Managing Interest rate and exchange rate volatility Essay

Managing Interest rate and exchange rate volatility - Essay Example (Buckley, 1996) Assume for example that Junor 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). Changes in interest rates will therefore affect both the cash flows and expected cash flows of Junor Plc in that an increase in interest rates will mean higher cash outflows for the company. 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 Junor 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. The degree to which a company is affected by currency fluctuations is referred to as foreign exchange exposure. (Shapiro, 2003). Foreign Exchange exposure can be divided into two main types-Accounting exposure and Economic exposure. Transaction reflects the firm’s risk to exchange rate movements regarding