chapter37 internationalfinancialmanagement

Chapter 37

INTERNATIONAL FINANCIAL MANAGEMENT

Centre for Financial Management , Bangalore

OUTLINE• World monetary system• Foreign exchange markets and rates• International parity relationships• International capital budgeting• Financing foreign operations• Raising foreign currency finance• Financing exports• Insuring exports• Documents in international trade• Foreign exchange exposure• Management of foreign exchange exposure


DISTINGUISHING FEATURES

The basic principles of financial management are the same whether a firm is a domestic firm or an international firm - a firm that has a significant foreign operation is called an international firm or a multinational firm. However, international firms must consider several financial factors that do not directly have a bearing on purely domestic firms. These include foreign exchange rates, variations in interest rates across countries, different tax regimes, complex accounting methods, barriers to financial flows, and intervention of foreign governments.



WORLD MONETARY SYSTEM

• In 1971 the US dollar was delinked with gold. Put differently, it was allowed to “float”. This brought about a dramatic change in the international monetary system. The system of fixed exchange rates, where devaluations and revaluations occurred only very rarely, gave way to a system of floating exchange rates.

• Since governments of most countries intervene in the exchange markets, in a smaller or bigger way, we have ‘managed’ or ‘dirty float’.

• The exchange rate regime of the Indian rupee has evolved over time moving in the direction of less rigid controls and current account convertibility.


GLOBALISATION OF THE WORLD ECONOMY: RECENT TRENDS

The following trends have contributed to the process of globalisation.

• The 1980s and 1990s witnessed a rapid integration of international capital

and financial markets, the impetus for which came from the deregulation of

the foreign exchange and capital markets by the governments of major

countries.

• The advent of the euro at the beginning of 1999 heralded a new era, which

may possibly lead to a bipolar international monetary system.

• There was rapid expansion of international trade from 1950. This is being

pushed further at the global level (by WTO) and the regional level (by EU,

NAFTA and others).

• Economic integration and globalisation that started in 1980s gathered

momentum in 1990s, thanks to massive privatisation initiatives.


MULTINATIONAL CORPORATIONS

Companies go global for the following reasons:

• Trade barriers

• Imperfect labour markets

• Intangible assets

• Vertical integration

• Product life cycle

• Diversification

• Shareholder diversification


FOREIGN EXCHANGE MARKETS AND RATES

The foreign exchange market is the market where one country’s currency is traded for another’s. It is the largest financial market in the world. The daily turnover in this market in mid –2003 was estimated to be about $ 1500 billion. Most of the trading, however, is confined to a few currencies: the U.S dollar ($) , the Japanese Yen (¥), the Euro (€), the British pound sterling (£) , and the Swiss franc (SF), Exhibit 37.1 lists some of the currencies along with their symbols


CURRENCIES AND THEIR SYMBOLSCountry Currency Symbol

Australia Dollar A$ Canada Dollar Can $ Denmark Krone Dkr EMU Euro € Finland Markka FM India Rupee Rs Iran Rial Rl Japan Yen ¥ Kuwait Dinar KD Mexico Peso Ps Norway Krone NKr Saudi Arabia Riyal SR Singapore Dollar S$ South Africa Rand R Sweden Krona Skr Switzerland Franc SF United Kingdom Pound £ United States Dollar $


INTERNATIONAL FOREIGN EXCHANGE MARKET

• The key participants are importers, exporters, traders, brokers, speculators, and portfolio managers.

• Essentially an ‘over the counter’ market.

• Virtually a 24-hour market.

• Speculative transactions account for more than 95 percent of turnover


FOREIGN EXCHANGE MARKET IN INDIA

• RBI, banks, and business firms are the key

participants

• RBI plays a key role in setting the day-to-day

rates.

• Business firms can’t resort to speculative

transactions


CROSS-CURRENCY RATES


SPOT RATESIn the foreign exchange market, a spot rate refers to the rate applicable to transactions in which settlement is done in two business days after the date of transaction. To understand spot rate quotations, we will use the ACI (Association Cambiste International) conventions, which are followed in the inter-bank market. These conventions are as follows:

• A pair of currencies is denoted by the 3-letter SWIFT codes for the currencies separated by an oblique or a hyphen. Examples: GBP/CHF : Great Britain Pound-Swiss Franc

USD/INR : US Dollar-Indian Rupee• In a pair, the first currency is the ‘base’ currency and the second currency is the ‘quoted’ currency.• The exchange rate quotation reflects the number of units of the quoted currency per unit of the base currency. Thus a GBP/INR quotation reflects the number of India rupees for British pound.


