Döviz kurunu belirleyen faktörler ve kur riski

Abstract

T.R. MARMARA UNIVERSITY INSTITUTE OF BANKING AND INSURANCE DEPARTMENT OF BANKING DETERMINATION OF FOREIGN EXCHANGE RATES AND FOREIGN EXCHANGE RISK (MASTER THESIS) M. COŞKUN OZAVNIK ISTANBUL 1994CONTENTS Page INTRODUCTION 1 1. DETERMINATION OF FOREIGN EXCHANGE RATES 3 1.1. Prices, Foreign Exchange Rates and Purchasing Power Parity (PPP) 3 1.2. Purchasing Power Parity 4 1.2.1. Limitations of PPP 5 1.3. The Balance Of Payment Approach 7 1.4. The Asset Market Approach To Exchange Rates 10 1.5. The Monetary Approach 11 1.6. Interest Rates 13 1.6.1. Fisher Effect 13 1.6.2. International Fisher Effect 14 2. FOREIGN EXCHANGE POLICIES PURSUED IN TURKEY 15 2.1. The Aim of The Foreign Exchange Policy 15 2.2. Foreign Exchange Rate Policies In Turkey 15 2.3. The Effects Of Foreign Exchange Rate Policies After 1980 17 3. FOREIGN EXCHANGE RISK 23 3.1. Foreign Exchange Risk 23 3.2. The Types Of Foreign Exchange Exposure 24 3.2.1. Transaction Exposure 24 3.2.2. Translation Exposure 24 3.2.3. Economic Exposure 25 3.3. Techniques Developed To Hedge Foreign Exchange Risk 26 3.3.1. Multilateral Netting 26 3.3.2. Matching 27 3.3.3. Leads and Lags 27 3.3.4. Forwards and Futures 27 3.3.5. Swap 28 3.3.6. Options 29 CONCLUSION 30INTRODUCTION The collapse of Bretton Woods system led to the evalution of the international monetary system into the regime of flexible exchange rates. In such an environment determination of foreign exchange rates created some problems. Existing economic theories are not totally efficient to explain the complicated relationship of determining the foreign exchange rates. The elements that must be taken into consideration of determinations of exchange rates are changing due to time. Purchasing Power Parity (PPP) was the first theory placed within a systematic framework. Balance of payment approach then tried to explain the process of determination. These two concepts have contributed to the understanding of foreign exchange. The elements determining the foreign exchange rates are the same for developed and less develeoed coutries, but differs in some aspects. For example in the case of balance of payment approach, the question of which balance to choose as the target for exchange rate policy. Obviously, the exchange rate should be set to balance. For small developing coutries, balance which consists of trade and services for developed countries trade and capital accounts together formulate the overall balance. Monetary approach is accepted to best fit to the developed countries' conditions. On the other hand, asset market approach contributes the determination of long term equilibrium exchange rate. Any meaningful analysis of the appropriate exchange rate level should contain both backward - looking and forward - looking elements. The backward approach is designed to explain how post exchange rate policies, pari passu with other economic policies and with the chancing exogenous circumstances, brought the economy to its present position. A number of alternative backward - looking investigations have been conducted into price competitiveness, the economic viability of production and its trends, the implicit market value of foreign exchange and the distortionary nature of the exchange regime. These backward approaches measure the recent movements in the various indicators with possible implications for the appropriateness of the exchange regime and the exchange rate but any conclusion regarding the sustainability of an exchange rate at the existing nominal level would be premature without a forward - lookinganalysis. In the forward approach, the search procedure for the appropriate exchange rate level involves specification of the underlying adjustment mechanisms that follow a hypothetical exchange rate action. Rapidly fluctuating exchange rates are creating major problems for international banks and multinational corporations. As international economic transactions are realized with different currencies and these currencies should be changed, foreign exchange markets become crucial. With the globalization of the economic activity, changes in one nation's economy are rapidly transmitted to that nation's major trading partners. Then these fluctuations in economic activity are reflected influcluations of currency values. As a result multinational corporations frequently face devaluation or revaluation worries due to their integrated cross - border production and marketing operations. This unstable environment led to the development of a literature on trading and hedging decisions under foreign exchange rate uncertainity.DETERMINATION OF FOREIGN EXCHANGE RATES 1.1. Prices, Foreign Exchange Rates and Purchasin Power Parity (PPP) The basic assumption is that exchange rate changes can alter the prices of one country's goods relative to those of another country and that these price changes are the key factors in inducing quantity changes that adjust values of exports and imports and hence the balance of trade. The overall price level of the depreciating country adjusted for the exchange rate change will diminish relative to that of the appreciating country. There exists a causal relationship between prices and exchange rates. The causality goes from prices to the exchange rates. As an empirical matter, however, most of the formal studies of PPP have involved regressions of the exchange rates on price ratios with the implicit assumption that the latter is in some sense exogenous to the former. The transmission of inflation naturally starts with a price increase abroad and then try to identify the channel by which domestic prices are affected. A price increase abroad will lead to an immediate increase in the domestic price without even the need for flows of goods to occur. Such flows constitute an integral part of a channel of transmission under which an increase in the foreign price of imports leads to a temporary deterioration of the terms of trade, an increased flow of exports as consumers and producers react to altered relative prices and finally increased export prices and a return of the terms of trade to its initial level either as exporters meet the augmented demand directly by increasing prices or as the higher rate of production hits capacity constraints and leads to cost and price increases. Purchasing power parity is mostly the subject of flexible exchange rates. In the flexible exchange rate regime, the supply of and demand for money determine the domestic price level, which in turn determines the exchange rate through the purchasing power parity condition. The aim, however, is for a rough yardstick that will help theauthorities to maintain a reasonable exchange rate and to prevent it from becoming undervalued or overvalued. Even the countries that leave the determination of their exchange rate to a large extent to the free-play of market forces, possibly because of a lesser reliance on foreign trade and a firmer monetary policy, need a yardstick that would signal situations where market forces have pushed the current rate widely out of line with its longer run sustainable value. 