Background information
Kim (2006, p.110) defines the exchange rate as the price of a particular currency compared to another currency. In a free market, the exchange rate is determined by the market forces of demand and supply. The exchange rate is important in facilitating investment and foreign trade. In their operation, Multinational Corporations (MNCs) are faced with numerous risks (Kim, 2006, p.110). Some of these risks arise from the fact their cash flows have to be transmitted across national boundaries. As a result, the cash flows are subject to several constraints, for example, exchange rate fluctuations.
Madura (2010, p.233) thinks that managers of MNCs should have a comprehensive understanding of how the interest and inflation rates affect the exchange rates. This arises from the fact that inflation and interest rates have a significant impact on the value of MNCs.
To be effective in making investment decisions in various investment vehicles such as bonds, investors should evaluate the term structure of interest rate (Choudhry, 2004, p. 59). This enhances the efficiency with which the investors evaluate the future value of their bonds. One of the theories that explain the investors’ expectations of future interest rates is referred to as the expectations hypothesis. The hypothesis asserts that the bondholders’ expectations influence the changes in future interest rates.
Aim
This paper is aimed at evaluating the value of Purchasing Power Parity (PPP) theory to managers of multinational corporations. Additionally, the paper also evaluates whether the assertion that the forward rate is a valid predictor of the future spot rate according to the expectations hypothesis.
Scope
This paper is organized into two parts. The first part entails an analysis of the importance of purchasing power parity to managers of multinational corporations. The second part gives an analysis of the expectations hypothesis. The last part gives a conclusion and several recommendations.
The Purchasing Power Parity theory
One of the theories that managers of MNCs can use to determine the exchange rate is the Purchasing Power Parity [hereafter referred to as PPP]. The PPP theory postulates that the exchange rate applicable between two currencies is in equilibrium if the purchasing power of the two countries is similar (Afanasenko, Gischer & Reichling, 2011, p.125). The theory attempts to predict the change in spot rates based on the forward rate. According to Madura (2010, p.233), there are two main forms of PPP. These include a relative and absolute form of PPP.
Determination of the effect of inflation on the exchange rate
In their operation, MNCs are faced with numerous risks. One of these risks is an economic risk. Economic risk refers to the risk that a firm faces about the present value of its future cash flows. Economic risks arise from exchange rate movements (Papaioannou, 2006, p.135). Economic exposure may erode the value of a subsidiary’s remittances to its parent company.
The theory of PPP enables managers of MNCs to manage their corporations more efficiently. According to Madura (2010, p.234), the relative form of PPP takes into consideration the possibility of occurrence of various forms of market imperfections that might arise as a result of tariffs, quotas, and transportation costs.
As a result, this form of PPP postulates that the price of similar commodities in different countries varies when the currency is measured in common terms. Additionally, a relative form of PPP theory postulates that adjustment of the exchange rate is critical to ensure uniformity of the purchasing power both locally and in the foreign country. This arises from the fact that a lack of uniformity in the purchasing power may cause consumers to switch to competitors’ products (Madura,2010, p.235). According to Buckley (2004, p.117), the relative form of PPP proposes that changes in the relative price of a particular group of commodities between countries determine the adjustment in the exchange rate. On the other hand, the absolute form of PPP postulates that in the absence of international barriers, consumers will prefer sourcing their products from markets with the lowest prices.
Managers of MNCs may use a relative form of PPP to determine how the exchange rate will react in response to a different rate of inflation between countries.
A high rate of inflation in the domestic country relative to the foreign country
Consider a case where the exchange rate of a particular currency is initially stable. If the domestic currency experiences inflation of 5% and the foreign currency experience inflation of 3%, the PPP theory postulates that the foreign currency will change as illustrated below.
ef = [1+ Ih/ 1+ If]-1
= [1+0.05/1+0.03]-1
=0.0194 or 1.94%.
This means that the foreign currency will appreciate with a margin of 1.94% as a result of the high inflation in the domestic country compared to the foreign country.