• A quotation consists of two prices separated by a hyphen or slash. The first price is the bid price; this is the price at which the dealer is willing to buy. The second price is the ask price; this is the price at which the dealer is willing to sell. An illustrative quotation is given below:

USD/INR Spot : 45,000/45,5400

This quotation means that the dealer will buy one US dollar for Rs. 45,000 and will sell one US dollar for Rs. 45,5400.


BID-ASK SPREAD

The bid-ask spread - the difference between bid and ask prices – reflects the breadth, depth, and volatility of the currency market. The spread in normally expressed in percentage terms as follows:

Percent spread =Ask price – Bid price

x 100Bid price

For example, the percentage spread for the dollar quote Rs. 45,5000 – 45,5400 works out to 0.088 percent.

Percent spread =45,5400 – 45,5000

X 100 = 0.088 percent45,5000


CROSS-EXCHANGE RATE QUOTATIONS

To develop the concept of a cross-rate, let us for the time being ignore the transaction cost. Given the exchange rate between currencies A and B and currencies B and C, you can derive the exchange rate between currencies A and C. In general,

S (A/C) = s (A/B) x S (B/C)

Note that S (A/C) represents the spot rate between currencies A and C, and so on.

To illustrate consider the following rates:

S (INR/USD) = 0.0226

S (USD/CHF) = 1.2381


CROSS-EXCHANGE RATE QUOTATIONS

Given the above rates you can calculate the exchange rate between INR and CHF.

S (INR/CHF) = S (INR/USD) x S (USD/CHF)

= 0.0226 x 1.2381 = 0.0280

Most commonly, cross-rate calculations are done to establish the exchange rates between two currencies that are quoted against the US dollar but are not quoted against each other.


FORWARD RATE QUOTATIONIn the foreign exchange market, forward transactions are also possible in which the rate is fixed today but the settlement is at some specified date in the future. Such rates are called forward rates. Banks normally quote forward rates for maturities in whole calendar months – such as 1, 2, 3, and 6 months – but will tailor a forward deal to suit the customer’s requirements.

For commercial customers banks usually give an outright quotation in the same way as they give for a spot transaction. Thus a quote like

USD/INR 3 – Month Forward: 46.5220/46.6210

means that the bank (dealer) will buy one US dollar for Rs. 46.5220 or sell one US dollar for Rs. 46.6210 for a delivery to be made after 3 months.


SWAP POINTSIn the interbank market, however, forward quotes are given as a pair of “swap points” to be added to or subtracted from the spot quotation. A typical swap quotation is as follows:

USD/INR Spot 46.5015 / 46.5020

1 month swap : 12 / 9

The swap quotation is expressed in such a way that the last digit coincides with the same place as the last digit of the spot price. Thus in the USD/INR quote give above, the number “12/9” mean INR 0.0012 / INR 0.0009.


CONVERSION OF SWAP RATE INTO OUTRIGHT RATE

You can convert a swap rate into an outright rate by adding the premium to, or subtracting the discount from, the spot rate. The swap rates do not carry plus or minus signs but you can easily determine whether the forward rate is at a premium or discount, in relation to the spot rate, using the following rule.

If the forward bid rate in points is less (more) than the offer rate in points, the forward rate is at a premium (discount). So add (subtract) the points to the respective spot rate to get the outright quote.

Let us apply this rule to the USD/INR example given above. In that example the bid rate in points (12) is more than the offer rate in points (9). So the forward rate is at a discount in relation to the spot rate. Hence we subtract the points from the respective spot quotation to get the outright forward quotation. Thus, the outright forward quotation is:

USD/INR One-Month Forward : 46.5003 / 46.5120


FORWARD PREMIUMS AND DISCOUNTS

Consider the following spot and forward quotes

USD/INR Spot : 46.5020 / 46.5120

USD/INR 1-month forward : 46.5420 / 56.5620

The US dollar is costlier in the forward market than in the spot market. Put differently, it is at a forward premium in relation to the Indian rupee.

With two-way quotations, you cannot quantify the premium or discount in a unique way. One way to quantify the annual percentage premium or discount is as follows.

Forward (USD/INR)mid – Spot (USD/INR)mid x 12 x 100Spot (USD/INR)mid


FORWARD PREMIUMS AND DISCOUNTSIn this formula, the mid rate is simply the arithmetic average of the bid and ask rates. Note that multiplication by 12 converts the monthly premium (or discount) to annual premium (or discount) and multiplication by 100 translates it into percentage terms.

Applying this formula to the USD/INR spot and forward quotes given above, we get:

46.5520 – 46.5070= 1.16 percent

46.5070

This means that the annual forward premium on US dollar in relation to Indian rupee is 1.16 percent.