1.2. Purchasing Power Parity (PPP) The theory of PPP holds that the price of internationally traded commodities should be the same in every country. Hence the exchange rate between two currencies should simply be the ratio of the two commodity price levels. This known as the absolute version of PPP and is also known as the law of one price. A less restrictive version of the same theory is called the relative version of PPP. It states that if the spot exchange rate between two countries starts in equilibrium, any change in the differential rate of inflation between them tends to be offset over the long run by an equal but opposite change in the spot exchange rate. 1 : end of the period si 1 + I (T) 0: beginning of the period sO 1 + I (USA) s: spot rate I: PPP The purchasing power parity theory of foreign exchange is the proposition that movements in the price of a country's monetary unit in terms of foreign currencies tend to be inversely proportional to the relative movement of the respective price levels. Cassel linked the proposition up with a strict quantity theory and, in application, with the problems of war inflation. In this context, the PPP theory turned into the so called inflation theory of foreign exchange: an increase in M (money supply) raises the price level; the rise in a country's price level decreases the value of the monetary unit in terms of noninflated foreigncurrencies. Commodity arbitrage contributes to explaining the international transmission of inflation, the insulation properties of variable exchange rates, the exchange rate consequences of disparatemonetary growth rates, purchasing power parity tendencies. At the other extreme, the transitory absence of commodity arbitrage can contribute to explaining the short-run volatility of exchange rates. 1.2.1. Limitations of PPP In the theoritical discussions of relative price movements, it is often adequate to carry on the discussions in terms of a one commodity model. For empirical purposes, it is natural to regard a general price index as the matching measure, but this creates difficulties about some of the arguments about prices when the law of one price is involved in such models, for example, it is not clear whether we should take the meaning to be that (a) the t ime- to- 1 ime movement of the prices of identical commodities must be the same in all countries after adjustment for exchange rate changes, or that (b) the exchange rate adjusted movements in overall price levels in different countries must be identical. Trade restrictions may be more severe in one direction than in another. Speculation in the foreign exchange market may be against a country's currency and therefore may reduce its exchange value below the PPP. Long term capital movements can move the exchange rate away from PPP. For empirical purposes, it is necessary to have an operational definition of traded and nontraded goods and of exports and imports. For a country as a whole, PPP involves the comparison of aggregate inflation rates, or aggregate changes in prices. At this aggregate level, PPP postulates that if the inflation rate in a given country accelerates relative to other countries, the country's currency would tend to depreciate relative to the other currencies.Empirically, it has been found that PPP does not hold in the short term. Thus, this concept is most useful if we think of it as a long-term trend toward which exchange rates may tend to move. However, for those who wish to anticipate quarter to quarter exchange rate movements, PPP is not a very useful tool. A survey conducted by the Economist is based on the purchasing power parity - the notion that a dollar should buy the same amount in all countries. In the long run, argue PPP supporters, the exchange rate between two currencies should move towards the rate that would equate the price of an identical basket of traded goods in the respective countries. The basket is accepted to be the Big Mac, which is produced locally in 68 countries. The big mac PPP is the exchange rate that would leave hamburgers costing the same in America as in, say, Turkey. With the assumptions above, a survey is conducted on the value of Turhish Lira according to PPP theory as shown in table 1. According to this table TL seems to be over-valued due to major currencies. It can be said that PPP, itself, is not efficient totally to determine the exchange rate.Table 1 PPP and The Value of Turkish Lira Source: D ihya Gazetesi, May 18, 1994 (*) Actual TL exchange rate is the selling rate of CBRT at May 14, 1994 1.3. The Balance Of Payment Approach The balance of payments measure the flows across the exchanges and is therefore a measure of supply and demand. However, there are many difficulties in calculating what the actual balance of payments flows are at any stage of time. Nevertheless, on commonsense grounds it seems highly likely that the balance of payments plays a part in determining the exchange rate.8 The balance of trade is the balance struck after the- export and import of goods. It thus includes such items as raw materials, finished products, which include payment for services tourism, interest payments, dividend payments and governments transfers. The first attempts to explain the effect of the balance of payment on the exchange rate were developed between the two world wars and centered on the elasticities of different products in different