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Discuss why Okan Co’s subsidiary company may be exposed to economic risk (economic exposure) and how it may be managed?
answer:In the case of Okan Co’s subsidiary company, economic risk may have occurred because interest rates have been kept at a high level, causing the original parity conditions to break down. High interest rates will be attractive to international investors, as they can get higher returns.
my question is that why this will be attractive to foreign investors? and how this condition will allow them to produce goods more cheaply than the subsidiary company?
High interest rates are always attractive to investors because higher interest means higher returns!
However in this case. higher interest rates will mean that the currency depreciates. That will mean that the cost of the goods produced in the country will be lower than if they were imported from elsewhere. That would make it more profitable
If country A has higher interest rates than country B, then country A’s currency will depreciate against country B’s currency. (Higher interest rate in theory means higher inflation which in theory (according to purchasing power parity) means a depreciating currency.)
If the exchange rate is currently 1.50 $’s to the € then if it moves to 1.60 the $ has depreciated in value (because 1€ buys more $’s).
yes sir, i understood what u said but in the answer but then why did they say that the currency of country A or okan the subsidiary company currency will appreciate rather then depreciate in the answer?
“High interest rates will be attractive to international investors,
as they can get higher returns and may lead to the Y$ becoming stronger relative to other currencies” (note: the subsidiary currency is Y$)Sorry, I should have expanded on what I wrote before.
The problem that the examiner is referring to here is that whereas interest rates and inflation rates should normally go up and down together, here the inflation rate is being kept reasonably low but interest rates have been kept high. As the answer says, this means that the relationship between interest rates and inflation rates would appear to have broken down and the basic formulas would then not hold. On their own, the high interest rates may encourage foreign investors to deposit money into the country, and this in itself can make the currency appreciate in value.
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