FORWARD PREMIUM OR DISCOUNT

Forward rate – Spot rate 12 x

Spot rate Forward contract length in months

For example if the spot rate of the U.S dollar is Rs.43.26 and the three month forward rate is Rs.43.80, the annualised forward premium works out to :

43.80 - 43.26 12Forward premium = x

43.26 3

= 0.0499 or 4.99 percent

Forward premium or discount =


CURRENCY FUTURES

Instead of using the forward market, you can use the

futures market. Currency futures contracts are

standardised currency forward contracts. Such contracts

are standardised in terms of the size of the contract and

delivery dates and exist only for major currencies. They

trade on organised futures exchanges.


CURRENCY FUTURES

Both forward contracts and futures contracts impose a definite obligation on you to take(or give) delivery of the currency contracted. By contrast a currency option contract gives you the right, without imposing the obligation, to sell (put) or buy (call) the foreign currency at a predetermined price and maturity date. You can buy a tailor made currency option contract from a bank or a standardised currency option contract on an options exchange. Of course, in either case you have to pay a non-refundable premium to enjoy the option.


INTERNATIONAL PARITY RELATIONSHIP

• Interest rate parity

• Purchasing power parity

• Expectations theory and forward exchange rates

• Fisher effect and international Fisher effect


INTEREST RATE PARITY (IRP)When IRP exists, the difference between the forward rate and the spot rate is just enough to offset the difference between the interest rates in the two currencies. The IRP condition implies that the home interest rate must be higher (lower) than the foreign interest rate by an amount equal to the forward discount (premium) on the home currency. Formally, IRP is stated as follows :

F 1 + rh

=So 1 + rf

where F = direct quote forward rate

So = direct quote spot rate

rh = home (or domestic) interest rate

rf = foreign interest rate


EXAMPLE OF IRP

The 90-day interest rate is 1.25 percent in the U.S. and 2.00 percent in U.K and the current spot exchange rate is $1.50/£. What will be the 90-day forward rate?

F (1 + 0.015) =

$1.50 (1 + 0.025)

F = $1.4854

In this case the U.S. dollar appreciates in value relative to the British pound. Explain why this happens.


PURCHASING POWER PARITY

• The law of one price in economics implies that the exchange rate between the currencies of two countries will be equal to the ratio of the price indexes in these countries. In its absolute version this relationship is called purchasing power parity (PPP)

• In reality, of course, the PPP does not hold because of

the costs of moving goods and services and the presence

of various barriers.


RELATIVE PURCHASING POWER PARITYA less restrictive form of PPP is called the relative purchasing power parity. It says that the difference in the rates of inflation between two countries will be offset by a change in the exchange rate. For example, if the expected inflation rate is 6 percent in India and 2 percent in the U.S., then the Indian rupee will depreciate relative to the U.S. dollar at a rate of approximately 4 percent. More precisely, the relative PPP is expressed as follows :

Se1 1 + ih

=So 1 + if

where Se1 = expected spot rate a year from now

So = current spot rateih = expected inflation rate in home countryif = expected inflation rate in foreign country.


EXAMPLE

The current spot rate for U.S. dollar is Rs.45. The expected

inflation rate is 6 percent in India and 2 per cent in the

U.S. What is the expected spot rate of dollar a year hence?

Se1 1 + 0.06

= 45.0 1+ 0.02

Se1 = Rs.46.75


EXPECTATIONS THEORY AND FORWARD EXCHANGE RATES

If foreign exchange markets are efficient, the forward rate equals the expected future spot rate.

F1 = Se1

For example if the market participants expect the one-year future spot rate (Se

1) for the U.S dollar to be Rs.45.00, then the one year forward rate (F1) will also be Rs.45.00. If F1 were lower than Se

1, market participants would buy dollars forward, thereby pushing F1 upward till it equals Se

1. On the other hand, if F1 were higher than Se

1, market participants would sell dollars forward, thereby pushing F1 downward till it equals Se

1.


EXPECTATIONS THEORY AND FORWARD EXCHANGE RATES

The expectations theory has two important implications

for financial managers. First, financial managers should

not spend money to buy exchange rate forecasts since

unbiased forecasts are freely available in the currency

market. Second, forward contracts are a cost-effective way

of hedging foreign currency risk.


FISHER EFFECT

According to the Fisher effect, the nominal interest rate is equal to the real interest rate plus an adjustment for inflation :

(1 + Nominal interest rate) =

(1 + Real interest rate) (1 + Inflation rate)

For example, if the real interest rate is 6 percent and the inflation rate is 5 per cent, the nominal interest rate will be :

(1 + 0.06) (1 + 0.05) - 1 = 0.113 or 11.3 percent


GENERALISED FISHER EFFECTIf risk is held constant the real returns are equalised across countries due to arbitrage operation.

This implies that in equilibrium the nominal interest differential will be equal to the expected inflation differential. In symbols,

1 + rh 1 + ih

= 1 + rf 1 + if

where rh = home interest rate in nominal terms

rf = foreign interest rate in nominal terms

ih = expected inflation rate in home country

if = expected inflation rate in foreign country.


