DESIGN AND IMPLEMENTATION OF CURRENCY CONVERTER FOR MAJOR WORLD COUNTRIES
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LITERATURE REVIEW
Concept of exchange rate exposure
Notwithstanding the fact that the conversion rates of different currencies to
one another usually change over time, it can provide the condition of risk for
different parties from the countries that interact with each other through
multinational activities. The risk or exposures in this situation “represent the
sensitivity of the value of the firm to exchange rate randomness (Jorion, 1990,
p. 331).” In simple words, the amount of any assets, liabilities or cash flows
that are subject to exchange rate fluctuations, nominated as the exposure and
in turn the possibility of losing that may reached to the company because of
these fluctuations, are noted as the risk of the exposure (Bridges, 1988).
Mathematically and statistically this concept can be expressed as the slope of
the coefficient of firm’s value (based on domestic currency) on an exchange
rate through a linear regression. Since determining the value of a firm
(common stock price) and exchange rate changes are being considered
jointly, the concept of this exposure is an arbitrary bespoke (Adler & Dumas,
1984).
Mentioning the value of a firm, there are two main components that can be
influenced by exchange rate fluctuations; one is the value of all real assets
held by the company, and the other is the value of net monetary assets with
fixed nominal payoffs that also contain cashflows in the foreign currency
clarified by contractual affairs. Regardless of the uncertainty of inflation rate,
monetary assets in foreign currencies (especially short-term) are encountered
to the risk of exchange rate completely, while there has not been this kind of risk for local monetary assets. Nonetheless, the effect of this risk has realized
and has shown by many theoretical analyses like the one done by Choi and
Prasad in 2005. This concept is known as “Translation Exposure”. This
exposure has some effects on the value of real assets too, since the costs of
importing needed substances and goods or even aggregate demand may be
changed and influenced by the fluctuation of the foreign currency exchange
rates. Hence, the value of local corporations can be influenced by the risk of
the exchange rate exposure too. The other category of exposure that is more
relevant in this research is “Transaction Exposure” that usually takes place for
the corporations that involve in foreign interactions via trading or operating
abroad. Like in translation exposure, the volatilities of exchange rate will
change the value of financial obligations of the firm that already entered into a
foreign transaction and then can lead to gain or loss for the firm. So, the risk of
the recent exposure is focused in this study.
Internal and External Hedging Definitions
Hedging strategies and techniques are segregated into two main categories in many previous scholar studies; internal and external. Most of the time in
internal ways the corporations use the techniques related to the company
itself like setting the rules and instructions via their financial instruments while
in external methods the firms use the instruments that can engage the other
parties for decreasing their risks. Although the internal strategies are not the subject of this study, since some previous mentioned investigations discussed the internal methods, the two of the most relevant techniques are just explained briefly.
Matching and Netting (Internal Hedging Strategies)
Matching strategy provides a condition of interest or dividend payment to
investors at the interval times regularly and the payment’s amounts are
usually fixed in this situation. As a case in point the strategies for payments to
retirement workers that must be stable and continuous could be notified as
matching. So, a company can acquire a portfolio including the securities
catering for stable payouts altogether. Netting technique encompasses two different concepts; one is the condition for settling the mutual obligations between two or more parties based on the net value of their contract that can lead two win-win interactions for the parties coincidentally. The other meaning is setting the limitation net amount for funds transformation between foreign subsidiaries.
FCD and FDD (External Hedging Strategies)
FCD is the abbreviation for the three words of Foreign Currency Derivatives.
In fact, derivatives used as an overall label for financial instruments that their
values related to the other variables. These variables usually are the assets
which are underlying them, so FCD is a kind of contract which value depends
on the value of its underlying assets. Four main categories of contracts can be
mentioned under the label of FCD; Options, Futures, Forewords, and Swaps
that each of them has its own terms and conditions. Some of these contracts
can be traded within the exchange market while others could be traded via
OTC (Over the Counter) market that is much bigger than exchange. The trade
is usually bilateral in OTC and in turn has two alternatives; one trade takes place between two financial institutions and the other contains one financial
institution and its client.
Options: this contract can be traded through both OTC and exchange market and includes two types; Call Option is a kind of contract whereby its holder has the permission for buying the underlying asset with a certain price at a specific time and Put Option that provides the right for its holder to sell the
underlying asset with specified time and price.
Futures: provide an agreement for both sides (buyer and seller) to trade
specific asset with a distinctive price and time. Only some of these contracts
may request for physical delivery of their assets while others are settled in
cash and they normally trade within the exchange market.
Forward: it has the same contract as Futures, but delivery of their underlying
assets (commodity) is deferred until after the contract has been made. These
contracts usually are traded within OTC.
Swap: a kind of contract that provides the condition for both parties to
exchange two different securities, interest rates, or even currencies for mutual
benefits. In fact, in this situation two parties enter in the contract that can lead
to win-win for both of them. For instance, in the condition that one can take a
loan at a lower rate than the other party and then allocate a part of the loan to
the other party at a higher rate.
Since the recent party could not take the loan
in the rate that the first one has taken, it would be profitable for him. From the
other view, the one that has already taken the loan based on the specified
interest rate, can make a profit by allocating some parts of the loan to the
other party with the higher rate. FDD refers to Foreign Denominated Debts and encompasses any debts that a corporation takes based on foreign currency like issuing the bond (in foreign currency) or taking the loans from outsiders that often is used for raising funds or other financial purposes as well as hedging against the risk of foreign exchange rate instability. There are some important factors for choosing the right currency to issue the debt indisputably. First and foremost, the currency of the countries that a firm interacts with through operations or exports is in the focal point of notification and is known as exposure. Some previous
researchers noted that the issuance of foreign debt could be effective on
hedging against the exposure that arises from revenue side while for cost side
this strategy can lead to increasing the exposure. Moreover, the hindrances
that are in front of international investment on the one hand and capital market
segmentation on the other hand provide opportunities for selecting the
suitable foreign currency to issue debt. Legal barriers like tax differentiation
and higher costs for gathering information for foreign decision makers (about
investment) are the most two noticeable sources of segmentation (Hietala,
1989). Furthermore, tax regulation is a remarkable factor for deciding about
debt currency. In fact, tax can influence debt sourcing for multinational
corporations. Tax treatment differences in interest and exchange rate for
gaining and losing must be considered at the first, and the second is due to
differences in judgment of firms in corporate tax rates for different countries
(Kedia & Mozumdar, 1998).
Besides the previous factors, liquidity and legal regimes are the other
important factors that a company must consider in times of debt issuance.
Firms are eager to issue the securities in the debt markets with higher
liquidity, as the transaction costs can be reduced by the liquidity that is
underlying this market and finally they can issue the bonds with lower yields.
Last but not least, legal regime must be notified in this situation, as the
countries that have constraint rights for creditors cause the costs of borrowing
to be increased. Hence, when corporations can find the other alternatives with
less restrictions, they apply for them as soon as possible and ignore the
previous one.
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