Question

question 1

a. What is the effect on a country’s economy of an artificially low exchange rate? Of an artificially high exchange rate?

b. Explain how a company can use forward contracts to eliminate Foreign Exchange risk. What is counter-party risk?

Explain in detail

Answer 1

a) Artificially lowering exchange or increasing the exchange rate is done by the country when it is devaluing the currency or reevaluation of currency, it is done with the aim of impacting the export or import more competitive. When the country is devaluing its currency, it means it is done to make the export more competitive. After the devaluation of the currency the country goods and services become cheaper for foreign countries prior to devaluation. It promotes export and inflow of foreign currency. The revaluation is when the government or central bank feels that the exchange rate is way below the value of the currency of the country and it is negatively impacting the import. With revaluation the currency becomes costlier to foreign currency.

b) Forward contract is the private agreement between two parties where they agree to buy or sell at certain point of time in future. Let’s say a US based company is expecting to receive 1,000,000 Euro in 6 month and it worried as what would be the value of the that payment in dollar. It can enter into a forward contract at fixed price that it will convert 1,000,000 euro into dollar 6 months from now at fixed price.

The counterparty risk is risk that the other party will default on its obligation and will not oblige to it. Let’s say in the above case the party with which the US company entered into a contract but after 6 months that company does not have the financial ability to execute the contract, this is counterparty risk. Counterparty risk can be avoided in future contract because there is mark to mark settlement daily.