INTERNATIONAL FISHER EFFECT

If we combine purchasing power parity with generalised Fisher effect, the result is the international Fisher effect.

Se1 1 + ih

Purchasing power parity : = So 1 + if

1 + rh 1 + ih

Generalised Fisher effect : = 1 + rf 1 + if

Se1 1 + rh

International Fisher effect : = So 1 + rf

Forward Rate as an unbiased Relative purchasing estimator of the future power parity spot rate

International fisher effect Interest rate parity Fisher effect

Forecasted future spot exchange rate - 5% rupee weakens; $

appreciates

Forward premium or discount on foreign currency (observed)

- 5%

Difference in expected inflation rates

(forecasted) + 5%

Difference in nominal interest rates

(observed) + 5%


AN INTEGRATED PICTURE OF INTERNATIONAL PARITY RELATIONSHIP


INTERNATIONAL CAPITAL BUDGTING

There are two ways of analysing a foreign investment proposal:

Home Currency Approach Foreign Currency Approach

• Convert all the dollar cash flows • Calculate the NPV in dollars

into rupees (use forecasted (use the dollar discount rate)

exchange rates)

• Calculate the NPV in rupees • Convert the dollar NPV into

(using the rupee discount rate) rupees(use the spot exchange rate)


FINANCING FOREIGN OPERATIONS

Long-term financing

• Parent company’s stake in equity

• Optimal capital structure

• Sources of long-term funds

Short-term and intermediate financing


RAISING FOREIGN CURRENCY FINANCE

• Foreign currency term loans from financial institutions

• Export credit schemes

• External currency borrowings

• Euroissues

• Issues in foreign domestic markets


FOREIGN CURRENCY TERM LOANS FROM FINANCIAL INSTITUTIONS

Financial institutions provide foreign currency term loans for meeting the foreign currency expenditures towards import of plant, machinery, and equipment and also towards payment of foreign technical knowhow fees. The periodical liability for interest and principal remains in the currency/currencies of the loans and is translated into rupees at the then prevailing rate of exchange for making payments to the financial institution.


EXPORT CREDIT SCHEMES

Export credit agencies have been established by the

governments of major industrialised countries for

financing exports of capital goods and related services.

Two kinds of export credit are provided : buyer’s credit

and supplier’s credit.


EXPORT CREDIT SCHEMES

Buyer’s Credit Under this arrangement, credit is provided

directly to the Indian buyer for purchase of capital goods

and/or technical services form the overseas exporter.

Supplier’s Credit This is a credit provided to the overseas

exporters so that they can make available medium-term

finance to Indian importers.


EXTERNAL COMMERCIAL BORROWING

Subject to certain terms and conditions, the Government

of India permits Indian firms to resort to external

commercial borrowings for the import of plant and

machinery. Corporates are allowed to raise upto $100

million from the global markets through the automatic

route. Companies wanting to raise more than $ 100

million have to get an approval of the MOF.


FEATURES OF EUROCURRENCY LOANS

A eurocurrency is simply a deposit of currency in a bank outside the country of the currency. For example, a eurodollar is a dollar deposit in a bank outside the U.S.

The main features of eurocurrency loans, which represent the principal form of external commercial borrowings, are:

• Syndication• Floating rate• Interest period• Currency option• Repayment and prepayment


FEATURES OF EUROCURRENCY LOANS

• Eurocurrency loans are often syndicated loans, wherein a group of lenders, particularly banks, jointly lend.

• The interest on eurocurrency loans is a floating rate

• The interest period may be 3,6,9 or 12 months in duration

• The borrower often enjoys the multi-currency option

• The loans are repayable in instalments or in the form of a bullet payment, as agreed to by the parties.

EUROISSUES

Euroissues are issues of bonds and equities in the euro

market. The two principal mechanisms used by

Indian Companies are Depository Receipts mechanism

and the Euroconvertible Issues. The former represents

indirect equity investment while the latter is debt with an

option to convert it into equity.



GLOBAL DEPOSITORY RECEIPTS (GDRs)

In the depository receipts mechanism the shares issued by a firm are held by a depository, usually a large international bank, who receives dividends, reports, etc., and issues claims against these shares. These claims are called depository receipts with each receipt being a claim on a specified number of shares. The underlying shares are called depository shares. The depository receipts are denominated in a convertible currency- usually U.S. dollars. The depository receipts may be listed and traded on major stock exchanges or may trade in the currency which is converted into dollars by the depository and distributed to the holders of depository receipts. This way the issuing firm avoids listing fees and onerous disclosure and reporting requirements which would be obligatory if it were to be directly listed on the stock exchange. Global Depository Receipts(GDRs), which can be used to tap multiple markets with a single instrument, have been the most popular instrument used by Indian firms.


