Question

1) An unexpected change in exchange rates impacts a firm's expected cash flows at three levels, depending on the time horizon used (Short Run, Medium Run, and Long Run). Describe the three operating exposure's phases of adjustment assuming that parity conditions do not hold among foreign exchange rates, national inflation rates, and national interest rates (disequilibrium).

Answer 1

Dear student,

The answer of your question is mentioned below..

The unexpected change in exchange rate impacts on firms expected cash flows in three ways and firstly we have to understand the meaning of those parameters.

1- Foreign exchange rate:

It is also known as Forex market. It means we have to trade our home country's currency with any other country's currency. So we can trade in foreign exchange market and get optimum price from their.

So if there is unexpected change in exchange rate then their is two possibilities either we got more value or less. It's totally depends on your contract which you have done in past. (i.e futures, forward & spot market)

2. National inflation rate:

In simple words we can say that inflation rate means percentage of increase and decrease in prices of products in specific time period.

It impacts on the consumer's purchasing power capacity and value of the currency.

Each and every time we can't say that inflation is harmful for the country because sometime it will positively impact on country. Central bank will manage to control price rising through inflation and deflation.

3. National interest rate:

The interest rate at which banks borrow money from a country's central bank known as national rate.

Two possibilities:

Bank's national interest rate goes up then cost of money get costlier and consumer spends and borrowings less. So inflation will be in control.

And when bank's national rate goes down then cost of money get cheaper and consumer spends and borrowings more.

So from above solution we can say that it is duty of central bank to make an equilibrium between Foreign exchange rate, National interest rate and National inflation rate through increasing or decreasing in base rates.

Hope you will get your answer.

Thank you.