economies. Clearly, if a good was price elastic (i.e. volumes changed substantially in response to price changes.) then a balance of payment deficit or surplus will quickly be adjusted back to equilibrium by an adjustment in the exchange rate. If, on the other hand, the good is price inelastic ( in the case of oil ) the effect of the price changes may well be destabilising. A good deal of work went into attempts to measure different elasticities, but of course as time passes, such things as consumer preference or taste can change quite rapidly, making a nonsense of any empirical work that has gone on before. In the end the arguments were reduced to those of the elasticity optimists, who believed that import in particular were very sensitive to price changes and who were in the vanguard of those calling for a floating exchange rate system and those of the elasticity pessimists, who felt there was little or no response to price changes and who therefore argued that floating exchange rates would in fact lead to greater exchange rate instability. If there is no central bank intervention in the foreign exchange markets, then the current account deficit or surplus must be exactly matched with the capital account deficit or surplus because, overall, tha balance of payment must balance. International capital inflows to countries affect the economy in at least four ways. First, they increase the avalibility of capital in the individual economies and allow domestic agents to smooth out their consuption over time and investors to react to expected changes in profitability. Second, capital inflows have been associated with a marked appreciation of the real exchange rate in most of the countries. Third, capital inflows have an impact on domestic policymaking. Fourth, capital inflows can provide important signals to participants in world financial markets. An increase in capital inflows can be interpeted as reflecting more favorable medium and long-term investment oppurtunities in the receiving country.Drops in interest rates and a slowing of growth in industrial countries sent capital from industrial countries looking for higher rates of return in other countries. These developments, however, did not often coincide with the surges in inflows, suggesting that other domestic factors must have played an important role as well. Such as changes in domestic economic policies, including structual changes that improve potential productivity or reductions in public sector deficits that promise greater macroeconomics stability and support a real depreciation. The second is a tightening of domestic credit policies or increases in administered interest rates, without a corresponding fiscal adjustment. With exchange rate fixed ( or on a fixed nominal path), inflows are attracted by high domestic interest rates. There are three types of concerns that policymakers tend to voice about capital inflows: (1) since capital inflows are typically associated with real exchange rate appreciation and with increased exchange rate volatility, they may adversely affect the export sector; (2) capital inflows may not be properly intermediated and may therefore lead to misallocation of resources: and (3) capital inflows especially the hot money variety- may be reversed on short notice, possibly leading to a domestic financial crisis. Trade policy measures can help to insulate the export sector from real exchange rate appreciation. One possibility in this area is to pay higher export subsidies. However, this policy distorts resource allocation between exportable and importable goods and the fiscal cost could be substantial. For example, to offset a 20 percent overvaluation of the real exchange rate through export subsidies would increase fiscal expenditures by about 4 percent of GDP, given that the average export-to-GDP ratio hovers around 20 percent. Concentration on one part of the balance of payments accounts is not sufficient. Current account and capital account flows are both important, but at certain times the role of capital account flows seem to become all pervading and currencies appreciate even though the current account is slipping into deficit - a process which is likely to be exacerbated if the expectation of further exchange rate appreciation becomes widespread. Further out, though, such current account deficits become unsustainable and either the market corrects itself.10 1.4. The Asset Market Approach To Exchange Rates The asset market approach and the monetary approach base on the hypothesis that foreign exchange market is efficient. It means that prices accurately reflect all the information available and respond rapidly to new information. Many economist reject the view that the short term behaviour of exchange rates is determined in flow markets. Exchange rates are asset prices traded in an efficient financial market. Indeed, an exchange rate is the relative price of two currencies and therefore is determined by the willingness to hold each currency. Like other asset prices, the exchange rate is determined by expectations about the future, not current trade flows. The underlying thesis is that exchange rates should be viewed as an asset. This means that the price will be that at which investors are prepared to hold all the assets available. There is an underlying supporting factor that the foreign exchange markets are increasingly being dominated by investors and speculators, as the impact of capital flows overpowers the effects of trade and invisible flows. It seems reasonable that investers will look upon currencies as assets and that their decision on whether or not to change their portfolio of currencies will be based on their expectations of how these currencies are expected to perform. There are some other properties that the foreign exchange market is an asset market rather than a flow market. First, the next movement in an exchange rate is not guaranteed to be related in any pattern to previous movements. But the rational is that all present information is in the present exchange rate and therefore any new information will lead to a random movement in the exchange rate. Contemporaneous international flows should have little effect on exchange rates to the extent they have already been expected. Since