Euro Essay Research Paper 1 IntroductionOne market

Euro Essay, Research Paper

1. Introduction

One market, one money. Being mentioned in the European Commission s book, it brought the euro to financial world. To attain faster growth of the economy, the euro was introduced with three advantages. The first consists in seigniorage gains and transaction cost savings inside the EU; the second links with advantages to the European financial services industry; the third provides monetary relationships with the other major currencies, the US dollar and the yen (Johnson, 1996).

In 1999, the euro was described a stable, rock-hard currency with the beginning of its life. In fact, the performance of the euro has not proved this description right. More than two years after the launch of European grand monetary project, the euro has slumped by nearly 10% of its value in Pound Sterling and 25% in US dollar since January 1999, recording a low of $0.84/ and 0.58/ in November 2000. (See Figure 1 and Figure 2)

Not surprisingly, the devaluation of the euro is one of the biggest issues in currency world. Thus, this article considers the behaviours and the reason of the euro s depreciation during last two years, discusses the economic exposure as a result of this depreciation, forecasts the trend of the euro for the period between 1st April 2001 and 30th September 2001, and gives the appropriate hedging strategy for the UK exporter based on the prediction of the euro s value.

Source: www.oadon.com

Figure 1: Last 25 months of the euro ($/ rate)

Source: www.oadon.com

Figure 2: Last 25 months of the euro ( / rate)

2. The Euro, Since January 1999

For the long-term view, it could look back over the performance of the euro and its predecessors, the European Currency Unit (ECU), since 1996. Table 1 shows the value of the ECU/euro against the US dollar and the pound sterling over the period since mid-1990s. It demonstrates that, the ECU and its successor, the euro, depreciated about 25% value in this period. Healey (2000) argued that this relative depreciation significantly reflected the extraordinary strength of the dollar, stemming from high US interest rates rather than any inherent weakness in the European economy.

Table 1: ECU or Euro Exchange Rate

1996 1997 1998 1999 2000

US Dollar 1.270 1.134 1.121 1.066 0.924

Pound Sterling 0.814 0.692 0.676 0.659 0.609

Source: Europe Central Bank

While examining the behaviour of the euro after it s launching, it confused people about its depreciation in the early stage. In addition, amongst financial analysts view, it should concern the unexpected strength of the US economic (Healey, 2000). In 1999, the actual growths in the United States, the EU were respectively 4.0% and 2.2%. As a consequence of the booming of Internet industry, the US economy grew faster than it was expected. Therefore, this would influence the euro getting weak and the US dollar getting strong.

Furthermore, the critics were to claim that the fall in the euro showed the lack of confidence that the foreign exchange market has in the ability of the European Central Bank (ECB) to effectively manage monetary policy. Healey (2000) suggested that the ECB preferred to pursue the internal monetary (i.e. price) stability rather than the external monetary (i.e. exchange rate) stability. Hence, the ECB pay relatively less attention to exchange rate development and it could be the reason which led to the weakening of the euro.

Moreover, Hill (2000) argued that the decline in the value of the euro probably reflect the fact that the largest national economy in the euro zone, Germany, had a difficult year characterized by slow growth and relatively high unemployment in 1999. Because of Germany accounting one-third output in the Euro-zone, its economy plays an important role in the value of the euro. Thus, Germany goes weak, so does the euro. As a result, with the weakness in Germany in 1999, global investors have been hesitant to hold euro-denominated assets, preferring instead to hold US dollars. Accordingly, this phenomenon contributed that the euro sunk in value against the dollar (Hill, 2000).

On the other hand, the significant difference interest rate appeared contributing to the weakening of the euro. Table 2 shows the interest differences over the period between 1996 and 2000. In the first period after the birth of the euro, the interest rate in the Euro-zone fell, while the US rate increased, the interest rate differential widening from less than 2% to over 2.5% in1999. This differential forced people hold the US dollar rather than the euro. Consequently, the euro depreciated.

Table 2: Interest Rates in the US and Euro-zone

US Euro

1996 5.51 4.92

1997 5.76 4.24

1998 5.57 3.83

1999 5.42 2.96

2000 6.43 4.40

Source: Europe Central Bank

Nevertheless, over the past few months, the euro has gained 10% in value against the dollar and the pound. This has had immediate consequences for inflation. Thus, the Euro-zone consumer price inflation decelerates from 2.9% in November to 2.6% at the end of last year. (Barclays Economic Review: First Quarter 2001) A narrowing of the interest differential against the Euro-zone as the Federal Reserve cut the US interest rate by more than the ECB also helped the strength of the euro in that period.

