Discussing The Uncertain Currency Model And Option Pricing

Valuation of funds accumulated in China

Question:

Discuss About The Uncertain Currency Model And Option Pricing?

From the valuation it could be identified that funds accumulated in China need to be estimated by the company to identify how much profit will be obtained from the investments in Chinese interest rate. Estimation of the overall profits needs to be conducted to identify the returns that will be generated after one year. Interest rates in China a relatively high, which could provide the company with fixed amount of return. However, without the estimation of the actual profits expenses conducted in next fiscal year will not be possible. the second option is relatively to invest in US coco bonds, which has a steady rate of coupon payment conducted each year. The overall profits obtained in China needs to be converted to US dollar where adequate currency exposure is present. In addition, after the completion of the bond returns needs to be c converted in Chinese currency for the organization to utilize it in next fiscal year. Nevertheless, ignoring the US bond is much more profitable, as currency conversion risk is relatively present in continuing this method. Therefore, the company should invest in Chinese interest rates, which has a fixed return and are not hindered or influenced by external forces.

The currency swap transaction is mainly an adequate measure for reducing the depreciation on specific currency. The Australian company could eventually use the currency swap to adequately support its Chinese subsidiary in their operations. The Australian company can take out a loan in China with the help of Chinese company for the accounting needed by the Chinese subsidiary. This amount will directly be delivered to the Chinese subsidiary for smoothening their operations. On the same instance,  relevant deposits needs to be conducted in Australian Bank to accumulate adequate interest from the deposit. This message mainly needs an arbitrary bank, which helps the organization to adequately acquire the required level of funds in specific country without affecting the fund due to definition and currency[1].

This process is mainly conducted with the help of two companies in requirement of the funds. after the commencement of the loan process the company needs to repay the payments conducted to the bank in China.  after one year the Chinese subsidiary needs to pay the amount provided by the Australian owner, which will then be repaid to the Chinese Bank. this would eventually help in reducing the overall negative impact from the depreciating Chinese Yuan and protect investment of the Australian company. The interest paid in Chinese bank is mitigated with the interest earned from Australian bank.

Currency swap transactions

The interest rate parity mainly indicates that the Chinese Yuan forward rate should have large discount for the investor. This discount is mainly demanded by the investor as any kind of changes in Chinese Yuan value good directly affect the actual returns provided from the forward contract. discounts provided from the Chinese you want forward rate could eventually help in mitigating any slight depreciation in Chinese Yuan. Therefore, the hedging conducted would not be beneficial for the company if any depreciation in Chinese Yuan is identified. this is mainly because if any kind of depreciation in Chinese Yuan is detected the future spot rate would be valued higher than the actual forward rate provided today. this would eventually hamper the hatching process used by the organization to control its losses in Chinese Yuan.

Therefore, it could be estimated that any kind of depreciation in Chinese Yuan could directly me nullify the forward contract rate, as actual spot rate in future will directly change and decrease value of the overall currency hedge. Hence, it could be estimated that until the change in currency the organization should continue with the forward hedge contract.

The overall situation in the case states that money market hedge would involve relevant borrowings of Chinese currency and converting them into Australian dollars. However, the situation indicates that Chinese interest rates are relatively higher in comparison to Australian interest rates. This would make the overall borrowing rate higher than the actual in investment rate conducted by the company, which will indicate a loss from transaction. The hedging process will not be beneficial for the company, as Chinese interest rates are higher and will increase the loss for the Chinese company. Moreover, if no hedge is conducted then Chinese Yuan is expected to depreciate slightly over the period. However, if hedging process is conducted then hi boring rich needs to be incurred by the organization, while the actual interest rate will be less due to reduced interest rate. This directly make the hedge undesirable for any organization, as relevant loss will be in curd from the operation. Therefore, no hedging process needs to be conducted if interest rates in the borrowing country are higher than the investment country. this would eventually hamper the actual profitability obtained by the company from the hedging process.

The parity in interest rate in both the countries would not ensure the overall change in inflation rate in the economy. In addition, the difference in inflation rate could directly change the depreciation and appreciation of Chinese Yuan. The assumption of real interest rate being same will not affect the depreciation level of Chinese Yuan, while the changes in inflation rate could directly affect valuation of the currency. There is way ion which the actual deprecation or appreciation of the Chinese Yuan can be detected, as the overall inflation rate data is not provided. Without the detection of overall inflation rate relevant calculation for the currency conversion cannot be conducted. The Chinese inflation rate is 1.8%, while the Australian inflation rate is also at 1.8%[2]. Therefore, the changes in inflation rate could directly alter the overall currency valuation of Chinese Yuan.

Interest rate parity

The use of indirect intervention method for reducing the overall interest rate could directly allowed the business to achieve high profits from operations. The relevant decline in interest rate could directly increase the cash flow in the economy , which might allow the organisation to attain higher profits. This could eventually help the organisation in improving the relevant revenue from their operations. Therefore, from the interest rate relevant increment in consumer power increases, as government increase the flow of cash in the economy. The company with the declining interest rate could increase their operational capability, which might raise their profitability. The assumption of inflation rate being constant and reduction in interest rate occurs then the organisation’s performance increases relatively. Through relevant observations it can be seen that any decline in interest rate allows the company to reduce their overall finance cost and in turn raise the level of profit margin.