ISSUES IN FOREIGN DOMESTIC MARKETS

Indian firms can also issue bonds and equities in the domestic capital market of a foreign country.

• Reliance Industries Limited, for example, issued bonds

in the US domestic capital market (Yankee bonds).

• Infosys, for example, tapped the US equity market by

issuing American Depository Shares (ADSs).


FINANCING EXPORTS

Pre-shipment Finance

• Clean packing credit

• Packing credit against hypothecation of goods

• Packing credit against pledge of goods.

Post-shipment Finance

• Purchase/discounting of documentary export bills

• Advance against export bills sent for collection

• Advance against duty drawbacks, cash subsidy, etc.


FORFAITING

Basically forfaiting refers to non-recourse discounting of medium term (1 year to 5 years) export receivables. In a forfaiting transaction, the exporter surrenders, without recourse to him, his rights to claim for payment of goods delivered to an importer, in return for immediate cash payment from the forfaiter. As a result, the exporter is able to convert a credit sale into a cash sale with no recourse to him. Under this arrangement the export receivables are usually guaranteed by the importer’s bank (referred to as the ‘avalling’ bank).


DOCUMENTS IN INTERNATIONAL TRADE

• Trade draft

• Bill of lading

• Letter of credit


TRADE DRAFT

The international trade draft, also referred to as a bill of

exchange, is a written order by the exporter (the drawer)

asking the importer (the drawee) to pay a specified amount

of money at a certain time. The draft may be a sight draft

(which is payable on presentation) or a usance draft

(which is payable a certain number of days after

presentation).


BILL OF LADING

A bill of lading is a document of shipping employed when

the exporter transports goods to the importer. It serves

several functions: (i) It is a document of title to goods. (ii)

It is a receipt given by the transportation company to

deliver the goods to a specified party at a certain

destination.


LETTER OF CREDIT

A letter of credit is issued by a bank on behalf of the importer. As per this document, the bank agrees to honour the draft drawn on the importer provided certain conditions are satisfied. Through the letter of credit arrangement, the credit of the importer is substituted by the credit of bank. Hence it virtually eliminates the risk of the exporter when he sells to an unknown importer in a foreign country. This arrangement is further reinforced if the letter of credit is confirmed by a bank in the exporter’s country.


FOREIGN EXCHANGE EXPOSURE

Foreign exchange exposure can be classified into three broad categories:

• Transaction exposure

• Translation exposure

• Operating exposure

Of these, the first and the third together are sometimes called “cash flow exposures” while the second is referred to as “accounting exposure” or “balance sheet exposure”.


TRANSACTION EXPOSURE

When a firm has a payable or receivable denominated in a foreign currency, a change in the exchange rate will alter the amount of local currency received or paid. Such a risk or exposure is referred to as transaction exposure. For example, if an Indian exporter has a receivable of $100,000 due three months hence and if in the meanwhile the dollar depreciates relative to the rupee a cash loss occurs. Conversely, if the dollar appreciates relative to the rupee, a cash gain occurs. In the case of a payable, the outcome is of an opposite kind: a depreciation of the dollar relative to the rupee results in a gain, whereas an appreciation of the dollar relative to the rupee results in a loss.


TRANSACTION EXPOSURE

In the books of accounts, the foreign currency amount is expressed in the reporting currency by applying the exchange rate prevailing on the transaction date. If an item is settled during the current account period, it is revalued at the rate prevailing on the settlement day. This may result in loss or gain.

At each balance sheet date, foreign currency monetary items are reported using the exchange rate on the balance sheet date, non-monetary items carried at historical cost are reported using the exchange rate on the transaction date, and non-monetary items carried at fair value are reported using the exchange rate that existed when the fair values were determined. Exchange differences arising from either settlement or restatement of monetary items on the balance sheet date should be recognised as income or expense in the period in which they arise.

When a forward exchange contract is entered into as a hedge, the premium or discount arising at the inception of the contract should be amortised as expense or income over the life of the contract.


TRANSLATION EXPOSURE

Translation exposure, also called accounting exposure, stems from the need to convert the financial statements of foreign operations from foreign currencies to domestic currency for purposes of reporting and consolidation. If there is a change in exchange rates since the previous reporting period, the translation or restatement of foreign-currency denominated assets, liabilities, revenues, and expenses will result in foreign exchange gains or losses. Translation gains/losses do not involve cash flows as they are purely paper gains/losses, except when they have some tax implications.



Indian accounting standards require consolidation of the accounts of foreign subsidiaries or branches with those of the parent firm in India. The method used for translating foreign currency statements depends on the nature of relationship between the parent and the foreign operations. From this point of view, foreign operations are classified into two categories.