In summary, the performance of the euro made unpredictable to most economists due to the different economic factors in last 25 months. However, the depreciation of the euro might be not a bad thing to the Euro-zone unless the euro-zone is running a trade surplus. Furthermore, the euro is recovering recently, which seems to be good news for the Euro-zone.

3. Economic Exposure

As its definition, economic exposure could be the fundamental currency exposure facing the firms and be concerned with impact of exchange rate changes on the uncertain foreign currency stream of corporate cash flows and ultimately with the impact on the value of the firm (Holland, 1993). In macroeconomic view, devaluation of the house currency tends to favour companies competing in the export market and a favourable impact on import-competing areas. In contrast, the disadvantages could occur when the foreign currency devaluation (Buckley, 2000).

Since the monetary policies and markets are becoming more global, exchange rate changes can affect all the companies in globally competitive industries, no matter whether or not they export their products. In addition, the exchange rate change could result in relative price changes, both within and between countries. Demirag and Goddard (1994) argued that relative price changes could affect company, its competitors, suppliers and customers. A simple illustration is listed in Table 3.

Table 3: The Effect of Economic Exposure

Home Currency Strengthens Home Currency Weakens

Direct economic exposure

Sells abroad UNFAVOURABLE FAVOURABLE

Imports from abroad FAVOURABLE UNFAVOURABLE

Earn profits abroad UNFAVOURABLE FAVOURABLE

Indirect economic exposure

Competitor sources abroad UNFAVOURABLE FAVOURABLE

Supplier sources abroad FAVOURABLE UNFAVOURABLE

Customer sells abroad UNFAVOURABLE FAVOURABLE

Customer sources abroad FAVOURABLE UNFAVOURABLE

Source: M631 Resource Pack

During the last 2 year, the performance of the euro creates some problems for British economy. First of all, it is obviously for the British firms to face with the danger of being outside the Euro-zone. As a result of depreciation of the euro, the British exporters confronted the intense competition when competing with their competitors in the EU11 economics. Two kinds of competition became severely. The data shows that exports to the rest of the EU account for approximately 50% of the total British exports (Healey, 2000). Unsurprisingly, the economic impact of the euro s devaluation has been felt hardest in the British exporters. They could get the losses by either receiving the euro payment or decreasing the orders from the Euro-zone due to the strength of the pound. Furthermore, the depreciation of the euro against the US dollar has made the firms in the Euro-zone more competitive. The relative lower price formed the competitive advantage of the European firms and affected the different industries in the UK.

In contrast, the performance of the euro in the first 2 years brought some economic benefits and costs in favour of British entry the euro market. It could be also favourable to the British firms to import the relative cheap goods from the Euro-zone and invest in Europe. Although there are some advantages occurred by the depreciation of the euro, from the macroeconomic view, it could weaken the competitive advantages of Britain. Furthermore, whether Britain joins the euro or not leads to the discussion in British government. However, being a member of euro zone will let Britain get more benefits even it also has some disadvantages. Hence, it is likely that the British government would join the euro in few years. This signal for the integration of the UK economy and the Euro-zone economies would lead to the new issues of the euro exchange rate for both side of England channel.

The economic exposure occurred by the devaluation of the euro should be managed by both British firms and European firms. Since economic exposure is concerned with the future cash flows and extending over a longer period, it could be not possible to cope with this risk simply through the normal hedging techniques. Demirag and Goddard (1994) stated that the key to economic exposure management is flexibility. One way to achieve such a kind of flexibility could be to diversify internationally in different aspects, e.g. sales, location of production facilities, raw materials and financing.

Concerning the managerial skills of the economic exposure influenced by the euro, it could be a good way to have some portfolio in euroland for British firms. Result from the trend of the euro in its first 2 years, the British companies should pay attention to the market selection against the Euro-zone competitors or use the sources from the Euro-zone to set up their plants. Last not the least, it should focus on forecasting foreign exchange rate changes. Although it would be the trend that Britain would be a member of the euro zone, the risk of the exchange rate of sterling/euro would be eliminated. Therefore, the rate of dollar/euro or dollar/sterling could be the new risks to manage in the long-term management for the companies.

4. Transaction Exposure Management in Next Six Months

Transaction exposure could be defined as a short-term component of economic exposure (Demirag & Goddard, 1994). Buckley (2000) defined transaction exposure as to be concerned with how changes in exchange rates affect the value, in home currency terms, of anticipated cash flow denominated in foreign currency relating the transactions already entered into. The real world is different from the theoretical one. Hence, in short term, transaction exposure is very important to international firms and needs to be managed.

Holland (1993) stated that the sources of information, such as forecasts of spot rate changes, are vital to strategic, operational and internal/external responses to currency risk of transaction exposure. Furthermore, once these forecasts have been developed they can be applied to corporate measurement of exposure to produce estimates of likely real gains and losses.

