Exchange Rate Risk

Exchange rates between currencies of countries with any currency of the country has a very important function as breaking ties between the outside world and the country’s economy. The international economic transactions and comparison of domestic and foreign prices expressed in different currencies required directly or indirectly the emergence of the current exchange rate between the national currency and foreign currencies. Foreign currency risk or the risk of foreign exchange position explains adverse conditions as the loss of banks‟ profits due to the changes foreign exchange rate depending on the positions of foreign currency in the balance sheets of banks. In other words, the bank’s foreign currency positions due to the unexpected direction of exchange rate will create the risk of negative clauses in the banks‟ revenues, the bank’s equity, cash flows, asset quality and ultimately meeting the commitments (BabuĢcu 2005, pp.70). The exchange rate risk affects all companies of the assets and liabilities denominated in foreign currency. If the assets denominated foreign currency are not equal to the liabilities denominated same foreign currency, the companies expose to foreign exchange risk. The international companies is the most affected by the exchange rate risk. The below table shows a few large firms which suffer losses due to exchange rate risk suffer losses due to exchange rate risk in the end of accounting periods

The Losses of Same Countries due to Exchange Rate Risk

Company Country Loss (U.S. $)
Kashima Oil Japan 1.500.000.000
Abbott Labratories U.S. 41.298.000
Reader’s Digest U.S. 2.200.000
Telefones de Mexico Mexico 218.000.000
Bank Negana Malaysia 2.100.000.000
Allied – Lyons England 219.000.000
Viking Star Bahama islands 31.400.000
Quaker Oats England 19.000.000

The exchange rate is vital in terms of the international economic relations external balance. When mutual commitment and the interaction between the external and internal balance were taken into account, the exchange rate was the most strategic tools of the economic.

The increase or decrease changes of the exchange rate will cause the change in stock prices. According to theoretical framework, exchange rate changes which are one of the exogenous factors affect stock prices. In fact, foreign exchange market is a market where the supply and demand elements of the encounters. There are several criteria that affect the demand for the currencies of various countries. Therefore, analysis of exchange rates alone should not think as a partial framework of the foreign trade sector and integrate into the general framework of the macro economy.

The vitality and the recession in the foreign exchange markets affect the stock market, thus these markets constitute alternative markets to stock markets. The goods passed each other to meet a particular need is known competing goods. Therefore, the stock and exchange are rival financial instruments. Increase in the price of competing goods, the quantity demanded of the other goods which is a rival increases and in this case, the demand of goods whose price increase will decrease. There is a negative and functional correlation between the stock exchange. The cross-elasticity of demand between competing goods is always positive. There are two types of investors who invest in stocks. The first of them is small savers and the second speculators. The small savers want to invest in long-term, continuous and stable. Speculators invest in the portion of assets as risk loving people or organizations. This type of investors, has a dynamic and active structure. Alternatively, they follow closely the developments in the markets. If there is a continuous rise in foreign exchange rates in a country, this situation will attract the attention of investors. Investors will pay the foreign exchange market after stocks have become a partially or fully liquid market during movement in the foreign exchange markets. The increase in exchange prices decreases the stock prices because stock and exchange rate are competing investment vehicles. Thus the demand of stock increases or the stock value or the stock price increases. There are many factors affecting the price of foreign exchange. Regardless of these factors, the price of foreign exchang will influence stock price. As a result, there is a positive or negative change in stock prices.

In the capital market, the values of securities may be falling due to a specific reason or reasons from time to time or sometimes without any valid reason. There are many factors that cause such changes in the market. Market risk is the risk that investment returns will decline due to market factors independent of the given security or property investment. Examples include political, economic, and social events, or changes in investor tastes and preferences. The impact of market factors on investment returns is not uniform; the degree as well as the direction of change in return differs among invesment vehicles. For example, legislation placing restrictive import quotas on Japanese goods may result in a significant increase in the value (and therefore the return) of domestic automobile and electronics stocks. Esentially, market risk is reflected in the price volatility of a security (the more volatile the price of a security, the greater its perceived market risk). The changes of the social and economic structure of country, the new economic policies, the moral structures of individuals who invest and the indivuals are pessimistic and optimistic, an unexpected war affects the market. For example, when the news which is President Kennedy’s death on November 22,1963 (Kennedy is the present of the New York Stock Exchange) was heard, the stock prices immediately began to decline. Then the stock market is closed. When stock exchange re-opened, the prices of securities rose to normal levels due to the market risk are eliminated (Francis 1972, pp.262). The high-quality securities (securities refers to the level of confidence in terms of capital and income.) are affects more than low-quality financial assets by market risk. Non-active markets have got more market risk than active markets. (with high transaction volume markets) Stocks are affected higher than the bond by market risk. Because, the real value of debt securities such as bonds can be estimated more accurately than the value of stock. This feature is caused that the volatility of the market price of bonds is less than the value of stocks due to market risk (BaĢoğlu, Ceylan and Parasız 2001, pp.123). The concept of market risk are included under the concept of political risk. Therefore, the part of detailed information provided at the bottom of the market risk.
Political risk defined as uncertainties which accrue as a result of unexpected or unpredictable of the the attitudes of governments or organizations and affect adversely continuity of its activities in the company (Goddard and Demirağ 1992, pp.269). According to Üstünel (2000) the politics risk occurs political, economic crisis and war situations. The elements of political risk is as important as the definition of the politics risk. In this context, the factors which
listed as below items can be defined as the elements of political risk.

  • The rate of tax, Tariff and restrictions,
  • The policies of exchange rate,
  • Licensing and monopolies,
  • Environmental and health safety practices,
  • Expropriation,
  • Revocative risk of securities

The scope of the poltical risk factors should assess the existence of non-functional and legal systems in foreign countries, bureaucratic obstacles, the processes of democratic transition and civil – ethnic wars. Niederhoffer, Gibbs and Bullock (1970) examine the stock price behaviors during governmental and/or congressional elections in various developed countries, and they find some inefficiency in share prices around the time of elections, implying a profitable trading rule. They argue that changes in government administration caused by elections tend to affect financial policies or legislation, thereby significantly affecting stock prices. Bekaert (1995), Bekaert and Harvey (1997) claimed that the increase of political risk may reduce the performance of the market and the rates of return.

 

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