The law of one price (LOP) is stated the same concept of Purchase Power Parity. But for the real market it couldn't work sometimes. It can happen if one country's market has trade barriers for same commodity or price regulation by government. So, some goods can't be trade internationally and in this case price for typical goods will be different (houses, land etc.). The transportation cost and exchange rates volatility can lead to different price for the same product in two countries.
Otherwise, as Rashid (2007, p. 84) argues:
the law is true for those commodities for which accepted standard amounts can be defined, and which have prosperous traders who are habituated in transacting large sums of both money and quantities of goods.
Therefore, LOP could hold for raw materials such as steel. These type of commodity globally used and usually has equal price except transportation cost. The steel market is controlled by large companies, some of them is state owned. Thus, in 2007, "the 15 biggest manufacturers account for one-third of global crude steel output" (Perlitz, 2008, p. 8). The mining methods for ore and processing raw material to various steel products are similar to these companies. This fact as well as limited product range for steel raw products, traded internationally, applies to Law of One Price.
To define if LOP holds we obtain market data for steel common product - hot rolled sheet (w1500) in two countries.
In Russia this product could been purchased (on 12 of November) for 20400 rubles (RUR) per ton (MetalStroySnab, 2010).
The same product at the same date in China costs 4430 yuan per ton (Han-Steel, 2010).
To compare these prices we convert them to USD:
Exchange rate for Rubles: 30.7 RUR/$
Exchange rate for Yuan: 6.6YUAN/$
Hot rolled sheet price in Russia
20400/30.7=664$
Hot rolled sheet price in China
4430/6.6=671.2$
Therefore, cost of Russian steel product is nearly to cost of the same Chinese product. Thus, we can estimate that the LOP is holding.
Otherwise, in other countries or under certain circumstances this law can't keep up as well. The cause of this lays in different factors, including trade barriers, custom rates and price regulation.
Answer to Question 3:
As Buckley (2004, p. 747) argues:
Purchasing Power Parity (PPP) is the hypothesis that, over time, the difference between the inflation rates in two countries tends to equal the rate of change of the exchange rate between the currencies of the countries concerned.
PPP theory faces failure of possible arbitrage in price difference of the same product in different countries. The price calculated in currency in one country is equal to price in other country (price calculated with exchange rate for these currencies). For this assumption we don't include transportation and additional cost.
The formula for PPP is:
Pb(t)=Sab(t)*Pa(t),
where is
Pb(t) - price for product in country b, in domestic currency
Pa(t) - price for same product in country a, in domestic currency
Sab(t) - exchange rate for currency a against currency b
PPP theory shows that price difference between countries are not constantly in the long period as mаrket frces will equalize prices between these countries and chаnge exchаnge rates.
PPP defines for same international traded goods or basket of products. This method can be used to estimate whether the currency is undervalued or overvalued. In international trade PPP can be used for anticipating of exchange rate movements for foreign currency. Although it's very approximate method and depends on many factors including trade barriers and government regulatory policy for domestic currency.
Most famous index for measuring PPP is The Big Mac index based on the popular product of McDonald's fastfood restaurant and published by "The Economist":
"The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad. Comparing actual exchange rates with PPPs indicates whether a currency is under- or overvalued" (The Economist, 2000).
Despite some success this index is not used for defining real exchange rate of currencies and mostly shows the cost of living in different countries.
BigMac Index refers to absolute Purchase Power Parity.
Other variation is relative PPP. According to Suranovic (1997a) "In the relative PPP theory, exchange rate changes over time are assumed to be dependent on inflation rate differentials between countries".
It can be expressed with the following formula:
E(s)/S=(1+io)/(1+ih),
where
E(s) - expected spot rate
S - current spot rate
io - inflation rate in overseas country
ih - inflation rate in home country
This index can be based on the basket of commodities and services which have no internationally traded. RPPP used to predict exchange rates movements for currencies in long run.
For example, predicted year inflation rate in Russia is 7% and in USA 1%. According to RPPP RUR will depreciate against USD at 6% per year.
For international company the knowledge of expected inflation rate has great meaning. So, if company planning to open production facility within a country with high inflation rate in long run it must use this rate for finance calculation of production cost of product. It's necessary to save competitive level of price. By the way, the high level of inflation affects the purchasing power and makes negative impact on economic.
Important application of PPP exchange rates is in making cross-country comparisons of income or GDP. Using these rates instead of current market's rates give us more correct values of income or living costs in countries whose currencies are undervalued (Suranovic, 1997b).
In long run this index can be used to predict the value of forward exchange rate and it's helpful for international trading companies who expect payments or receiving in long terms.
Answer to Question 4:
ii. As said by Marshall (2010, p.7):
A forward exchange contract is firm and binding agreement between two financial institutions or between a financial institution and customer to exchange one currency from another at some future date.
The main advantage of this hedging method is fixed exchange rate. And there is no anxiety about movement exchange rates in future.
But also there is no ability to terminate or change executing date of forward contract if we need to do so. This one can be considered as main disadvantage. Another weak point is that exchange rate could be uncompetitive for foreign currencies. Also this contract includes interest fee for agent, which arises the final cost of such type of hedging method. Furthermore, forward contract excludes possible gain of exchange rate movement in the future.