economic expectations are potentially volatile and influenced by many variables, especially variables of a political nature, the short -run behavior of exchange rates is volatile. The asset market approach has improved our understanding of11 the foreign exchange market to some extent they are based on the thought that currencies are assets and that analysis of flows is not helpful generally. This is not to denigrate the importance of earlier theories entirely, because investors may well base their expectations of future currenc values, at least in part, on what the earlier theories suggest. What it means is that a slavish concentration on one or other of these factors or theories is not appropriate, except as in the longer term. The fact that we believe that exchange rate movements are determined by the investors' willinigness to hold the assets is of little help if we do not know what determines their expectations. There are numerous factors that may do so. For example, relative interest rates are likely to have an influence because in the absence of an expectation that exchange rates will move, then rational investors will move their money to highest interest rate. Inflation differentials and trade positions are also likely to affect expectations, but then so are political factors, along with a wide range of economic factors. The asset market approach is unlikely to be able to produce an equation or a model which will in all circumstances produce a correct forecast. Perhaps the most important contribution of the asset market approach is that it explains why such a model is unlikely to be obtainable and underlines the fragility of any forecast. 1.5. The Monetary Approach The exchange rate is the relative price of two currencies. It would seem sensible to expect that the exchange rate would be determined by changes in the supply of and demand for each of the currencies. The monetary model focuses on the demand and supply of stocks of assets, rather than on determination of the flows that result from the sale and the purchase of assets. Traditional monetary theory stated that any excess money supply in an economy, while possibly leading to some temporary increases in output, would eventually be absorbed by an increase in prices, as the supply of goods would not be able to mod up the extra supply of money totally. However, for more open economies, the theory was developedfurther by the international monetarists. The added dimension here was that the increased supply of goods reguired to offset the increased supply of money could come from overseas. But, this increase in imports would lead to a deterioration in the balance of payments which would in turn lead to a decline in the exchange rate. Having accepted that the relative demands for öne currency against another are affected by expectations. Thus, if expectations are crutial to the movement of exchange rates in this model, then it is vital that the model explains what determines expectations. Rational expectations must also assume that the present rate is based on ali known information that will influence the expected value. The monetary approach has certain elements and assumptions. These are,- i) The balance of payment is a monetary phenomenon. There is a direct relationship between the domestic money supply and the balance of payments of an öpen economy. ii) The approach assumes that the demand for money is a stock demand, not a flow demand and is a stable function of a small number of variables. This stability ensures that excess money supply, for example, is not absorbed in idle cash balances, but reflected in the balance of payment. The demand for money is usually set out as a function of the price level, the level of income and the rate of interest. iii) National income is given, at its full ör natural level. iv) The monetary approach assumes that interest rates are fixed by foreign rates and exchange rates expectations. Any difference between the domestic and the foreign interest rates is egual to the expected change in exchange rates. Majör shortcomings of the monetary approach can be summerrized as follovs; i) The assumption of stable demand for money function. it is argued that the demand for money may not be stable in ali countries and that not ali the detrminants of the function are appropriate in every country. For example, demand for money may not respond to interest rates in many developing countries. Here, the interest rates are institutionally fixed, real rates of interests are largely negative ör rural money markets play significant role. in many developing countries, because demand for money has a strong liguid asset motive, theopportunity costs of holding money as approximated by movements in the price level are more important. ü) The link between the balance of payment and money supply in the monetary approach has been guestioned on many grounds. First, it is argued that in the real world, especially in developing countries, the asumption of free trade and perfect capital is not valid. Movement of capital in ör out of the country may be restricted by government policy. Moreover, capital may not flow into a country in response to interest rate differentials. Capital mobility may be influenced by other factors including expectations which may in turn be affected by political and social consideration. At any rate, interest rates may be institutionally determined which makes the assumption of international interest arbitrage not valid. Secondly, the increase in the domestic money supply may not be completely reflected in a balance of payment deficit because of various lags in adjustment - even in the absence of government restrictions on international transactions. in spite of these criticisms, the monetary approach has impressive ability to explain the behaviour of the balance of payments.lt focuses the attention of policy makers on the need to coordinate monetary and exchange rate policies. 