If this occurs, the price index in the foreign country will increase similar to that in the domestic country according to domestic consumers. This means that the domestic consumers experience an equal increment in the price index both in the foreign and the domestic markets. Madura (2010, p.236) asserts that appreciation in the foreign currency results in an increment in the price index in the foreign country despite the low rate of inflation. From the above illustration, the price indexes in the two countries increase with a margin of 5%. The resultant effect is that the consumer’s purchasing power for local and foreign products is similar.
Illustration 2
A high rate of inflation in the foreign country relative to the domestic country
Consider a case where the foreign exchange rate is initially stable. If the rate of inflation in the foreign country in which a multinational corporation operates is 7% while that of its domestic country is 4%, the foreign currency will be adjusted as illustrated below.
ef = [1+Ih/1+If]-1
= [1+.04/1+0.7] -1
= -0.28
=-2.8%.
This shows that the foreign currency will depreciate with a margin of 2.8% as a result of the high rate of inflation compared to the domestic country. Despite the rate of inflation in the domestic country being low, the depreciation of the foreign currency exerts downward pressure on the price of foreign commodities according to domestic consumers’. The resultant effect is that the prices of commodities in both countries increase with a margin of 4%.
The above illustration shows that the theory of PPP enables managers of MNCs to develop a comprehensive understanding of how exchange rate movements may affect their firms’ future cash flows. This enhances the efficiency with which managers of MNCs incorporate effective strategies to hedge against the risk. For example, the managers of MNCs can be able to determine the impact of deviations in the exchange rate from the benchmark rate that the firm used to project its cost and revenue over some time. According to Papaioannou (2006, p.135), the theory of PPP enables managers of MNCs to net the impact of exchange rate movements over a particular range of products in different markets. Additionally, the theory of PPP enables managers of MNCs to be effective in undertaking international investment. This arises from the fact that the manager can understand the inflation rate differentials. For example, if a multinational company has a subsidiary company that is experiencing cost inflation that is higher than the general inflation, the subsidiary firm may experience a decline in its competitiveness. Additionally, its original value may decline if the exchange rate adjustments are not aligned to the PPP (Papaioannou, 2006, p. 135).
The Expectations Hypothesis suggests that the Forward Rate is a valid predictor of the future Spot Rate (e.g. the suggestion is that a 90-day GBP / EUR Forward Rate is a valid predictor of the GBP / EUR Spot Rate in 90 days). Using appropriate evidence, discuss whether this suggestion is true.
The expectation hypothesis
According to Buckley (2004, p.125), the future-forward rate of a particular investment is not always equivalent to the future spot rate. However, the forward rate tends to be higher than the future spot rate. This means that the forward rate is an unbiased estimator of the future spot rate. Choudhry (2004, p.61) further emphasizes that the forward rate is an efficient estimator of the future spot rate. According to this hypothesis, it is assumed that all investors behave in a manner that eliminates any benefit of holding an investment instrument to its maturity. The resultant effect is a positive-sloping yield curve. The theory asserts that the market expects that the spot interest rate will rise in the future. Additionally, this theory asserts that the long-term rate of interest represents the geometric mean of the expected future short-term rate of interest. This is the concept that is used to formulate the forward rate yield curve which is represented by the formula below.
1+rSN)N=1+rS1-1)N-1(1+N-1rfN)
rSN = Spot yield on a bond whose maturity is N years.
N-1rfN = implied one-year rate of interest for n years.
For example, if the spot rate is 5% and the market expectation of the interest rate after one year to is 5.539%, then the market expectations of a £ 100 bond after 2 years to be:
£ 100(1.05) (1.05539) =£ 110.82
For the expectations hypothesis to hold, a 2-year bond should result in equivalent returns. This would mean that the current 2-year rate would be rS2= 5.27% to yield £ 110.82. That is:
£100(1+rS2)2 =£110.82
This illustrates the assertion by the expectation hypothesis that the forward rate is a valid predictor of the spot rate.
