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Running head INTERNATIONAL FINANCE INTERNATIONAL FINANCE Ahmed Majed AL-Hrazin 200800293 Bader Marzouk AL-Balawi 200900163 Dr. Mohammad A. Magableh 1 2 INTERNATIONAL FINANCE International Finance Introduction Up-tech Technologies is a multinational computer and mobile phone developing company. Up-tech Technologies has branches in over five countries in five continents. Up-tech Technologies headquarters is in Amrock New York City in the United States of America. The company was established in 2002 with the aim of providing innovative technologies for daily and professional use. Up-tech Technologies has a global market capitalization of 35% of the computers supplies. Through is brand of computers and mobile phones known as Up-tech, the company reaches over 30% of the domestic computer users and 15% of companies using computers. The main market for Up-tech Technologies products are the personal users of computers and mobile phones and organizations that require special computing equipment. Up-tech Technologies’ main products Up-tech computers and Up-tech mobile phones are recognized as the preferred brands in the United States of America, China, South Africa, Canada, Australia, United Kingdom, and Germany. The brands are known for their superior design in aesthetic feel and functionality. Up-tech computers are known to be high performance computers with the ability to perform advanced computing operations. The brands are known to be small and slim offering unmatched portability attributes in the market. Up-tech mobile phones emerge as high performance mobile phones that operate as smart phones. The devices have a long battery life and quality music and pictures. The mobile phones are also known to have multiple functionality including the ability to perform as Wi-Fi hot spot devices and are equipped with modern technologies such as compatibility with android and open source platforms. Up-tech Technologies Company intends to roll out the distribution of Up-tech computers and Up-tech mobile phones in South Korea. South Korea has emerged as a formidable economic country in Asia after the Korean War. The country, which hosts more than 50 million nationals, has seen the rise of urbanization and the continuous acceptance of the western culture and modern trends. South Korea has also emerged as an Asian technological hub. The South Korean currency is the won. 1 United Stated dollar equals an average of 1,154 Korean won. The exchange rate varies over time. South Korea has had a robust foreign trade and economic input with respect to the export and import. The fact that South Korea is a member of Organization for Economic Cooperation and Development that coordinates economic policies makes it a viable market and stable partner with regard to policies and legal issues. INTERNATIONAL FINANCE 3 The commerce of Up-tech computers and Up-tech mobile phones faces challenges resulting from the fluctuation of the South Korean currency exchange rate against the dollar. Being that Up-tech technologies has its headquarters and production plant in the United states while the market will be in South Korea, the exchange rate has the potential of altering revenue stream and profit margin of the company. The production process, which is the object of the cost of production, is carried out in the United States. Continuous change in the exchange rate of the currencies of these two countries poses a risk to the financial projections of the multinational. This study assesses the effect of the variation in exchange rate in the financials of Up-tech technologies from the export of its goods to South Korea. Country Factors That Affect the Demand for the Product South Korea is the ninth largest exporter of good and services in the world. The country is also the fourth largest economy in Asia. Most of South Korea revenue comes from its exports to other countries. Although the country has vast amount of manufacturing activities, the lack of natural resources and sources for basic goods has put South Korea into a predominant importer position. The balancing of the capital flow based on short term debts and foreign investment has pose challenges to the country. South Korea is in a precarious situation in maintaining the domestic economy that relies primarily in the foreign trade and the international economy (Svensson, 2000). The country has instituted several foreign exchange controls that are aimed at managing this situation. These controls primarily instituted to manage the fluctuation of the currency will affect the export of mobile phones and computers to South Korea by Up-Tech technologies. South Korea has in the past instituted currency controls with the aim of curbing the shifts in capital flows. The country had faced challenges that are linked to its short-term foreign debts because of its nature as a major exporter. The actions are purposed to stabilize the currency. The restrictions include the control of slap limits on the exchange banks and other financial institutions. The restrictions are aimed at controlling currency forwards, cross currency swaps and non-deliverable currency forwards. The rules infer that currency forwards and derivatives will be at 50% of their equity capital with the foreign branches of the banks having a cap of 250% of the equity to account for their lower capital (Svensson, 2000). South Korea intends to control the capital flow through these rules. INTERNATIONAL FINANCE 4 In addition to these laws, there are other regulations that have been imposed on the exchanges. Other controls such as transaction taxes and transaction limits exist in the economy. South Korea has employed caps to allow the volumes of foreign currencies to be sold or purchased of various assets. The country sets transaction taxes such as the Tobin tax and imposes minimum stay requirements. Other regulations that will affects the operation of Up-Tech technologies in South Korea include the required mandatory approval of the exchange and the limits on the amount of money allowed to be removed from