1.6. interest Rates 1.6.1. Fisher Effect The Fisher effect, named after economist Irving Fisher, states that nominal interest rates in each country are egual to the reguired real rate of return to the investors plus the expected rate of inflation. in a world where investors can buy any interest-bearing securities, real rates of return should tend toward eguality everyvhere, but nominal rates of interest will vary by the difference in expected rates of inflation. Empirical tests using ex-post national inflation rates have shown the Fisher effect to exist particularly for short maturity government securities such as Treasury biliş and notes. Comparison based on longer maturities suffer from the increased financial risk inherent in fluctuation of the market value of the bonds prior to maturity. Comparisons ofprivate sector securities are influenced by unegual credit worthiness of the issuers. Ali the tests are inconclusive to the extent that the ex-post rate of inflation does not correctly measure the ex-ante expected rate of inflation. 1.6.2. International Fisher Effect The international Fisher effect holds that the spot exchange rate should change in an egual amount but in the opposite direction to the difference in interest rates between two countries. Empirical tests lend some support to the relationship postulated by the international Fisher effect, although considerable short run deviation occur. However, a more serious criticism has been posed by recent studies that suggest the existence of a foreign exchange risk premium for most majör currencies. Thus, the expected change in the exchange rates might be consistently tnore than the difference in the interest rates.FOREIGN EXCHANGE RATE POLICIES PURSUED IN TURKEY 2.1. The Aim Of Foreign Exchange Rate Policy Foreign exchange rate is one of the major mechanisms that market economy is based on. This mechanism is expected to realize the following duties. i) To establish a similarity between domestic and foreign goods prices due to foreing trade, ii) To establish an equilibrium in foreign exchange demand and supply so that the balance of payment could balance. 2.2. Foreign Exchange Rate Policies in Turkey Applications of foreign exchange rates policy in Turkey can be separated into three main period; 1923-1973 period, 1973- 1980 period and the period after 1980. In this summary only important dates which have importance for Turkish foreign exchange rate policy improvements will be indicated. May 16, 1929 The acceptance of the law about stock and foreign exchange markets. (The begining of the foreign exchange controls) February 25, 193 0 The law about the protection of the value of Turkish Lira. June 11, 193 0 The law about the foundation of Turkish Central Bank. September, 1946 Devaluation of Turkish Lira (From 1 USD = TL 1.30 to 1 USD = TL 2.80)16 Agust 10, 1950 A regular foreign trade regime was made effective. September 30, 1950 60 percent freedom to foreign trade in accordance with OECD decisions. 1952 Partial free trade ended. September 15, 1955 The acceptance of more foreign exchange control. August 4, 1958 Economic stabilization policy and devaluation. Agust 22, 1960 Devaluation of Turkish Lira 1 USD= TL 9. 0 February 16, 1973 The acceptance of Smithsonian aggrement and the application of managed floating ( 1 USD = TL 14 and +/- 2.25 fluctuation) January 24, 1980 Economic stabilization policy and outward orientation of Turkish economy. May 1, 1981 Transition to daily foreign exchange rate application. December 29, 1983 Foreign exchange trade was liberalized and partial foreign capital flows was allowed. July 1, 1985 Banks were given authority to determine their foreign exchange rates freely. March 14, 1986 Banks' foreign exchange rate determination were restricted to the limit of +/- l percent of official rate. October 30, 1986 It was accepted that banks' foreign exchange rates could not exceed the Central Bank's rates.17 July 29, 1988 The foundation of foreign exchange and effective markets in the Central Bank. February 5, 1994 Economic stabilization policy. Of f icial exchange rates raised to the market level and it is accepted that official exchange rates will be determined by the rates of ten major banks in Turkey. Table 2 Foreign Exchange Rates Years TL/USD Nominal Foreign Echange Index Index Due to USD 1973 1974 1975 1976 1977 1978 1979 1980 Source: SPO, Main Economic Indicators, May 1981 2.3. The Effects of Foreign Exchange Rate Policies After 1980 Foreign trade deficit is used to be the major problem of the Turkish economy. Outward looking economic policies of the year after 1980 brought a solution to some extent but, unfortunately foreign trade deficit still, time to time, becomes a serious problem. The years between 1980-1989 export increased 11.4 percent and import increased 7.4 percent. In this positive evolution, foreign exchange rate policies played a very important role. Positive interest rate policy followed with market economy which gave rise to make a comparison with exchange rate movements had an impact on foreign exchange flows. The main reasons for the increase18 in export during this period were regular devaluations (due to inflation) following a prolonged practice of grossly over valued currency, rapid growth rate in the real GNP and in the exportable surplus sectors as well as export price rises in the world marketes and of course given export premiums. Increases in Turkish imports, on the other hand, were the result of gradual liberalization of Turkish economy. Table 3 Foreign Exchange Rate Years TL/USD (Annual Averages) Source : CBRT In 1990, intensive foreign capital inflows held the foreign exchange rates below the inflation rate. As a result, it decreased the export while increasing the import. It can be stated that foreign exchange movements has a very strong impact on foreign trade, but the impact of foreign exchange policy on foreign trade can not be analysed by isolating it from other macroeconomic policies. It is claimed that devaluation stimulate export and slow down import. But the claim that devaluation will slow down the import in Turkey should be assessed attentively as Turkey's import goods are comprised of energy, raw materials, intermadiate and investment goods whose demand elasticity of import is low. Increased domestic prices after devaluation will raise the costs and this will also increase the price of exportable19 goods. An investigation of table 4 will exibit that foreign exchange movements stipulated the export but changement of the import is free from echange rate movements. A closer scrutiny reveals