• Integral Foreign Operations: An integral operation carries out business as it is an extension of the operations of the parent. For example, the foreign operation may just sell goods imported from the parent and remit the proceeds of the same to its parent.

• Independent Foreign Operations: An independent or non-integral foreign operation is run independently, as if it is a separate enterprise. It is also referred to as a foreign entity.



The financial statements of an integral foreign operation are translated using the rules that we discussed under transaction exposure.

The assets and liabilities, both monetary and nonmonetary, of the non-integral foreign operation are translated at the rates prevailing on the balance sheet date. The profit and loss items of such operations are translated at the exchange rates prevailing on the date of the transactions. All the resulting exchange differences are accumulated in a foreign currency translation reserve until the disposal of the foreign operations.



The Income Tax Act requires that foreign currency liabilities are “marked to market” at the exchange rate prevailing on the date of casting the balance sheet. If the foreign currency liability increases (decreases) on account of such revaluation, the value of the fixed asset which is financed by the foreign currency borrowing is correspondingly increased (decreased). Depreciation is admissible on such revalued assets.


TRANSLATION METHODS

Internationally, four methods of foreign currency translation

are used in practice.

• Current / Non current Method

• Monetary / Non monetary Method

• Temporal Method

• Current Rate Method


FACTORS INFLUENCING TRANSLATION GAINS/LOSSES

Foreign currency depreciates Translation loss

Exposed Exposed vis-à-vis rupee occurs >

Assets Liabilities Foreign currency appreciates Translation gain

vis-à-vis rupee occurs

Foreign currency depreciates Translation gain

Exposed Exposed vis-à-vis rupee occurs <

Assets Liabilities Foreign currency appreciates Translation loss

vis-à-vis rupee occurs

OPERATING EXPOSURE

Operating exposure, like transaction exposure, involves an

actual or potential gain or loss. While the former is specific

to a transaction, the latter, much broader in nature, relates

to an entire investment. The essence of operating exposure

is that exchange rate changes significantly alter the cost of

a firm's inputs and the prices of its output and thereby

influence its competitive position substantially.



OPERATING EXPOSURE : AN EXAMPLE

An example may be given to explain this concept. Volkswagen had a highly successful export market for its 'Beetle' model in the U.S. before 1970. With the breakdown of the Brettonwood system of fixed exchange rates, the Deutschemark appreciated significantly against the dollar. This created problems for Volkswagen as its expenses were mainly in Deutschemark but its revenues in dollars. However, in a highly price-sensitive U.S. market, such an action caused a sharp decrease in sales volume - from 600,000 vehicles in 1968 to 200,000 in 1976. (Incidentally, Volkswagen's 1973 losses were the highest, as of that year, suffered by any company anywhere in the world).


MANAGEMENT OF TRANSACTION EXPOSURE

Transaction exposure arises on account of imports, exports, and foreign currency borrowings. To cope with such exposure, the following may be used:

• Forward market hedge

• Option forwards

• Money market hedge

• Financial swaps

• Currency options

• Leading and lagging

• Netting and offsetting


FORWARD MARKET HEDGE

In a forward market hedge, a net liability (asset) position is covered by an asset (liability) in the forward market. To illustrate the mechanism of the forward market hedge, consider the case of an Indian firm which has a liability of $100,000 payable in 60 days to an American supplier on account of credit purchases. The firm may employ the following steps to cover its liability position:

Step 1 Enter into a forward contract to purchase $100,000 in 60 days from a foreign exchange dealer. The 60-day forward contract rate is, say, Rs.46.90 per dollar.

Step 2 On the sixtieth day pay the dealer Rs.4,690,000 ($100,000 x Rs.46.90).


ROLLOVER CONTRACTIn the foreign exchange market in India, a forward contract for a maturity period exceeding six months is not ordinarily possible because in the inter-bank market, quotations beyond six months are not available. So, an Indian firm which has a foreign currency borrowing payable over an extended period of time, will have to go for a 'rollover' contract, if it wants a forward cover. Essentially this means that the borrower buys forward the entire amount to be covered for a date which synchronises with the next instalment date. Come that date, the borrower uses a portion of the forward contract to meet the instalment amount and rolls over the balance of the contract to the next instalment date - this means he sells the balance in the spot market and buys it in the forward market. This is continued till the last instalment is paid.

Under the rollover contract, the basic rate of exchange is fixed. However, each rollover may result in some cost (or gain) depending on (the) a premium (or discount) at the time of each rollover.


OPTION FORWARDS

A variant of the forward contract is an option forward in which the exchange rate between the currencies is fixed when the contract is entered into but the delivery date is not fixed. In this contract, one of the parties (typically the corporate customer) enjoys the option to give or take delivery on any day between two fixed dates. For example, Alpha Corporation enters into an option forward with National Bank under which it agrees to sell forward $1million at Rs. 46.50 per dollar, to be delivered on any day between the 91st day and the 120th day from the time the contract is entered into. In this case, the period 91-120 days is the option period during which Alpha Corporation has to give delivery. Option forwards make sense when the exact timing of a foreign currency inflow or outflow is not known, though the amount is known.