However, forecasting the likely path of foreign exchange movements is a very complex task. Hill (2000) suggested that two ways of thought could address exchange rate forecasting. The efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rate. The other school of though, the inefficient market school, argues that companies can improve the foreign exchange market s estimate of future exchange rates by investing forecasting services. Since the global market is not the efficient market, or could be defined as semi-efficient market, some kind of approaches could be used to improve the estimate of the future spot rate.

l Forward Exchange Rates

First of all, assuming the market is effective, the forward rate could represents the future spot rate. In 1st March, the forward rates of the euro against the pound sterling and the US dollar are listed in Table 4.

Table 4: Forward Rates of the Euro

1st Mar One Month Three Months One Year

Rate PA% Rate PA% Rate PA%

Sterling 0.6396 0.8 0.6405 0.8 0.6443 0.8

Dollar ($) 0.9301 0.5 0.9305 0.3 0.9328 0.3

Source: Financial Time, 2nd March 2001

Using the data above, it could calculate that the forward exchange rates of / and $/ would be 0.6396 and 0.9301 respectively on 1st April, 0.6422 and 0.9315 respectively on 30th September.

l International Fisher Effect

Next, it is instructive to revisit the basic theory of exchange rate. Significantly, one of reasonable theories could be International Fisher Effect. The International Fisher Effect states that interest rate differentials would reflect the expected movement in between today s exchange rate S0 and the expected exchange rate at some point in the future St relative to the domestic interest rate Id and the foreign interest rate If. Using mathematical quotation, it could be stated: (If－Id)/(1+Id)=(St－S0)/S0

Table 5 shows the interest rates in Euro-zone, the US, and the UK in 1st March. Using the data listed in Table 5, it could calculate the exchange rate in 3 months by International Fisher Effect.

Table 5: Interest Rate in UK, US, Euro-zone

1st March One Month Three Months Six Months One Year

UK 523/32 521/32 59/16 51/2

US 55/16 53/32 429/32 47/8

Euro-zone 413/16 43/4 421/32 41/2

Source: Financial Time, 2nd March 2001

The spot rate is 1.5645/ on 1st March. And one-month interest rate in the UK and the Euro-zone are 523/32 and 413/16 respectively. The effective interest rate would be:

UK 523/32 +1/12=0.477%

Euro-zone 413/16 +1/12=0.401%

Using (If－Id)/(1+Id), the interest rate aspect would be:

(0.00401-0.00477)/(1+0.00477)=－0.076%

Using (St－S0)/S0, the exchange rate aspect would be:

(St－1.5645)/1.5645=－0.076%

Accordingly, the spot rate would be 1.5633/ on 1st April. That means 0.6396/ .

Similarly, it could calculate that the spot rate of pound/euro in six months would be 0.6420/ , on 1st September. Using the same formulation, the rates of dollar/euro would be $0.9301/ and $0.9308/ on 1st April and 1st September respectively.

l Analyst Data

From Barclays Economic Review (First Quarter 2001), some analyst data would be useful to predict the euro exchange rate. (See Table 6)

Table 6: Key International Forecasts

Year Average 1999 2000 2001 2002

Growth (%)

UK 2.3 3.0 2.3 2.3

USA 4.2 5.0 2.0 2.5

EMU 12 2.4 3.3 2.3 2.8

Inflation (%)

UK N/A 2.1 N/A N/A

USA 2.2 3.4 3.0 2.2

EMU 12 1.2 2.3 2.1 1.8

Financial Market

UK Interest Rate 5.4 6.1 5.5 5.5

US Interest Rate 5.4 6.5 5.0 4.4

Euro Interest Rate 2.9 4.4 4.6 4.4

Euro/Sterling 1.52 1.64 1.54 1.48

Dollar/Euro 1.07 0.92 1.02 1.10

Dollar/Sterling 1.62 1.52 1.57 1.63

Source: www.barclays.co.uk

Due to the forecast of Barclay Bank, the / rate would be around 0.649 and the $/ rate would be around 0.980 during 2001.

l Forecasting

In conclusion, combining the different resources of forecasting the euro exchange rate, it is likely to predict that the / rate would be from 0.640 on 1st April to 0.642 on 30th September. And, the $/ rate would be from 0.930 to 0.932 at the same period.

Since, the exchange rate of / and $/ are being forecasted over the period between 1st April and 30th September. It would become an issue to the British or European firms to react this prediction and how might the risks of forecasting exchange rate be managed whether or not through the use of derivatives.

