Question

BFRC Auditing (BFRC-Partners) Company, originated in Germany, would like to assess the country risk of Turkey. BFRC-Partners has identified various political and financial risk factors after Covid-19, as shown below. BFRC-Partners has assigned an overall rating of 80 percent to political risk factors and of 20 percent to financial risk factors. BFRC-Partners is not willing to consider Turkey for investment if the country risk rating is below 4.0. Should BFRC-Partners consider Turkey for investment?

POLITICAL RISK FACTORS ASSIGNED RATING ASSIGNED WEIGHT

Factor 1 5 40 %

Factor 2 3 60 %

FINANCIAL RISK FACTORS ASSIGNED RATING ASSIGNED WEIGHT

Factor 1 1 10%

Factor 2 4 20%

Factor 3 5 30%

Factor 4 4 20%

Factor 5 5 20%

A)Calculate the country risk of Turkey and decide whether to invest or not to this country.

B) Explain why foreign exchange rates are important for investment? Please explain it.

C)Why companies need to forecast Exchange rates? Is it easy to estimate the Exchange rate?

Answer 1

A) Political risk factors =f₁*w₁ + f₂*w₂ + --------- + f_n*w_n = 0.40*5 + 0.60*3 = 3.8

financial risk factors = f₁*w₁ + f₂*w₂ + --------- + f_n*w_n = 1*0.10 + 4*0.20 + 5*0.30 + 4*0.20 + 5*0.20 = 4.2

Overall rating = 80% of political risk and 20% of financial risk = 0.80*3.8 + 0.20*4.2 = 3.88

Country risk rating is 3.88 which is below 4.0. Hence, BFRC partners wont invest in Turkey.

B) The foreign exchange rate is used to convert your domestic currency into foreign currency at a specified rate. The foreign exchange rate helps us to determine how much worth our domestic currency is in terms of foreign currency. Foreign currency is required by the domestic investor to do business in a foreign country. For eg, If you live in the USA and want to build a plant in the UK then you need GBP pounds to invest in the UK so you need to convert US dollars into GBP pounds before investing in the UK and that conversion factor is a forex rate. It is also one of the determinants of a country's relative level of economic health. If the domestic currency is relatively stronger than the foreign currency, then its imports are less expensive and its export is more expensive in the foreign markets and vice versa. It also impacts the country's balance of trade. A country with a higher exchange rate can be expected to worsen a country's balance of trade, while a lower exchange rate can be expected to improve it.

C) Companies who deal in foreign markets need to forecast foreign exchange rates so that they can make a profit out of it. Let's suppose a company in India wants to buy oil from the USA after 6 months, then if the USA dollar strengthens in between these 6 months, the Indian company needs to pay more to the USA in terms of Indian rupees to buy the same amount of oil. Due to this, the Indian company will make losses or shrink its profit due to a rise in the exchange rate. If the Indian company is successfully able to forecast the foreign exchange rate today, then they can hedge this foreign currency risk by entering into the forward market and lock the forward price today itself. They can enter into such positions where they can completely hedge the foreign exchange risk. Hence, company's need to forecast foreign exchange rate so that they can hedge against the arising risk of increase/decrease the value of the currency in the foreign market so that they can save some cost and make some profit out of it.

The foreign exchange rate can be determined either by the market forces through supply and demand on global currency markets or by the Government of the country through its central bank.

Floating rate: If the demand for domestic currency is high, the value of the currency will increase and if the demand for a domestic currency is low, then the value of the currency will decrease. The value or foreign exchange rate can be altered by increasing/decreasing the demand and supply of the currency in the foreign markets according to the need.

Fixed-rate: The central bank can also determine the foreign exchange rate which will be pegged/fixed against the major currencies of the world. The central bank will buy/sell its currency in the market against the foreign currencies to which it is pegged to keep the exchange rate fixed.