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Forecasting Exchange Rates and Risks Associated with Transaction and Translation Exposure" Please respond to the following: From the first e-Activity, determine whether or not the Big Mac Index supports the theory of PPP. Analyze the essential manner in which the IFE is reflected in the different prices on The Big Mac Index from country to country. Elaborate on the correlations between inflation and index prices, and the correlations between personal incomes and prices. 1PARAGRAPH From the second e-Activity, examine the main effect that relative inflation and interest rates could have on the selected company’s translation and transaction exposures from subsidiaries abroad. Outline a plan that proposes key steps that an MNC could take in order to mitigate translation and transaction exposures on international operations. Recommend two (2) tools that an MNC could use in order to mitigate such exposures. 1 PARAGRAPH

Paper For Above instruction

Introduction

The exchange rate environment and the associated financial risks have a profound impact on multinational corporations (MNCs) operating across various countries. Accurate forecasting of these rates and the understanding of risks related to transaction and translation exposures are crucial for maintaining profitability and stability. This paper examines the validity of the Big Mac Index as an indicator supporting the Purchasing Power Parity (PPP) theory, analyzes how the International Fisher Effect (IFE) influences the variation in Big Mac prices internationally, and explores the relationship between inflation, personal incomes, and index prices. Additionally, it evaluates how relative inflation and interest rates affect translation and transaction exposures for companies with foreign subsidiaries and proposes risk mitigation strategies, including two effective tools for managing these exposures.

Does the Big Mac Index Support the PPP Theory?

The Big Mac Index, developed by The Economist, provides an informal measure of the purchasing power parity (PPP) between different currencies by comparing the price of a Big Mac burger across countries. According to PPP theory, exchange rates should adjust to equalize the price of a basket of goods—Big Macs serving as a proxy—across nations. Empirical evidence shows that while the index often reflects long-term trends consistent with PPP, deviations occur due to factors such as transportation costs, tariffs, and local market conditions (Ma, 2006). The index supports the PPP hypothesis in many cases, particularly over extended periods, but short-term discrepancies highlight that PPP alone cannot fully explain currency movements. This suggests that market imperfections, trade barriers, and non-tradable goods influence exchange rates beyond PPP considerations.

The International Fisher Effect and the Big Mac Index

The International Fisher Effect (IFE) posits that the differential in nominal interest rates between two countries is equal to the expected change in exchange rates. The variations observed in Big Mac prices often mirror these interest rate differentials, indicating their reflection of underlying economic expectations (Fama, 1984). Countries with higher interest rates tend to have weaker currencies, which correspond to higher Big Mac prices when converted at prevailing rates, aligning with IFE predictions. The index captures not only exchange rates but also reflects differences in inflation rates and monetary policy stances, providing an essential glimpse into the economic fundamentals influencing prices and currency value across nations.

Correlations Between Inflation, Personal Income, and Price Levels

A positive correlation exists between inflation rates and index prices, as higher inflation typically leads to increased costs of goods and services, including Big Macs. Countries experiencing inflationary pressures often see their Big Mac prices rise correspondingly (Rogoff, 1996). Conversely, there is also a relationship between personal income levels and price levels; higher income levels can lead to increased consumption and potentially higher prices due to increased demand (Krugman & Obstfeld, 2009). The analysis indicates that economies with rising personal incomes tend to experience upward pressure on prices, reflecting greater purchasing power and spending capacity, which influences the Big Mac Index and other price-based indicators.

Impact of Relative Inflation and Interest Rates on Currency Exposure

For an MNC operating internationally, relative inflation and interest rates have significant effects on translation and transaction exposures. Elevated inflation in a host country can erode currency value, leading to adverse translation effects when consolidating financial statements. Higher interest rates may attract foreign capital, causing currency appreciation, which impacts transaction exposures through hedging costs and forecasted cash flows (Shapiro, 2013). Fluctuations in these macroeconomic variables affect the value of foreign assets and liabilities, exposing companies to exchange rate volatility.

Strategies for Mitigating Forex Exposures

To mitigate translation and transaction exposures, an MNC should adopt comprehensive risk management strategies. Key steps include implementing forward exchange contracts to lock in current rates for future transactions, thereby reducing uncertainty in cash flows. Additionally, the company can utilize natural hedging by matching foreign receivables and payables, effectively offsetting currency risks through operational adjustments. Diversifying currency exposure across multiple markets and continuously monitoring macroeconomic indicators enable proactive risk management (Eiteman et al., 2016). These measures help stabilize financial outcomes despite currency fluctuations.

Tools for Managing Currency Risks

Two effective tools for mitigating currency exposures are currency forwards and options. Currency forwards are agreements to buy or sell specific amounts of foreign currency at a predetermined rate on a future date, providing certainty over cash flows and protecting against adverse currency movements (Madura, 2019). Currency options, on the other hand, give the right, but not the obligation, to exchange currencies at specified rates before expiry, offering flexibility and protection against unfavorable movements while allowing participation in favorable trends. Both tools serve to hedge transaction and translation risks effectively and are widely used by multinational firms to preserve financial stability in volatile currency environments.

Conclusion

In conclusion, while the Big Mac Index supports the PPP theory over the long term, deviations highlight practical market frictions and structural differences among economies. The IFE is reflected in the variations of Big Mac prices and interest rate differentials, emphasizing the interconnectedness of inflation, monetary policy, and currency valuation. For multinational companies, understanding these relationships is essential for managing translation and transaction exposures. Employing financial instruments such as forward contracts and currency options, alongside operational strategies like natural hedging and diversification, can effectively mitigate currency risks, ensuring financial resilience in the global marketplace.

References

• Fama, E. F. (1984). Forward exchange rates as predictors of future spot rates: An empirical analysis. Journal of Financial Economics, 14(1), 3-37.
• Eiteman, D. K., Stonehill, A. I., & Moffett, M. H. (2016). Multinational Business Finance. Pearson Education.
• Krugman, P. R., & Obstfeld, M. (2009). International Economics: Theory and Policy. Pearson.
• Madura, J. (2019). International Financial Management. Cengage Learning.
• Ma, G. (2006). The Big Mac Index: An informal gauge of exchange rate misalignment, Applied Economics Letters, 13(9), 593-595.
• Rogoff, K. (1996). The Purchasing Power Parity Puzzle. Journal of Economic Literature, 34(2), 647-668.
• Shapiro, A. C. (2013). Multinational Financial Management. Wiley.