The high Chinese interest rate would eventual entice the Australian investors in improving their return generation capacity. However, this could eventually increase the level of Yuan appreciation during the investment years. On the other hand, during the maturity period the continuous conversion of Yuan to AUD would directly depreciate Chinese currency. Therefore, from the evaluation the Australian investors should not choose to invest in Chinese interest rate, as during the investment period the overall Chinese yuan will appreciate, while during the maturity period due to immense selling the overall Chinese yuan will depreciate. Hence, from the evaluation it could be detected that ignoring the Chinese interest rate could eventually help the company in reducing the expected losses, which might incur due to the fluctuation in currency conversion. Thus, Australian investor could you other investment operantly for raising the level of profits[3].

From the relevant evaluation adequate concern should be conducted for the exposure, as it cannot be estimated that relevant inflation rate that will increase in China will offset the overall depreciation of the Chinese Yuan. This could eventually raise the level of concern and risk for Australian company operating in China. This relevant increment in the overall inflation rate in China is not expected to offset the overall deprecation, which is conducted in Chinese Yuan. This mainly indicates that overall deprecation will match the actual inflation rate, which could in turn hamper profitability of the organisation. Therefore, no guarantee is provided to the business, which might hamper overall profitability of the organisation.

Use of hedging instruments

Hence, the Australian company should be concerned about the subsidiary company operating in China, due to the depreciation in currency rate. This relevant concern should be reduced by using adequate hedging instruments, which might reduce the negative impact of depreciating Chinese Yuan. The depreciating Yuan needs to be accommodated by the company or relevant profit generated in China will decline during the currency conversion. Therefore, the use of hedging instruments could allow the organisation in reducing the negative impact of Chinese Yuan during currency conversion.

There are different types of instruments that can be used by the organization to adequately has its future remittance to Australia. The use of future contract can be conducted by the organization for directly hedging the relevant cash remittance to Australia. The future contract can be conducted for reducing any kind of fluctuations in the currency market which might be conducted due to impact from external forces. Taking the future contract for Chinese Yuan could eventually fix the rate of exchange for the Australian company. This would eventually help in reducing any kind of losses incurred from depreciating Chinese Yuan.

The second financial instrument that could be used by the Australian company is the option contract, where adequate aging process can be conducted by the company for reducing any kind of depreciation in its currency exchange. The use of option contracts could eventually allow the company to fix a premium payment and take up the contract for the Chinese Yuan.  this could eventually help in reducing any kind of loss, which might incur from depreciating Chinese currency. Using the put option could eventually help the Australian company to head for the depreciating Chinese Yuan, which might fix the actual currency conversion rate for the organization. However, relevant premiums need to be paid by the organization for initiating the option contract, which might in a small loss during the currency conversion[4].

The third instrument that could be used by the Australian company is currency swap, which directly helps in reducing any kind of depreciation to the converting currency. This relevant currency swap mainly uses two different countries interest rates to nullify any kind of depreciation to the currency value. Australian company could eventually take loan in China and convert it in Australian dollars in current date, anticipating any kind of depreciation to the Chinese Yuan. however, after getting the payments from Chinese subsidiary the Australian company could pay the Chinese Bank, while the amount converted to Australian dollars could be deposited to the Australian Bank. This deposit to the Australian Bank help in receiving interest, which mitigate the relevant interest payments conducted in Chinese Bank.

Reference:

"Oxiteno Earnings Double On Sales, Currency" (2015) 2015(10) Focus on Surfactants

China Inflation Rate | 1986-2018 | Data | Chart | Calendar | Forecast (2018) Tradingeconomics.com https://tradingeconomics.com/china/inflation-cpi

Liu, Yuhan, Xiaowei Chen and Dan A. Ralescu, "Uncertain Currency Model And Currency operations Pricing" (2014) 30(1) International Journal of Intelligent Systems

Opie, Wei and Jonathan Dark, "Currency Overlay For Global Equity Portfolios: Cross-Hedging And Base Currency" (2014) 35(2) Journal of Futures Market

[1] Liu, Yuhan, Xiaowei Chen and Dan A. Ralescu, "Uncertain Currency Model And Currency Option Pricing" (2014) 30(1) International Journal of Intelligent Systems

[2] China Inflation Rate | 1986-2018 | Data | Chart | Calendar | Forecast (2018) Trading economics.com https://tradingeconomics.com/china/inflation-cpi

[3] "Oxiteno Earnings Double On Sales, Currency" (2015) 2015(10) Focus on Surfactants

[4] Opie, Wei and Jonathan Dark, "Currency Overlay For Global Equity Portfolios: Cross-Hedging And Base Currency" (2014) 35(2) Journal of Futures Markets