The Concept of Forward Rates
The forward rate , in all probabilities, contains a discount. Thus, if the forward rate is used to forecast the value of Yuan in the future, it will imply a lower spot rate in the future than the spot rate that is prevailing today (depreciation of the Chinese Yuan).
Forward rates estimated by Chinese interest rate and currency will cause favourable premiums.
Forward rates help in predicting future contracts and prices for Bell Being School.
Bell Beijing School will be more profitable in Non-Australia country like China. Since ,interest rates are higher in China than Australia. More teacher will be willing to teach English to students.
Does the forward rate reflect a forecast of appreciation or depreciation of the Chinese Yuan? Explain how the degree of the expected change implied by the forward rate forecast is tied to the interest rate differential
The larger the degree of the interest rate differential, the larger is the value of the forward rate discount, and the larger is the expected degree of depreciation in the Chinese Yuan that has been implied while utilizing the forward rate to forecast the future spot rate
When interest rate is high, greater influence is stimulated on forward prices at the end of the month. Increased revenues in Bell School causes high supply of money in the economy.Interest rate is set by the People`s Bank of China which also influences supply of money (Chinese Yuan) in the economy (Gopinath, 2015). A depreciation of the Chinese yuan may be observed
Investing initial capital $60000 on forward rates will reflect a depreciation. Having in mind that the Chinese Yuan is weaker currency compared to Australia dollar.
you think that today’s forward rate or today’s spot rate of the Yuan would be a better forecast of the future spot rate of the Yuan?
The forward rate in comparison to the spot rate, should be a better forecast of the future spot rate of the Yuan. This is because it accurately covers the potential adverse or negative effects of the high inflation in China which is evident from the higher interest rates. Furthermore, the spot rate as a forecast tool reveals no change in the value of the Yuan.
Spot rate is a price or a quote for a contract that involves sale or purchase of a commodity or currency for the purpose of payment or delivery within two business days after the trade date . This is not suitable as it poses a short term plan for Bell Beijing.
Instruments for Hedging Risk
Spot rate is determined by bid ask spread. Bid involves students who are willing to register for a month or week course immediately. Ask is a price which teachers will charge and student are willing to pay. This may reduce the liquidity of business due to large bid spread which would lead to a lower number of contracts.
When high liquidity is experienced due to a greater number of contracts, greater risk should occur.
- Methods to reduce the risk of a depreciation in Chinese Yuan
Risk is an important component of business. Forward rate reflects depreciation of the Chinese Yuan currency.
The country`s economy will experience a disturbance due to manipulation on interest rates and money supply. Lowering of the interest rate will motivate a MNC manager and investors to use forward rates due to high profits. Profits or revenues derived from the business of Bell Beijing, will further encourage the business to expand and train more students.
Note that depreciation is also an advantage as a result of forward rates. Depreciation encourages high student registration to part-take the each courses.
One of the most potential solution for handling risk of a depreciation in Chinese Yuan is investment in hedged assets .
The method that may be adopted by the business owner in reducing the risk of depreciation in Chinese Yuan is currency futures. Currency futures refers to that method which is widely used for the purpose of hedging risks with a meagre amount of upfront margin.
The availability of the exchange traded funds also help the business owners to hedge risks in dealing with foreign currencies
List, explain and illustrate what other instruments you can use to hedge your future cash remittance to Australia.
Currency risk may occur due to higher deposit rate leading to high risk. Spot rate would be less risky (Gopinath, 2017) for Bell Beijing. Exchange and interest rates have to be predicted by the owner. Various instruments are used to hedge risk, for instance:
Interest rate parity ensures coverage of interest rates that are more or less likely to be 1%. When Australia interest rate is lower than China`s, if one month structure course has a lower interest rate, the owner of the business will receive more currency transaction. Interest rate differences allows forward premium.
International fisher effect shows percentage change in spot exchange rate over differences between two countries nominal rate. If interest rate in China is 4% while the interest rate in Australia is 9%, business owners in China will take advantage of arbitrage profit of 5%.Teachers in the school of Bell Beijing in China will teach more students for both course structures.
Currency Swap Transaction
Assume that for the expansion of the China business company you decided to invest five million Chinese Yuan in your Chinese subsidiary to support local operations. You would like your subsidiary to repay the Yuan in one year. In order to protect against a depreciation in Yuan you would like to engage in a swap transaction. Explain how you would structure the swap transaction today.
