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International Finance and Open-Market Macroeconomics, Essay Example

Pages: 4

Words: 1153

Essay

Investing excess cash in a currency that pays a higher interest rate peripheral to the Euros utilized at the Bank of Rotterdam retains both risks and possibilities that need to be taken into consideration. Various steps need to be taken in order to increase the wealth of the bank via operations in the money and capital markets.

Step 1: Borrowing 2 million Euros from a Serbian bank for a period of five years requires a calculation that converts Euros to Serbian Dinars utilizing prevailing spot rates.

1 Serbian Dinar = 0.0084 Euros spot rate.

2,000,000 Euros = 2,000,000 x 1/0.0084

= 238,095,238 RSD

Step 2: The amount is borrowed from a Serbian bank at an interest rate of 6%, and the liability the company will create in terms of the cost of financing will be:

PV = 2,000,000 Euros, or 238, 095,238 RSD

FV = PV x [FV factor for n=5, I = 6% per year]

= 238,095,238 RSD x [5 years at 6% per year]

=  238,095,238 x 0.3 = 71,428,571.4 RSD + 238,095, 238 = 309,523,809 RSD as FV

Interest:  238,0095,238 x 0.06 = 14,285,714.3 per year

14,285,714.3 x 5 = 71,428,571.4 RSD over 5 years when interest expense is added to the initial investment. Compound interest retains the capacity of boosting investment returns over the period of five years of the investment.

Long-term bonds can be utilized as a reference point in the determination of interest rates using the yield curve during the pricing process, a practice that is commonly conducted across the globe. In Serbia, there is a blaring elision of pertinent benchmark for pricing such loans as the one discussed in this scenario, and related benchmark functions as the yield for long-term investment being used in the liquid secondary market. Investments are risky because the value can shift fluctuate over time if there is a change in the absolute level of the interest rate of 6% over the five years or if the contours of the yield curve change (Gandolfolo, 2002). Such changes typically inversely impact securities and thus can be minimized through hedging via a swap in the interest rate or diversification.  There are various associated risks with this five year investment at a fixed rates and may result in missed opportunities to yield higher profits throughout the 5 years. However, the Serbian economy is unstable and continues to reel as a result of its escalating deficit of 4.7% of its GDP while the debt remains at 65% (Vasovich, 2013). While the Dinar has a higher investment rate than the Euro, there are exchange risks due to the fact that the economy is slow to recover and Serbia is in a politically tumultuous situation. As a result, the bank’s investment must be protected, which is why it is necessary to calculate the purchasing parity between the investment (Dinars) and the currency used to protect the investment—in this case, in Russian Rubles. Purchasing power parity calculations are utilized as barometers for ascertaining the spending power of GDP and other macroeconomic indicators in real terms in addition to comparing two different currencies related to the investment (Pilbeam, 2006). A ratio derived from the price of the investment compared to the currency exchange rate is used to calculate the purchasing power parity.

Step 3: Ascertaining the equivalencies of the Dinar and the Ruble is necessary in order to derive the purchasing power parity.

1 Serbian Dinar = 0.59 Ruble

= 238,095,238 x 0.59 Ruble = 140,476,190 Rubles

This amount is then invested through the purchase of Delta Credit Bonds. To find the present value of cash flows from the bond, it is necessary to discount the current interest rates and the discounting rates. The purchasing power ratio is as follows:

238,095,238/140,476,190 = 1.69

If the exchange rate between the Dinar and the Ruble changed to 5 Dinars per Ruble and the purchasing power remained the same, the purchasing power parity calculation would evince a loss of purchasing power for Serbian consumers in relation to Russian consumers. This scenario thus underscores the risk of foreign investment using currency that fluctuates and can result in the fluctuation of purchasing power and monetary clout.

Invoicing Euros and hedging enables firms that are active across the world to curtail their exposure to exchange rate variations (Dhoring, 2008). Exchange rate needs to be discussed in terms of transaction risk such as risking variations of value of cash flow in the future in addition to translation risk—the risk of variations of asset liabilities and assets within foreign currency—and other economic risks that are more broad. Exchange rates variations directly affect competitiveness, which is why it can be argued that hedging and invoicing the Euro using exchange rate derivatives enable transaction and translation risks to be managed in an optimal way (Dhoring, 2008). Such instruments prove helpful in curtailing any adverse affects on the appreciation of the euro and fluctuations in the Dinar or rubble when investing such a large sum of money over a five year. Exchange rate risk can be hedged via the financial instruments discussed. It is unequivocal that financial derivatives have emerged as the standard mechanisms for hedging risks associated with interest rates, commodity prices, and exchange rates.

Risks in Serbia and in Russian prompt many security risk analysts to take into consideration the very prospects of investing on these respective countries. For the next five years, it is hoped that Serbia undergoes various economic and political reforms in order to build up a stable government in the upcoming elections.  Foreign investment bolsters GDO growth on an annual basis despite the fact that the business and regulatory environments will still be quite tenuous and challenging. Social friction amongst competing factions and minorities is a noted concern, especially because it undermines security in the nation due to the fact that the financial institutional foundations remain uneven and weak. In an alternative risk scenario, persistent political and economic problems may require military intervention in the future to protect national security, which would worry financial investors because the economy would most likely stagnate in addition to Serbian politics. As a result, the economy would remain highly dependent on foreign aid due to the fact that domestic stability is called into question and foreign investment profoundly shrinks. Finally, foreign investment often transpires during a so-called honeymoon phase as a country like Serbia shows signs of political and economic recovery. Once that phase ends, and if the stability of Serbia oscillates during the recovery period, then politicians would most likely call for the implementation of certain sanctions in order to perpetuate the recovery process. Foreign investors would thus be more likely to lose out within this scenario.

References

Dhoring, B. (2008). Hedging and invoicing strategies to reduce exchange rate exposure: a euro-area perspective. European Commission. Retrieved January 2, 2016 from http://ec.europa.eu/economy_finance/publications/publication11475_en.pdf

Gandolfo, G. (2002). International finance and open-market macroeconomics. Berlin, Germany: Springer.

Pilbeam, K. (2006). International finance, 3rd edition. New York: Palgrave.

Vasovic, A. (2013). Serbia seeks to borrow up to $3 billion from UAE: official. Reuters. Retrieved January 1, 2015 from http://www.reuters.com/article/us-serbia-borrowing-idUSBRE98C0CQ20130913

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