that Turkey's foreign trade deficit showed signs of deretioration after 1990 as shown in table 4. For a long time the structure of the Turkish economy was not very responsive to devaluation due to low price elasticities of both internal demand for imports and internal supply of export. Therefore, to alleviate balance of payments problems generally import duties and export premiums and tax rebates were raised rather than effecting devaluation. Whenever devaluation was affected, on the other hand, its favorable affects on the balance of payments were short-lived due both to the inelasticities mentioned and the inability of the government to halt inflation. Turkey could not manage to control the increase of money supply, so this caused to high level of inflation and devaluation of Turkish Lira. It is quite normal that Turkish Lira should drop in value as Turkey is practicing a cronic inflation. Foreign exchange rate policy persued after 1988 was anti - inflationary. The new policy aimed the low devaluation, so foreign exchange rates would be below the inflation rate. A long period of acutely over-valued currency caused by domestic inflation distorted the allocation of investments and gave rise to over valuation of Turkish Lira and over development of import sector. In table 5, there is a comparison between the increase level of inflation and foreign exchange rates. Trade - weighted real effective exchange rate index also indicates the appreciation of Turkish Lira after 1989.ÜU S: İS *?. r« c» r« r« r» ~« t» ?, -# :a. *.'.'. *. I I oo t- VO t- VO On O enWHONr/vDHVSenH. `.`.'....`..'.'..`.....`. £ »n O CM O W Jt CM `. `. '. `. `o '. f» r> oo so H H rt o en m.* en cm cm cm ırıvOCMNH-tfmr--*. ». `«...... 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'.. en m h oo h o r» cm oo vo »n J- niAvOCOJ-HvON H H t- 00 00 »A en VD O H H CM CM J- O t- CM OOONOHCMCn^tırvvOt-OOONOHCMCn t-r-cocococooococooocooooNCNONON 0/ftftftO/(î/0/0/ftO/0/ftO/ftCAft.d ti H O ti o u w ti.H S o OTable 5 Inflation, Changement in USD and TERK Inflation (%) Increase Years (consumer) in USD {%) TERK 1986313166.8 1987553566.3 1988757860.6 1989642775.4 1990602778.5 1991717373.5 1992706973.7 1993716073.1 Source:CBRT, Monthly Bulletin, February 1994 EP Review, September 26, 1993 Low devaluation policy sharply slowed down the export growth rate. in order to finance the balance of payment deficit, government made some regulations to facilitate foreign capital inflows. Low devaluation policy also led to the increase of short term debts in foreign currency.lt can be followed in table 6. Table 6 Total Foreign Debts (million dolar) Years1990 1991 1992 1993 Total Debts 49.035 50.489 55.592 67.356 Medium-Long Term 39.535 41.372 42.932 48.823 Short Term 9.500 9.117 12.660 18.533 Source: SPO Main Economic Indicators, May 199419 goods. An investigation of table 4 will exibit that foreign exchange movements stipulated the export but changement of the import is free from echange rate movements. A closer scrutiny reveals that Turkey's foreign trade deficit showed signs of deretioration after 1990 as shown in table 4. For a long time the structure of the Turkish economy was not very responsive to devaluation due to low price elasticities of both internal demand for imports and internal supply of export. Therefore, to alleviate balance of payments problems generally import duties and export premiums and tax rebates were raised rather than effecting devaluation. Whenever devaluation was affected, on the other hand, its favorable affects on the balance of payments were short-lived due both to the inelasticities mentioned and the inability of the government to halt inflation. Turkey could not manage to control the increase of money supply, so this caused to high level of inflation and devaluation of Turkish Lira. It is quite normal that Turkish Lira should drop in value as Turkey is practicing a cronic inflation. Foreign exchange rate policy persued after 1988 was anti - inflationary. The new policy aimed the low devaluation, so foreign exchange rates would be below the inflation rate. A long period of acutely over-valued currency caused by domestic inflation distorted the allocation of investments and gave rise to over valuation of Turkish Lira and over development of import sector. In table 5, there is a comparison between the increase level of inflation and foreign exchange rates. Trade - weighted real effective exchange rate index also indicates the appreciation of Turkish Lira after 1989.25 foreign exchange rates arises when a corporation has transactions denominated in currencies other than its own or when it has net assets or liabilities outside the home country. As foreign exchange rates change, the value of the transaction or the value of the net assets or liabilities abroad changes when translated into the parent currency. Accordingly foreign exchange gains or losses arise. Translation exposure results from rewriting the foreign currency statements of foreign affiliates in terms of the parent's reporting currency so that the parent can prepare consolidated financial statements. IBX (Germany) Inc is a subsiadiary of the IBX Corporation, a multinational corporation with headquarters in the USA. On March 31, 19X0, IBX (Germany) has DM2.000.000 of net exposed current liabilities in its balance sheet, valued at the spot exchange rate of DM 2 = USD 1. An evaluation of the forces affecting the dollar/DM exchange rate indicates that the dollar will depreciate relative to the DM over the next year and that, on March 31, 19X1, the exchange rate will be DM 1.8 =USD 1. The appreciation of DM causes the translated value of IBX Corporation's liability to increase USD 1 million to USD l.lli million. Translation loss of USD lll.l results from the increase in the corporation's liability when translated into US dollars at new exchange rate. The increased US dollar liability represents a potential loss that would affect the corcoration' s cash flow at a future date when the IBX Corporation decides to liquidate the net liability in its subsidiary, IBX (Germany). 