EXCHANGE RATE DETERMINATION

According to Toshiki (2006:346), since the international business environment is one in which there is no universal medium of exchange, exchange rates are a matter of necessity for international trade. As a result, when transactions are denominated in foreign currencies, two basic needs arise. Firstly, there is the need for translation. That is, the transaction that is stated in terms of a foreign currency must be re-expressed or restated in terms of the local currency before it can be recorded in the local accounting records. Secondly, settlement of the transaction requires conversion. This means that when payment is due, a sufficient amount of the local currency must be exchanged for the stated amount of foreign currency so that payment can be made.

According to Toshiki (2006:346), an exchange rate has been defined as a relative price of two national monies. More specifically, it can be stated that the exchange rate is "the ratio between a unit of one currency and the amount of another currency for which that unit can be exchanged at a

particular time." As such, it can be seen that exchange rates are designed to facilitate the actual exchange of one currency for another.

Toshiki (2006:231) states that theory of exchange rate determination can be explained using different approaches. In the following section this study has dealt with some of them.

3.5.1 Purchasing Power Parity

According to Toshiki (2006:347), the purchasing power parity (PPP) happens to be one of the most significant approaches to determine the exchange rate. The purchasing power parity is primarily based on the

―Law of One Price‖. However, this law is based on the assumption that identical goods are sold at equal prices.

= /

This is the absolute purchasing power parity approach. Where p represents domestic prices, p* refers to foreign prices and e is the exchange rate.

There is also the relative purchasing power parity approach. It is the same model but applied to differences: the change in the exchange rate will compensate for inflation differentials.

1 + = (1 + ) (1 + )

where π and eˆ represent domestic inflation, foreign inflation and the depreciation.

It is a flow model of the balance of payment. This law lays down that an exchange rate of currencies has to compensate for the differences in prices of goods. The Relative PPP approach continues to be applied to date. This approach lays down the fact that the exchange rate has to compensate for the difference in the inflation rate. The theory behind purchasing power parity is very appealing. However, when taken to the data, the multinational corporation usually does not find PPP to hold in the long run.

According to Toshiki (2006), there are several important reasons for purchasing power parity not holding in the long run:

 The law of one price might not hold in the short run. The law of one price requires a perfect arbitrage in goods. This means that individuals should be able to import and export any products that are identical and have different prices across countries. This is hardly a good assumption in the short run. In addition, the fact that domestic markets are relatively oligopolistic in the short run, implies that prices will indeed differ. The real world is closer to one in which good segmentation is relevant, both in the decision of production and pricing.

 Purchasing power parity assumes that there is no government intervention.

 Purchasing power parity might not even hold in the long run.

 There is an important component of non-tradable goods, and productivity differentials in those sectors might be different across countries. This implies that there is a permanent change in the price level across countries that should not be compensated by the exchange rate

 Taste might change, and thus the real exchange rate.

 Market structures might change, and thus the equilibrium exchange rate.

Indeed, there are few cases in which purchasing power parity holds in the short run. When it does hold, it is usually in economies with very high inflation rates (mostly hyperinflation) where domestic currency has no meaning in the determination of prices, and the agents tend to dollarize their economies.

3.5.2 Balance of Payments Approach

According to Toshiki (2006:348), this approach is mainly the dependent economy. The idea is that there exists an exchange rate with internal and external equilibrium.

According to Toshiki (2006:348), the internal equilibrium assumes that there is full employment; unemployment is in the natural rate of unemployment. Or in other words, the unemployment is such that there are no pressures to change real wages.

The external equilibrium refers to equilibrium in the balance of payments.

Sometimes, people look at the current account instead of the balance of payments.

This is indeed a wonderful theory. It can explain permanent deviations of the purchasing power parity, but also explain purchasing power parity if so required.

According to Toshiki (2006:348), the main problem with this approach is that in general it is extremely difficult to determine what is the exact natural rate of unemployment, or the exchange rate consistent with an equilibrium in the external accounts. Multinational corporations tend to think that this is a good guess of the long run exchange rate. This model will determine where the exchange rate has to converge to; however, it provides very little guidance regarding the short term fluctuations.

3.5.3 Monetary and Portfolio Approaches

According to Toshiki (2006:349), this is an asset-pricing view of the exchange rate. The idea is that agents have a portfolio choice decision between domestic and foreign assets. Those instruments (either money or bonds) have an expected return that could be arbitraged. This arbitrage opportunity is what determines the process of the exchange rate.

In its simplest form, this approach implies the uncovered interest rate parity.

Where the idea is that if the expected depreciation does not compensate for the interest rate differentials, agents would have arbitrage opportunities.

3.6 CONCLUSION

In this chapter, an overview of the literature studied in capital budgeting analysis for the multinational corporation has been provided to accept or reject a foreign project. The calculation of cash flows is crucial to achieve the result of capital budgeting appraisal and accept or reject foreign projects. Firstly, the concept of cash flows was introduced and the characteristics of cash flows, such as the importance of cash flows, elements of cash flows, incremental cash flows, parent and project cash flows, were identified to understand what the multinational capital appraisal should focus on.

Secondly, this chapter focused on capital structure that explores the situations under which capital structure is irrelevant to a firm‘s operations.

Examining these situations will allow us to explore how the following factors influence a firm‘s capital structure.

Thirdly, the capital budgeting methods (NPV, PI, PP and IRR) were introduced to help the multinational corporation select the most suitable method. At the same time, the exchange rate was introduced to evaluate and control the impact of exchange rate changes and inflation.

In Chapter 4, the risks, focused on by the multinational corporations, will be introduced to build risk-management consciousness.