Despite the forward rate being a decent estimator of the spot rate according to the expectations hypothesis, several studies conducted have shown that forward rates are biased estimators of the future spot rate. This arises from the fact that the forward rates regularly over-estimate the spot rate. Additionally, investors can’t predict the future spot rate over a long period for example 20 to 30 years. A study conducted on the forward rate about several currencies which included the US dollar, the Swiss Franc, and the Deutschmark revealed that the forward rate was an effective predictor of the 30-day forward rate but not on the 90-day forward rate (Buckley, 2004, p.125). This means that the accuracy of the forward rate as a predictor of the spot rate diminishes as time increases. Choudhry (2004, p.62) asserts that the future yield of a bond is determined by market change. Because it is not possible to estimate the market changes, it becomes difficult to estimate the future spot rate using the prevailing forward rate.
Another criticism regarding the validity of the forward rate as an unbiased predictor of the spot rate is evidenced by a study conducted by Kaserman in 1973 which revealed that forward rate results in undervaluation of the spot rate. This mainly occurs when the forward rate is rising. The theory also assumes that investors are risk-neutral (Hallwood & MacDonald, 2000, p.35).
Another study conducted by Wong in 1978 revealed that the forward rate is a valid predictor of the spot rate only in the long run. However, in the short and medium-term, it is a biased estimator (Buckley, 2004, p. 125). Buckley (2004, p. 125) further asserts that the current/ prevailing spot rate about a particular investment instrument is a more superior predictor of the future spot rate compared to the forward rate.
Conclusion
The analysis has illustrated the value of PPP theory to managers of multinational corporations. For example, in their operation, MNCs are faced with an economic risk that emanates from fluctuations in the rate of inflation both in the local and foreign markets. Fluctuation in the rate of inflation results in exchange rate movements which may affect the value of a multinational. The PPP theory enables managers of MNCs to develop a comprehensive understanding of how exchange rate movements may affect their firms’ future cash flows. This is because the manager can determine how the exchange rate will be affected and hence the corresponding changes in the consumer’s purchasing power. The theory also enables managers of multinationals to formulate effective strategies to hedge against economic risk. Additionally, by analyzing the inflation differentials between the domestic country and the foreign country, the managers of a multinational corporation can make an effective decision about international expansion.
The paper has also shown various criticism of the assertion by the expectation hypothesis that the forward rate is a valid predictor of the spot rate. For example, the forward rate can’t estimate the spot rate of particular security if its period is relatively long for example 90 days. The analysis has also illustrated the biased characteristic of forwarding rate in estimating the spot rate in that it results in undervaluation.
Recommendations
For managers of MNCs to be effective in making investment decisions, they should consider integrating the theory of purchasing power parity. This is because the theory will enable them in determining the effect of inflation on the exchange rate and hence the firm’s future cash flows. Additionally, PPP theory may enhance the efficiency with which the managers implement effective risk hedging strategies hence improving their firms’ competitiveness. For example, the managers can be able to implement decisions that safeguard the value of the company from being eroded. Additionally, to be efficient in predicting the future spot rate, investors need to take into account market changes. This arises from the fact that the market is characterized by numerous inefficiencies.
Reference List
Afanasenko, D., & Gischer, H., & Reichling, P., 2011. The predictive power of forward rates. A re-examination for Germany. Investment Management and Financial Innovations. Vol. 8, issue 1, pp. 125-139.
Buckley, A., 2004. Multinational finance. New York: FT Prentice –Hall.
Choudhry, M., 2004. Corporate bonds and structured financial products. Amsterdam: Elsevier Butterworth.
Hallwood, C., & MacDonald, R., 2000. International money and finance. Malden: Blackwell.
Kim, S., 2006. Global corporate finance. Malden: Blackwell.
Madura, J., 2010. Financial markets and institutions. Mason: Cengage.
Madura, J., 2010. International financial management. Australia: Cengage. Papaioannou, M., 2006. Exchange rate risk measurement and management: Issues and approaches for firms. South Eastern Europe Journal of Economics. Vol. 2, pp. 129-146. New York: International Monetary Fund.