Forward contract is effective for currencies with high volatile exchange rate and for long period when there is no ability to predict behavior of foreign currency.
Second mechanism to hedge the foreign exchange risks is by using money markets: "simultaneous borrowing and lending activities in two different currencies to lock in the value of a future FX currency cash flow" (Marshall, 2010, p. 4).
So, money market uses principle of interest rate parity and can be effectively locked-in the exchange rate for foreign currency. High safety and reliability make this method useful for risk hedging. The main disadvantage is necessity of amount of money (or borrowing) for hedging risk.
The most risk is in the third course of action for KENNEDY company. In this case exchange rate movements could be very volatile and not predictable. But with applying to different kind of foreign exchange market analytics and some luck the company could make additional profit in expected future exchange rate. Nevertheless, it is a high risk method and it can't be recommended for company.
Answer to Question 6:
When any company begins international business, it faces foreign exchange risks.
Such companies as importers and exporters of goods and services, as well as a group of companies with subsidiaries in more than one country, have to use a foreign exchange risk management to protect their income or assets' costs from exposure to foreign exchange markets.
The following exposures could occur (Buckley, 2004):
1. Transaction Exposure, when expected payment or receiving from customers is in different currency. This exposure will have dramatic meaning for exporter if domestic currency going to be stronger.
Translation Exposure could affect international company with subsidiaries in different countries. Exchange rate movement of foreign currencies will change the net worth of entire company in domestic currency.
Economic exposure brings the risk of economic instability in country and can affect each company in particular sector.
The foreign exchange risk represents the possibilities of appearance of a loss as a result of the adverse evolution of the foreign exchange rate (Balu and Armeanu, 2007).
As is known, currencies are constantly fluctuated and can shift dramatically in a short period of time, so it is a real risk. For exаmple, assume, that an exporter receives proceeds from the sale totaling $1m in June 2010. At that date, sum would have translated to €830 000. In October 2010 the same transaction would only translate to €730 000 - a difference of €100,000. In other words, the currencies risks can be significant, if they are not well managed.
Covering the foreign exchange risk is the term of hedging the risk. There are two main methods of hedging - internal and external.
The internal method of hedging is available within international company and does not involve any financial organization.
Using of financial derivatives, such as currency forwards or currency options, belong to external method and involve contracts with financial institutions. It is used wide in any types of companies and is more applicable for small companies which have no foreign subsidiaries or cash flows between these subsidiaries are small too. Also for companies, which receiving and payments are processed in different currencies, it's better to use forwards or options for hedging currency risk.
A common practice of application for these instruments is covered in next hypothetical examples.
In May 2010 Italian luxury yacht's manufacturer Azimut Benetti obtained offer to construct their new model of cruiser yacht Atlantis 48. The customer from USA agrees to make payment after construction in amount of $2m in USD. Azimut Benetti is a world class leader in yacht production and has well equipped shipyard to produce yacht in contractual term of 5 month from date of agreement. It will be 17 October 2010.
Five months is a long period and there can be unpredictable moving in exchange rate for Euro against US dollar.
Company is going to hedge foreign currency exchange risk using forward contract.
5months' forward exchange rate for EUR is 1.2650.
As a result Azimut Benetti has received the payment of $2m. After currency exchange it is equal to €1,581m. In case if company doesn't want to use a forward contract and just converted received amount by spot rate (1.3720) at the end of contract date, it'll gain only €1,457m.
The total currency exchange loss is:
1581k-1457k ~ €124000
or
~8% loss
Another useful method of foreign exchange risk hedging is options contract.
Again, in hypothetical situation, 'RosEnergoAtom', the Russian manufacturer of nuclear plants is going to bid to tender for developing nuclear waste containers from Turkish government. Tender will take 3 month long and in case if company will be winner it'll take contract for $18m.
Financial department of 'RosEnergoAtom' decided to hedge the risk of unfavorable movements of US Dollar rate against RUR. Obtaining of foreign currency put option gives the right to sell $18m at or before 03 February 2011 (date when tender's result will be published).
So, company had to fix exchange rate at strike price of 29.680 USD/RUR and if RUR after 3 months will appreciate, then company will avoid currency risks.
Moreover, company can gain additional revenue if RUR will depreciate against USD. In this scenario 'RosEnergoAtom' doesn't use the contract and sells USD on the FX market using current exchange rate.
At a negative case, when company loses the tender's contract there is an additional advantage of currency options can be used - it is the right to let it expire without selling (or buying) currency. Then company losses will be limited with cost for option contract known as a premium.
Despite of option advantages, it has a greater cost than forward contract. This is the main disadvantage of this type of contract.
Thus, companies can hedge their foreign exchange risk by using currency forward or options contracts. But which contract to choose for this?
In case when company anticipates guaranteed sum, it's better to use a currency forward for hedging method.
Otherwise, when date of payments is uncertain - it's better to settle an option contract.
So, foreign currency risk hedging is most important part of financial activity of company, which begins international business. The right choice of hedging strategy can dramatically limit losses and save money. The example of Google Corporation (2010) shows how important is to use hedging management program: "In the third quarter of 2010, we recognized a benefit of $89 million to revenues through our foreign exchange risk management program."
