Free trade Book Report

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free trade

Introduction The foreign exchange market is one of the most important financial markets.
It affects the relative price of goods between countries and so can affect trade. It means
that it affects the price of imports and so affects a country's price level (inflation
rate). It also affects the international investment and financing decision. In this
project, we will try to find why exchange rate would give many risks to a company and how
a company can hedge itself. Definition of Exchange Rate The price of one currency
expressed in terms of another currency is called an exchange rate. With the price it is
normal to quote them as the price for one unit of the good. The price of a jacket is how
much you have to pay to get 1 jacket. The price of a car is how much you pay to get 1 car.
The exchange rate between AUS and US from AUS's point of view is how many AUS dollars you
have to pay to get 1 US dollar. Since you have to pay about AUS$1.55 to get 1 US dollar
the exchange rate between AUS and US is 1.55. In this case, the US dollar is the
"commodity" currency and the AUS dollar is the "terms" currency. We denote this
SAUS/US=1.55. If a currency appreciates it becomes worth more and so you need less of it
to buy one unit of another currency. This makes imports cheaper. For example, if the AUS
dollar appreciates then SAUS/US will fall from 1.55. On the other hand, If a currency
depreciates it becomes worth less and so you need more of it to buy one unit of another
currency. This makes imports more expensive. For example, if the AUS dollar appreciates
then SAUS/US will rise from 1.55. Why does FX give risks to a company? Every daily
exchange rate is changing over time. It might fluctuate slightly or go up and go down
sharply. On the diagram1 is the daily exchange rate between AUS dollar and US dollar from
4 January 1999 to 17 March 2000. It shows that it fluctuates over time and the spread is
from 0.6018 to 0.6738. If we consider this point, we can see how important the exchange
is. For example, if the yearly international sales are $10 million US dollars and if the
exporter wants to convert US dollars into AUS dollars, he/she may need to hedge for
himself/herself. If the exporter can buy a forward contract in a year time at
SUS/AUS=0.6138 in 1 January 1999, he/she will receive $AUS16.3 million dollars in 1
January 2000. However, if the exporter does not do anything about it, the exchange rate is
SUS/AUS=0.6583 and he/she will only receive $AUS15.2 million dollars. There is a large
difference between those two strategies about $AUS1.1 million dollars. Thus, we can how
large the difference is. However, there are still many other effects to affect the
exchange rates such as: ? Economic conditions ? Government policies Economic Conditions A
country's economic condition has a great effect on the exchange rate such as inflation
rate, interest rate. From theory, it can be observed in the covered interest parity,
uncovered interest parity and purchasing power parity. We all know that at a booming
period, the exchange rate should appreciate that is bad to exporters and at a recession
period, the exchange rate should be depreciate that is bad to importers. However, the
following case is to illustrate that when the exchange is depreciating, there is no
advantage to either exporters or importers. Financial Crisis Financial crises can take
various forms. It can be individual crisis, multiple countries crisis and global
recession. Some examples are: ? A purely speculative attack on a fixed exchange rate (such
as New Zealand in 1984) ? A stock market and property collapse which leads to banking
problems and eventually bankruptcies and a slowdown or prolonged recession in the economy
(The Great Depression of 1930's) ? International financial crisis in which a crisis in one
country spreads across multiple countries (the Asian Financial Crisis 1997-1998) There are
still many other financial crises over centuries. However, most of those crises cause the
great depreciation on exchange rates. I will discuss the most recent issue in this
century: the Asian Crisis. Asian Crisis The excessively lending, borrowing and spending
and an overly view about the future growth and a poorly banking system. This creases
"self-fulfilling". Investors think only that there are always profitable investments, low
interest rates and stable currencies. Most other investments may not be such profitable at
that stage. They were still making an expansion decision because of government
encouragement and poorly banking system. However, investors were sensitive for the
profitability. Then they start to doubt the highly leverage firm that could pay the debt
or not. Finally, they started to pull the money out of sharemarkets and debts in those
countries. Some of the firms closed down. However, it was not the end of the story. There
was a second attack to corporate firms. Because of pulling out the funds from firms, the
foreign investors were trying to exchange back to their own currencies. Then the exchange
rate started to drop down sharply. Some importers were losing much money and bankrupt in
this period. However, some exporters also suffered in this depreciation of exchange rate
because the costs of raw materials imported from overseas were more expensive than before.
Currency Crisis made the government to be panic. Then the government was trying to
stablise the exchange rate by increasing the rate of interest. However, this action slowed
down the investments again and more companies had more problems in paying their debts.
There was a strong linkage between Asian countries meant that some companies borrowed from
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