MONEY MARKET HEDGEIn a money market hedge, the exposed position in a foreign currency is covered through borrowing or lending in the money market. To illustrate how the money market hedge may be employed, consider the case of a British firm which has a liability of $100,000 on account of purchases from a U.S. supplier, which is payable after 30 days. Today’s spot rate is $1.692 per £. The 30-day money market rates in the U.K. and the U.S. are, 1 percent for lending and 1.5 percent for borrowing. In order to hedge, the British firm can take the following steps:

Step 1 Determine the present value of the foreign currency liability ($100,000) by using the money market rate applicable to the foreign country. This works out to : $100,000/1.01 = $99,010.

Step 2 Obtain $99,010 on today's spot market in exchange for 58,516 pounds. Today's spot rate is $1.692 per pound.

Step 3 Invest $99,010 in the U.S. money market. (This investment will compound to exactly $100,000 the known future dollar liability after 30 days.)


FINANCIAL SWAPS

A financial swap basically involves an exchange of one set

of financial obligations with another. Widely used

internationally, financial swaps have in recent years

attracted the attention of firms in India. The two most

important financial swaps are the interest rate swap and

the currency swap.


CURRENCY OPTIONS

After a decade of hedging currency risk mainly through

forward contracts, the RBI allowed currency options from

July 2003. The salient features of the present guidelines are as

follows: (a) Corporates can only buy currency options, but not

write them. (b) Only banks can write currency options, that too

only plain vanilla European options. (c) Corporates can buy

currency options only for hedging underlying exposures. (d)

Corporates can buy cross-currency options. Despite a sluggish

start, the currency options market has now picked up.


LEADING AND LAGGING

Sometimes, exposures can be managed by altering the

timing of foreign currency flows through leading and

lagging. Leading involves advancing and lagging

involves delaying. The general rule is to lead

payables and lag receivables in "strong" currencies.

By the same token, lead receivables and lag payables

in "weak currencies."


NETTING AND OFFSETTING

If a firm has receivables and payables in different currencies,

it can net out its exposure in each currency. Suppose an

Indian firm has exports of $100,000 to the U S and imports of

$120,000 from the U S. It can use its receivables of $100,000

and hedge only the net US dollars payable. Even if the

timings of the flows are not matched, it can lead or lag one or

both of them to achieve a match.


MANAGEMENT OF OPERATING EXPOSURE

Transaction exposure is short-term in nature and well-identified.

Operating exposure, on the other hand, is long-term in nature and can

scarcely be identified with precision. So, the instruments of financial

hedging (forwards, options, and so on) which are helpful in hedging

short-term well-identified transaction exposure are not of much help

in hedging operating exposure.

Managing operating exposure calls for designing the firm’s

marketing, production, and financing strategy to protect the firm’s

earning power in the wake of exchange rate fluctuations.


LEVERS FOR MANAGING OPERATING

EXPOSURE

The important levers for managing operating exposure are:

• Product strategy

• Pricing strategy

• Plant location

• Sourcing

• Product cycle

• Liability structure


EXPOSURE MANAGEMENT IN PRACTICE

Several surveys have been done to study corporate foreign exchange exposure management in practice in various countries and industries. Although detailed findings vary, there are broad commonalities in these surveys. The principal findings are summarised below:

1. Very few companies do a quantitative assessment of how unanticipated changes in exchange rate impact on the value of the firm.

2. Many firms seem to believe that their exposure to exchange rate risk is not very serious.3. Firms that engage in systematically assessing and managing their foreign exchange exposure seem to focus primarily on transaction exposure extending upto a year. Here too, firms seem to prefer to deal with exposures individually and not collectively.4. For managing operating exposure, firms use mechanisms such as locating and sourcing of inputs in different currency areas, upgrading products to cater to

less price-elastic market segments, resorting to borrowing in local currencies through foreign subsidiaries, and indexing wages to the exchange rate.


SOME SUGGESTIONS

While managing its foreign exchange exposure, a firm must bear in mind the following :

• Be selective

• Seek more than one quotation

• Choose a proper mix of currencies and interest

rates

• Establish rapport with the banker

• Act swiftly


SUMMING UP• The basic principles of financial management are the same whether a firm is a domestic firm or an international firm. However, international firms must consider several financial factors that do not directly have a bearing on purely domestic firms. These include foreign exchange rates, variations in interest rates across countries, different tax regimes, complex accounting methods, barriers to financial flows, and intervention of foreign governments.