We have to identify our new word as swap. Swap is a derivative that is traded over the counter between parties. Swaps are used to hedge from risk due to speculated change in interest rate (Farhi, and Gabaix, 2015). Swaps have agreed dates when cash flow are to be paid and calculated.
There are three kinds of swaps, viz. commodity swaps, currency swaps and equity swaps.
Currency swap uses fixed interest rates and exchanging principal payments on a loan in one currency. Cash flows are calculated on principal amount. (Narayan, and Sharma, 2015.
Bell Beijing school for the purpose of expansion receives five million Chinese Yuan for the proper execution of the local operations. The business will have to return the amount in one year. It is assumed that the loan has been forwarded to business under floating rates.
Bell Beijing receives payments of five million multiplied by 1.5% interest rate, amounting to7.5 million. For investment 5M (0.25+1)=6.25 million. The business owner or the MNC manager owes Bell school 1.25 million since it was for hedging purposes.
Both parties monitor their cash flows. Swap contract helps them to hedge from uncertain variables like floating exchange rates and Bell Beijing English School fee structure.
4.a)You are already aware that a decline in the value of the Yuan could reduce your dollar cash flows. Yet, according to purchasing power parity, a weak Yuan should only occur in response to a high level of Chinese inflation, and such high inflation should increase your profits. If this theory holds precisely, your cash flows would not really be exposed. Should you be concerned about your exposure, or not? Explain.
The owner of the business or the MNC manager should be concerned with the exposure
This is because it cannot be accurately assumed that the rate of inflation in China would be able to offset the depreciation of the Chinese Yuan
Furthermore, even if the case is such that the inflation rate perfectly covers for the depreciation in the currency, the obtaining of the inflated profits from the business is not guaranteed that invariably matches with the country’s rate of inflation
Concerns about Exposure to Currency Risk
The occurrence of inflation also does not guarantee increased profits as the increase in the course fee structure will not be favorable, as the fellow competitors will be pricing their course very low
you shift your invoicing policy to be only in dollars, how will your transaction exposure be affected?
A shift in Bell school policy to only dollars will cause currency risk. Assuming that one Yuan equals 0.2 dollars. A decline in Yuan currency is a main factor. Less transaction will be made due to high interest rates. Losses will be incurred under currency trade into dollars.
There will be a decline in demand for English courses by students. This will result to reduced profits and forward rates hindrance to unexposed individuals. Short term economic exposure will result to deflation because of high interest and low money supply.
Less clients will be unwilling to use forward rates without hedging against risk.
Bell School will use floating exchange rates, making it difficult to hedge against risk. Lower interest rates will lead to low amounts of repayments by the business to its owner. A decline in the Yuan could reduce the worth of dollar cash flows due to fixed rates (Frenkel, and Johnson, 2013).
Bell School will use floating exchange rates, making it difficult to hedge against risk. Lower interest rates will lead to low amounts of repayments by the business to its owner. A decline in the Yuan could reduce the worth of dollar cash flows due to fixed rates (Frenkel, and Johnson, 2013).
Why might the demand for your business change if you shift your invoice policy? What are the implications for economic exposure?
The demand for the business would very likely be affected in case the invoice policy has been shifted
The weakening of the Chinese Yuan would result in the customers paying more, in order to obtain the estimated profit in dollars
Therefore, this will reduce the demand for the services offered by Bell Beijing
The shifting of the invoice policy does not necessarily protect the business against exchange rate risk
Moreover, the economic exposure cannot be eliminated even if the transaction exposure has been removed
References
Frenkel, J.A. and Johnson, H.G. eds., 2013. The Economics of Exchange Rates (Collected Works of Harry Johnson): Selected Studies (Vol. 8). Routledge.
Farhi, E. and Gabaix, X., 2015. Rare disasters and exchange rates. The Quarterly Journal of Economics, 131(1), pp.1-52.
Gertler, M. and Karadi, P., 2015. Monetary policy surprises, credit costs, and economic activity. American Economic Journal: Macroeconomics, 7(1), pp.44-76.
Gopinath, G., 2015. The international price system (No. w21646). National Bureau of Economic Research.
Gopinath, G., 2017, October. Rethinking Macroeconomic Policy: International Economy Issues. In Rethinking Macroeconomic Policy Conference, Peterson Institute for International Economics, October (pp. 12-13).
Narayan, P.K. and Sharma, S.S., 2015. Does data frequency matter for the impact of forward premium on spot exchange rate?. International Review of Financial Analysis, 39, pp.45-53.
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