South Korea in facilitating its operation. South Korea has identified the importance of the adjustment of the financial sector and policies that affirm the capital control measures. Low inflation and stable inflation are internal factors that are essential in balancing the value of the currency. Foreign trade lengthens the horizon of the South Korean economy (Roubini, 2000). In as much as the foreign trade facilitated by the currency exchange plays this role with respect to inflation control, the need for evaluation and management of short-term debt and capital flow is central. Equilibrium between the foreign trade and the need for capital flow management implies on South Korea to establish need based policies and control. South Korea finds it important for the stability of the won. However, issues such as political and environmental factors have managed to intrigue volatility incurring risks. Foreign Exchange Market The won is a freely floating currency. South Korea trade with the international community does not allow the country to manage the floating of the currency. Management of the currency would result to the creation of an artificial economic environment for trade between the partnering country and South Korea. The floating rates automatically adjust in response to the economic environment. This facilitates South Korea to dampen the impact of shocks and foreign business cycle (Goldfajn, and Werlang, 2000). Considering the extent of trade through which the country conducts with the international community, it is essential that the possibility of having balance payment crises be pre-empted. The Asian currency crisis discouraged most of the Asian countries including South Korea from keeping a managed exchange rate. The graph below illustrates the performance of the won against the dollar for the year beginning October 2011 to October 2012. INTERNATIONAL FINANCE 5 The trend of the graph illustrates a fluctuating currency. The value of the won against a dollar oscillates between 1180 and 1080 won for every dollar. A variation of up to 100 won is exhibited from the trend. The general trend of the performance of the won shows an increasing value of the won since 2011 to late 2012. The graph below illustrates the trend of the performance of the won against the dollar for the past three months (quarter) The data shows the performance of the won against the dollar for the months of August, September, and October with part of November included for the year 2012. The statistical line illustrates a general increase in value of the won over the dollar for the period of analysis. The won exchanged against the dollar at a rate of between 1139 won and 1080 won for a dollar for 6 INTERNATIONAL FINANCE the period analyzed. The won fluctuated significantly within the quarter showing an unstable exchange rate. This poses high risk emerging from the high levels of uncertainty. The table below illustrates the annual average value of the won against the dollar for the period between 2000 and 2012. The general trend of the won over the period of analysis indicates a strengthening currency against the dollar. It is important to note the variation from the general trend between the years 2008 and 2010. The weakening of the won is imminent. It is during this period that there was a global financial crisis. From the event, it is inferable that South Korea heavily relies on international trade. The table below shows the forecast of the currency up to April 2013 Month Date Forecast Value 0 Oct 2012 1 50% 80% accuracy accuracy 1,107.4 0 0 Nov 2012 1,109 14 31 2 Dec 2012 1,122 18 41 3 Jan 2013 1,140 21 47 4 Feb 2013 1,161 23 52 5 Mar 2013 1,142 25 57 6 Apr 2013 1,126 27 61 INTERNATIONAL FINANCE 7 The forecast value depicts an improving currency. The won is projected to gain over the dollar. However, the trend will fluctuate as the currency gains and losses. The forecast are based on the indicated errors. Exchange Market Derivatives Foreign exchange exposes multinationals to three main types of exposures, which are transaction exposure, economic exposure, and translation exposure. Transactional exposure occurs when contractual cash flows of the company are subjected to uncertainty. The unanticipated changes emerging from the foreign currency exchange poses risk to the companies involved in foreign trade. The companies may not realize the domestic value of the money. Translational exposure defines the extent to which reporting of the financial is affected by the variation in the value of currencies international. The position of multinationals in relation to the competitors is affected by the exposure (Labuszewski, 2012). Economic exposure reflects to a firm exposure based on the operations. The exposure defines the degree at which the market value of a company is influenced by the unpredicted exchange fluctuations. The South Korean market through the analysis has shown that it is efficient. Like other efficient markets characterized by purchasing power parity, interest rate parity and the international fisher effect, there is need for hedging against foreign exchange risk. Up-Tech Technologies like other multinational companies intends to employing hedging strategies to reduce the risks associated with the exchange rate. The transaction exposure of Up-Tech Technologies will be managed using foreign exchange derivatives such as forward contracts, futures contracts, option, and swaps. Up-Tech Technologies also considers operational techniques such as currency invoicing, leading, and lagging of the receipts and payment and other measures such as exposure netting (Roubini, 2000). The realization that South Korean currency the won has registered historical fluctuations necessitates the adoption of the strategies to hedge the company from the posed risk. Currency swap describes a foreign exchange agreement between two parties that are in a mutual understanding to do business but operate in different currency jurisdictions (Svensson, 2000). The agreement involves accepting to exchange aspects such as principle and interest of a loan for the