Hedging could be defined as the partial or total elimination of a risk by some compensating action. To decide whether or not to take a hedge strategy, the firm should assess all the costs involved before it (Demirag & Goddard, 1994). As the transaction undertaken incurs an inflow or outflow a future date, there should be a difference in the exchange rate between the time the original commitment was made for the transaction and the time it is settled in cash. Therefore, the transaction would therefore cost more or less then originally anticipated. There are several ways to manage the transaction exposure, such as forward contracts, currency futures, currency options, and borrowing or lending foreign currency. It could use a simple example to illustrate how the UK exporter hedges the transaction exposure by derivatives under the prediction of the euro exchange rate.

On 1st March, a British company HML exported goods to a French company ADL. Payment for the British goods, costing 125,000 is due in three months. The market information of 1st March is listed below:

Exchange Rate /

Spot 0.6392

3 Months Forward 0.6404

Future Market ( 125,000)

March 0.6400(Assumption)

June 0.6407(Assumption)

Option Market / 31,250 (cents per ) (Assumption)

Strike Price Calls Puts

May June May June

1.555 2.15 2.65 1.69 2.30

1.560 1.66 2.22 2.20 2.77

1.565 1.26 1.80 2.75 3.35

Three Months Interest Rate (Assumption)

Euro 425/32 – 325/32

Sterling 521/32 – 421/32

Source: Financial Time, 2nd March 2001

Three alternatives could be provided for the UK exporter.

l Do Nothing:

Due to the prediction of this article, the euro is premium to the sterling and the dollar. If the UK exporter has not done anything and the prediction is correct, the firm would not get the loss from the French receipt. However, there would be a risk if the prediction were wrong, the firm would lose the income as a result of the devaluation of the euro.

l Hedge on Forward Market:

The spot receives of payment is 125,000= 79,900. If the French payment is covered by forward contract, the income becomes: 125,000= 80,050. In such a case, the UK firm would get 150 gain. This is better than the current spot rate. Furthermore, if the spot rate in three months is higher than 0.6404. The gain from the payment would be less than the spot market due to the forward contract is a fixed cash flow.

l Hedge on Future Market:

The UK exporter could sell an 125,000 currency contract for June delivery at the rate of 0.6407/ . The income becomes: 125,000= 80,087.5. Hence, the UK exporter would get 187.5 gain.

l Hedge on Option Market:

The UK exporter could buy three 31,250 contracts for June delivery at strike price of 1.555/ , which costs 145,781. And the premium cost would be 0.0265+3+31,250= 2,484, while it equals 1,588. Due to the payment of 125,000, the difference between the payment and the option contracts would be 20,781, which could be covered by forward contract as 13,308. So the total cost of the options would be 14,896, while the total gain would be 93,750. The income becomes 78,854. Hence, the UK exporter would get 1,046 loss.

l Hedge on Borrowing/Lending Currency Market

The UK exporter could borrow 123,523 in the market at the interest rate of (425/32)/4=1.1953%, which would be 125,000 in three months. Then it could convert into the pound at the spot rate, which equals 78,956. Depositing the pound at the interest rate of (421/32)/4=1.1640%, it would get 79,875 in three months. Therefore, the UK exporter would get 25 loss

In conclusion, the solution of hedging on the Future market would be the best way to the UK exporter, which gives the biggest profit. However, those solutions would not only the choices to the UK exporter. Furthermore, the firm could other derivatives as alternatives. Nonetheless, the foreign exchange market is so uncertain that being flexible is important to the firms no matter what strategy they use.

5. Summary

Few economic predictions have caught the behaviour of the euro s depreciation in its first 2 years. Whatever the causes of the euro s weakness, it is likely to see the euro has been gaining its value. However, the foreign exchange market is so uncertain that it could not be easy to predict the trend of the euro in the future. Therefore, other political issues could also influence this trend. As a result, either British firms or European firms have confronted this devaluation to take the risks of gains or losses. The question to them is how to manage those exposures. In summary, the choices are variety to the firms, and in the real financial world, no one-way is the best way.

References:

Buckley, A., 2000. Multinational Finance, 4th Edition. Essex: Prentice Hall

Demirag, I. and Goddard, S., 1994. Financial Management for International Business. Berkshire: McGraw-Hill

Johnson, C., 1996. In with the Euro, Out with the Pound. London: Penguin Books

Healey, N., 2000. The Euro at 20 Months: What Have We Learnt, Teaching Business & Economics, 4:3, 14-21.

Hill, C.W.L., 2000. International Business: Competing in the Global Marketplace: Postscript 2001, 3rd Edition. New York: Irwin/McGraw-Hill

Holland, J., 1993. International Financial Management, 2nd Edition. Oxford: Blackwell

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