3.2.3- Economic Exposure Economic exposure, also known as operating exposure, measures the change in value of the firm that results from changes in operating cash flows caused by unexpected change in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices and costs. The objective of economic exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm's future cash flow. Economic exposure is more significant for the long term health of a firm than the rest of the exposures. Management is totally responsible for the planning of economic exposure which involves the interaction of strategies in finance, marketing, purchasing and production. A firm can manage its economic exposure by either diversifying internationally both its operations and its3.2. The types of Foreign Exchange Exposure An understanding of the various kinds of foreign exchange exposure should aid the firm in controlling its exposure to movements of the foreign exchange risk and to minimize losses that may arise from foreign exchange rate movements. The three majör types of foreign exchange exposure are: (1) transaction exposure, (2) translation exposure, (3) economic exposure. 3.2.1. Transaction Exposure Transaction exposure measure gains and losses that arise from the settlement of financial obligation whose terms are stated in a foreign currency. Transaction exposure arises from the purchasing ör selling on credit goods ör services whose prices are stated in foreign currencies, borrowing ör lending funds when repayment is to be made in a foreign currency, being a party to an unperformed forward foreign exchange contract and othervise acguiring assets ör incurring liabilities denominated in foreign currencies. The most common example of transaction exposure arises when an enterprise has a receivable ör payable denominated in foreign currency. Suppose that a US firm selis merchandise on öpen account to a Belgian buyer för BF700.000, payment to be made in 60 days. The current exchange rate is BF35/USD and the US seller expects to exchange the BF700.000 f ör USD20.000 when payment is received. Transaction exposure arises because of the risk that the US seller will receive something other than USD20.000. For example, if the exchange rate were BF38/USD when payment was received, The US seller would receive only BF700.ÛOO- BF38/USD = USD18.421, some USD1.579 less than anticipated. Had the exchange rate göne to BF33/USD, however, the seller would have receive USD21.212, an increase of USD1.212 över the amount expected. 3.2.2. Translation Exposure Translation exposure also known as accounting exposure to25 foreign exchange rates arises when a corporation has transactions denominated in currencies other than its own or when it has net assets or liabilities outside the home country. As foreign exchange rates change, the value of the transaction or the value of the net assets or liabilities abroad changes when translated into the parent currency. Accordingly foreign exchange gains or losses arise. Translation exposure results from rewriting the foreign currency statements of foreign affiliates in terms of the parent's reporting currency so that the parent can prepare consolidated financial statements. IBX (Germany) Inc is a subsiadiary of the IBX Corporation, a multinational corporation with headquarters in the USA. On March 31, 19X0, IBX (Germany) has DM2.000.000 of net exposed current liabilities in its balance sheet, valued at the spot exchange rate of DM 2 = USD 1. An evaluation of the forces affecting the dollar/DM exchange rate indicates that the dollar will depreciate relative to the DM over the next year and that, on March 31, 19X1, the exchange rate will be DM 1.8 =USD 1. The appreciation of DM causes the translated value of IBX Corporation's liability to increase USD 1 million to USD l.lli million. Translation loss of USD lll.l results from the increase in the corporation's liability when translated into US dollars at new exchange rate. The increased US dollar liability represents a potential loss that would affect the corcoration' s cash flow at a future date when the IBX Corporation decides to liquidate the net liability in its subsidiary, IBX (Germany). 3.2.3- Economic Exposure Economic exposure, also known as operating exposure, measures the change in value of the firm that results from changes in operating cash flows caused by unexpected change in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices and costs. The objective of economic exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm's future cash flow. Economic exposure is more significant for the long term health of a firm than the rest of the exposures. Management is totally responsible for the planning of economic exposure which involves the interaction of strategies in finance, marketing, purchasing and production. A firm can manage its economic exposure by either diversifying internationally both its operations and its26 financing base. A firm diversifies its operations by diversifying its sales, location of production facilities and raw material sources. Management should be able to recognize disequilibrium and to react competitively in case of international diversification. Diversirying financing means raising funds in more than one capital market and in more than one currency. By doing this the firm takes advantage of temporary deviations from the International Fisher Effect. In addition to this a multinational company can reduce its default risk by matching the risk of currencies it borrows to the mix of currencies it expects to receive from operations. There are some limitations to the feasibility of a diversification strategy for a foreign exchange risk management. An industry may require large economies of scale that it is not economically feasible to diversify production locations. A firm may also be too small or too unknown to attract international investors or lenders. Economic exposure is in general more difficult to hedge. Unless production plans are completely inflexible, exonomic exposure is non-linear and therefore connot be hedged with forward exchange contracts alone. 3.3. Techniques Developed to Hedge Foreign Exchange Risk Foreign exchange risk can be managed by either money market hedge or some techniques. Here, these techniques will be discussed briefly. 