manipulates the exchange rate by selling/buying the domestic currency in the market, it will have ripple effects in the market. If the central bank depreciates the currency, it will increase the supply of money thereby creating an inflation in the domestic market and inflate the GDP in nominal terms. When it appreciates the currency, it runs the risk of falling into a deflation, so this policy should be closel monitored to not affect the domestic economy severely.

7. Currency pegging is where the exchange rate is fixed. The country will fix a rate and this will not fluctuate in the market providing a pillar support to engage in foreign trade. The major advantage is on the country's exports. It can transact with a country with low production cost and reap benifits fully with fixed rate. The country will also not have the trickle down effect of a currency devaluation causing inflationary pressures in the nation. Thus it will have a good economic growth. However the disadvantage here is that the country has to hold an enormous amount of exchange reserves which will take a toll on the price level of the country.

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