Managing Interest Rate and Exchange Rate Volatility Assignment

Managing Interest Rate and Exchange Rate Volatility - Assignment Example Buckley (1996) identifies two other types of interest rate risk, which include basis risk and Gap risk. If interest rates are determined on a different basis for assets and liabilities then a firm having loans and debts will face basis risk. A company faces basis risk when the interest rates on its loans and debts are determined using different basis. (Buckley, 1996) Assume for example that Kaufman & Connelly Plc issues a fixed rate bond to fund its financing needs and at the same time gives out a loan to another party at a floating interest rate. Her interest payments will therefore be fixed while interest receipts will be variable and will depend on prevailing rates. She will therefore be facing basis risk since her interest expenses and revenues will be determined on different basis. A company faces gap risk when it has both fixed rate liabilities and assets. When fixed rate liabilities exceed fixed rate assets then there is positive Gap, with a positive gap a rise in short term rates increases margins while declining rates decrease margins. On the contrary if fixed rate liabilities are less than fixed rate assets, then there is negative gap. In this case a rise in short-term rates decreases margins while a decrease increases margins.(Buckley, 1996). Elekdag and Tchakarov (2006). Changes in interest rates have also been the major determinants of business cycles or trade cycles in emerging markets such as Thailand in recent times. (Elekdag and Tchakarov, 2006). The figure above is an indication of how interest rates and business cycles are related in Thailand. High interest rates lead to low output whereas low interest rates lead to high output. Therefore Kaufman & Connelly Plc is likely to face decreases in demand for its products during a period of the high interest rates and increases in demand during lower interest rates. ii. FOREIGN EXCHANGE EXPOSURE Exchange rate exposure can be defined as the degree to which a firm's cash flows, assets, liabilities and value can be affected by exchange rate movements. (Buckley, 1996). According to Buckley (1996), assets, liabilities, profits or expected future cash flows are said to be exposed to foreign exchange risk when a change in exchange rate would result in either a positive or negative change in the home functional currency (home currency) value of the asset, liability, profit, expected cash flow or firm value. The term "exposure" used in the context means that the firm has assets, liabilities, profits or expected future cash flow streams such that the home currency value of assets, liabilities, profits or the present value in home currency terms of expected future cash flows changes as changes in exchange rates occur (Buckley, 1996: pp 133). From the foregoing foreign-currency-denominated assets and liabilities as well as expected foreign-currency-denominated future cash flow streams are clearly exposed to exchange rate risk. (Buckley, 1996; Shapiro, 2003). Buckley (1996) also notes that home-currency-denominated expected future cash flows may also be exposed to foreign exchange risk. For example, a firm based and selling goods in the United States may be competing with European firms and as such its expected future c