• The field of international finance has witnessed explosive growth and dynamic changes in recent decades mainly because of a change in international monetary system from a fairly predictable system of exchange rates to a flexible and volatile system of exchange rates and greater integration of the global financial system.

• The exchange rate regime of the Indian rupee has evolved over time moving in the direction of less rigid exchange controls and current account convertibility.


• The foreign exchange market is the market where one country’s currency is traded for another’s. It is the largest financial market in the world.

• The important features of the foreign exchange market are: (a) It is an ‘over the counter’ market. (b) It is virtually a 24-hour market. (c) Speculative transactions account for more than 95 percent of the turnover.

• An exchange rate represents the price of one currency expressed in terms of another. A spot rate refers to the rate applicable to transactions in which settlement (i.e. delivery) is made in two business days after the date of transaction. A forward rate applies to a transaction in which the rate is fixed today but the settlement is at some specified date in the future.

• To develop a consistent international financial policy, you need to understand the relationship between interest rates, inflation rates, and exchange rates. In this context, international parity relationships provide useful guidance.


• The interest rate parity says that the difference between the forward rate and the spot rate is just enough to offset the difference between the interest rates in the two currencies. The relative purchasing power parity says that the difference in the rates of inflation between two countries will be offset by a change in the exchange rate. The expectations theory says that if foreign exchange markets are efficient, the forward rate equals the expected future spot rate. The international fisher effect says that the nominal interest differential will be equal to the expected inflation differential.

• There are two basic ways of evaluating an international capital budgeting proposal : the home currency approach and the foreign currency approach. Correctly applied both the approaches yield the same result.

• The key issues in financing foreign operations are: parent company’s stake in the affiliate’s equity, optimal capital structure, and dependence on the eurocurrency and eurobond markets.


• The major sources available to an Indian firm for raising foreign currency finance are: foreign currency term loans from financial institutions, export credit schemes, external commercial borrowings, euroissues, and issues in foreign domestic markets.

• The main features of eurocurrency loans, which represent the principal form of external commercial borrowings, are: syndication, floating rate, and currency options.

• Euroissues are issues which are made in the euromarket (a market which falls outside the regulatory purview of national regulatory authorities). The two principal mechanisms used by Indian companies are the Global Depository Receipts (GDRs) and the Euroconvertible Issues. The former represents indirect equity investment while the latter is debt with an option to convert it into equity.

• Apart from euroissues which are made in the euromarket, Indian firms can also issue bonds and equities in the domestic capital market of a foreign country.


• Commercial banks, the major source of export finance in India, provide finance before shipment of goods (pre-shipment finance) as well as after shipment of goods (post-shipment finance). The pre- shipment finance typically is in the form of packing credit of which there are three broad types: (i) clean packing credit, (ii) packing credit against hypothecation of goods, and (iii) packing credit against pledge of goods. The post-shipment finance is provided in the following ways: (i) purchase/discounting of documentary export bills, (ii) advance against export bills sent for collection, and (iii) advance against duty drawback, cash subsidy, etc.

• The Export Import Bank of India provides export and import finance through a variety of schemes.

• The Export Credit & Guarantee Corporation(ECGC) provides insurance to Indian exporters of goods and services, against the risk of non-payment for exports. ECGC offers a variety of policies and schemes.


• In comparison with domestic trade, international trade presents certain special problems. In order to cope with these problems, international trade relies considerably on three major documents/instruments: trade draft, bill of lading, and letter of credit.

• Foreign exchange exposure may be classified into three broad categories: transaction exposure, translation exposure, and operating exposure.

• Foreign exchange risk is like a double-edged sword – while it can entail losses it can also produce gains. On balance it appears that while it may be desirable to eliminate a portion of the exchange rate risk, it may not be worthwhile to eliminate the whole of it. Exchange rate risk can be eliminated by proper hedging.

• To cope with foreign exchange exposures the following devices are available: forward market hedge, rollover contracts, financial swaps, and money market hedge.

• In a forward market hedge, the net liability (asset) position is covered by an asset (liability) in the forward market.


• In a rollover contract the borrower buys forward the entire amount o be covered for a date which synchronises with the next instalment date. Come that date, the borrower uses a portion of the forward contract to meet the next instalment amount and rolls over the balance of the contract to the next instalment date.

• A financial swap basically involves an exchange of one set of financial obligations for another.

• In a money market hedge, the exposed position in a foreign currency is covered through borrowing or lending in the money market.

• While managing its foreign exchange exposure, a firm must bear in mind the following suggestions : (a) Be selective, (ii) Seek more than one quotation, (iii) Choose a proper mix of currencies and interest rates, (iv) Establish rapport with the banker, and (v) Act swiftly.

chapter37 internationalfinancialmanagement

Economy & Finance