Term Risk Management

1.0 Introduction

With the effects of globalisation in business world, the number of multinational corporations (MNCs) has been constantly growing. These corporations confront a series of challenges in running global business, particularly when they introduce products and services into local markets. Within these challenges, a significant one is fluctuation risk in currency exchange rates, involving a variety of types. Changes in exchange rates may have a considerable impact on profit and loss of a MNC’s operation.

The purpose of this assignment is to examine three specific types of exchange rate risks, including a managed floating exchange rate, a fixed exchange rate linked to a basket of currencies and a fixed exchange rate backed by a currency board system, and subsequently seek the associated economic implications. Additionally, Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are also discussed with an emphasis on the financial theory.

2.0 Foreign Exchange Risk

Generally, foreign exchange risks can be classified as three types: translation or accounting exposure, transaction exposure, and economic exposure. In this assignment, the foreign exchange risks faced by a MNC are discussed in terms of exchange rate system, including two broad systems (floating and fixed exchange rate). Moreover, the analysis of fixed exchange rate is divided into a basket of currencies-linked and currency board system-backed system.

2.1 Managed Floating Exchange Rate

3.0 Purchasing Power Parity

The purchasing power parity (PPP) is a financial theory that any movements of exchange rate between two economies should accordingly reflect the changes in the pricing levels. Essentially, PPP is a generalisation of the Law of One Price. Thus, in order to explain PPP, it might as well clarify the Law of One Price first.

In the Law of One Price, it is assumed that transport costs and trade barrier are extremely low and all goods between two countries are...