3.3.1. Multilateral Netting Multilateral netting of payments is usefull primarily when a large number of separate foreing exchange transactions occur between affiliates in the normal course of business. Netting reduces the settlement cost of what would otherwise be a large number of crossing spot transactions. Multilateral netting is an extension of bilateral netting. If a Belgian affiliate owes an Italien affiliate USD 5.000 while the Italien affiliate simulteneously owes the Belgian affiliate USD 3.000 bilateral settlement calls for a single payment of USD 2.000 from Belgian to Italy and the concellation, via offset, of the remainder of the debt. A multilateral system27 is an expanded version of this simple bilateral system. 3.3.2. Matching One of the techniques that a firm can use to hedge its risk is called matching which matchs its debt and receivable denominated in the same currency. 3.3.3. Leads and Lags Firms can reduce exposure by accelerating or decelerating the timing of payments that must be made or received in foreign currencies. To lead is to pay early. A firm holding a soft currency and having debts denominated in a hard currency will lead by using that soft currency to pay the foreign currency debts as soon as possible, before the soft currency drops in value. To lag is to pay late, a firm holding a hard currency and having debts denominated in a soft currency will lag by paying those debts late, hoping that less of the hard currency will be needed. If possible, firms will also lead and lag their collection of receivables, collecting soft foreign currency receivables early and collecting hard foreign currency receivables later. Leading and lagging may be done between affiliates or with independent firms. Assuming that payments will be made eventually, leading and lagging always results in changing the cash and payables position of one firm, with the reverse effect on the other firm. 3.3.4. Forwards and Futures A forward transaction requires delivery at a future value, date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time the contract is aggreed on, but payment and delivery are not required until maturity. Forward exchange rates are normally quoted for value dates of one, two,28 three, six and twelve months, but actual contracts can be arranged for other members of months or, on occasion, for periods of more than one year. Payment is on the second business day after the even-month anniversary of the trade. Outright forward transactions in the interbank market are normally entered into by banks to forward exchange contracts with nonbank customers such as business firms and individuals. These costumers usually make an outright forward transaction with the bank to protect themselves against a change in home currency value of foreign funds to be received or delivered in a business transaction. A foreign currency futures contract is an exchange - traded agreement calling for future delivery of a standard amount of foreign exchange at a fixed time, place and price. It is similar to futures contracts that exist for commodities, for interest bearing deposits and for gold. 3.3.5. Swap Another way of managing foreign exchange exposure is by arranging swap agreements. Originally most swap transactions are matched deals in which an intermidiary bank brougt together two counter parties, or end users with matching requirements. The intermidiary bank would typically write separate contracts with the end users act as principal in both swap contracts and charge an intermediation margin and possibly an arrangement fee. A foreign exchange swap is an agreement between two parties to exchange a given amount of currency for another and after a period of time, to give back the original amounts swapped. `Back- to-back` or `parallel loan`, currency swap and credit swaps are three types of foreign exchange swap agreements. These swap agreements are usually negotiated before an exposed situation is created since the purpose of these swaps is to avoid foreign exchange transaction exposure prior to entering into a potential risk. 3.3.6. Options Another alternative to hedge foreign exchange risk is the options market hedge. Foreign currency options are financial contracts that give the holder the right but not the31 instruments avalable for hedging. The rapidly increasing volatility of foreign exchange markets in recent years will cause a huge impact on exchange rates on international competitiveness of the firms. One of the reasons why the techniques developed to hedge foreign exchange exposure are not used heavily in Turkey is related with the lack of quality personel who have necessary knowledge and information about forward markets. Still the forward exchange agreements and their benefits are not very well known by the firms and some banks. Less developed foreign exchange markets in Turkey is another negative factor. It is clear that the developed forward exchange markets are necessary for Turkey in order to have a stable economy and to help importers and exporters to perform their major role; international trade. Without developed financial markets, the existance of an efficient forward market is not possible. For this reason, importance should be given to the develpoment of this market but this is directly related with the economic conditions in Turkey.29 obligation to buy (in the case of calls) or selling (in the case of puts) a specified amount of foreign exchange at a predetermined price on or berore a specified maturity date. If an option should be exercised at a specific day this is called a European option. However, a majority of options that are bought and sold can be exercised at any time during the life of the potion and this type option is called American option. Each foreign currency option is introduced for trading with one, two, three, six, nine and twelve months to run until expiration.29 obligation to buy (in the case of calls) or selling (in the case of puts) a specified amount of foreign exchange at a predetermined price on or berore a specified maturity date. If an option should be exercised at a specific day this is called a European option. However, a majority of options that are bought and sold can be exercised at any time during the life of the potion and this type option is called American option. Each foreign currency option is introduced for trading with one, two, three, six, nine and twelve months to run until expiration.