equivalent of one currency on the net present value of another currency. This agreement requires a comparative advantage between the two involved parties (Fischer, 2001). INTERNATIONAL FINANCE 8 This process will facilitate secure cheap debt and hedge against the exchange rate fluctuations. Being that the United States dollar is a world recognized standard of measurement, Up-Tech Technologies has the advantage of easily finding a company in South Korea that requires loan in United States dollars. Forward exchange rate involves Up-Tech Technologies agreeing with a bank to exchange the currency for future transaction in the projected future exchange rate when it will enter in contract to operate in South Korea. In this case, the risk of fluctuation is reduced because of the preempted value of the currency at the time it will be effectively required. The spot exchange rate and the difference in the interest rates between South Korea and the United States of America influence the parity relationship between Up-Tech Technologies and the other involved party. Through this arrangement, an economic equilibrium in the foreign exchange market is conceived for the elimination of the arbitrage opportunities (Labuszewski, 2012). Through the technique, the future spot rate is determined. The other derivative is the foreign exchange option. The foreign exchange option or the FX Option is an instrument that is usually employed by multinationals to reduce the exchange rate risks. The strategy involves the owner in this case Up-Tech Technologies having the right but not the obligation to exchange the money denomination in one currency to another currency based on a rate that was earlier agreed on a date. In this case, Up-Tech Technologies would have the right but not the obligation to change the United States of America dollars into South Korean won based on an agreed fixed rate. The market for FX option has the advantage of being the deepest, largest and the most liquid. The trading in this market is mostly over the counter but under high regulations. FX option hedging is primarily used in the event uncertain future cash flow in a foreign currency is expected. Certain cash flows are hedged using forward. Up-Tech technology is expecting to receive a cash flow of U.S. $ 10 million from its business in South Korea after 30 days if the current spot rate does not change. Being that the exchange rate is expected to depreciate; an FX option is the appropriate hedging strategy to be employed. In the event UpTech Technology does not hedge the expected cash flow, on the 30th day of payment, the company will receive less than US$10 million because of the depreciation. By using FX options, the expected cash flow will be fixed at its current exchange rate securing the cash flow from depreciation. Up-Tech Technology expected to pay for supplies in foreign currency equivalent to 9 INTERNATIONAL FINANCE U.S. $ 2 million from its business that foreign country after 30 days. However, the foreign exchange rate is expected to appreciate. To hedge these funds forwarding the exchange is advised. Through this strategy, the payment of the supplies will be made at the same amount of U.S. $ 2 million at an increased value won value than the current value. The spot rate is 0.0009221. The table above shows the futures option for the South Korean won against the united stated dollar futures/ options Discount Dec 2012 0.0009221 0.00000010 Jan 2013 0.0009210 -0.00000100 Feb 2013 0.0009195 -0.00000250 Mar 2013 0.0009183 -0.00000370 Apr 2013 0.0009171 -0.00000490 May 2013 0.0009159 -0.00000610 Jun 2013 0.0009146 -0.00000740 Jul 2013 0.0009136 -0.00000840 Aug 2013 0.0009125 -0.00000950 Month price The equation Futures = Spot Rate x 1 + [Rterm x (d/360)] is used to derive the discount rate of the won against the dollar as illustrated in the table above (Labuszewski, 2012). Summary and conclusion South Korea is a robust target market for Up-Tech technology investment. An analysis of the fiscal environment of the country indicates that South Korea has the potential to grow UpTech technology products and enhance the expansion. South Korea involvement in the international trade is encouraging for foreign investment. The correlation between the South Korea currency and the global economy indicate an economy that is consistent with the market trend. Moreover, the population of Seoul and other parts main cities is continuously growing. However, the venture needs to assess other risks specifically foreign exchange risk. INTERNATIONAL FINANCE 10 The impact associated with risk is established to be high. There is need for the situation to be managed through hedging. The appropriate hedging strategy and the derivative that works well for the situation is determined by the nature of the foreign exchange and the projected charge in the rate. Up-Tech technology should consider these factors as it proceeds to mitigate the available risks. The assessment recommends that Up-Tech technology company to proceed with investment in South Korea. However, there is need for management of exchange rate risks emerging from the possible fluctuation of the exchange rates. The report recommends appropriate hedging strategies for specified economic situations depending on projected depreciation or appreciation of the United States Dollar against the South Korean won. 11 INTERNATIONAL FINANCE Reference Fischer, S., (2001) Exchange Rate Regimes: Is the Bipolar View Correct? Journal of Economic Perspectives, 15 (2) pp. 3–24. Goldfajn, I., and Werlang, S. (2000) The Pass-Through from Depreciation to Inflation: A Panel Study, Working Paper No. 423, Department of Economics, PUC-Rio. Labuszewski , J.W. (2012) Managing Currency Risks with Futures, CME group [online]accessed form http://www.cmegroup.com/trading/fx/files/FX-261_FX-ManagingCurrency-Risks-with-Futures.pdf on 30 Nov. 12 Roubini, N., (2000) website on global macroeconomics [online] accessed from http://www.stern.nyu.edu/globalmacro/ on 30 Nov. 12 Svensson, L., (2000) Open-Economy Inflation Targeting, Journal of International Economics, 50, 155–183.