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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT1 International Financial Management P G Apte
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT3 It is December 1, 2009. An Indian pharmaceutical company has cleared a shipment of imported chemicals. The invoice is for $500,000 payable on March 3, 2010. The current exchange rate is Rs.46.60 per dollar. The recent history of the exchange rate shows a mixed trend with moderate volatility. During the latter half of 2007 dollar had shown considerable weakness against all currencies including the rupee. During early 2008, the rate was almost flat around Rs.40.00. Dollar was rising against the rupee in early 2009. An adverse movement in exchange rate will affect the firms cash flows. There is also the problem of how to value the imports for the purpose of product costing and pricing decisions. What should the firm do?
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  • 6 A US firm has exported some computer peripherals to a German buyer. For customer relationship reasons the sale has been invoiced in buyers currency viz. Euro. The invoice is for 1,000,000 to be settled 90 days from now. The current exchange rate is $1.4715 per Euro. The recent history of the dollar-euro rate shows a mixed down - up trend with some fluctuations. The firms bankers are fairly bullish about the Euro despite the recessionary conditions in the major European economies viz. Germany and France. However US treasury secretary has expressed concern about the weak dollar. What should the firm do?
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  • 9 Caterpillar is an American firm which manufactures heavy construction equipment. At the start of the 1980s all its manufacturing operations were located in the US while it sold its products around the world priced in local currencies. Its nearest competitor was Komatsu of Japan. Around mid-1981 the US dollar started rising against all currencies and continued rising month after month. Caterpillar found that its revenues measured in dollars were shrinking while costs kept pace with US inflation. Margins shrank. It could not compensate by raising local currency prices in export markets because Komatsu was holding the price line. How could Caterpillar cope with this?
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT12 Gems and jewelry exporters from India face stiff competition from firms in Thailand, Indonesia and Malaysia. After the East Asian currency crisis in the summer of 1997, some of these currencies crashed against the US dollar by as much as 60-80%. While rupee also fell, its fall was much smaller. Indian exporters lost market share as the East Asian exporters reduced prices in the light of falling currencies. From time to time Indian exporters and their federations like FIEO clamor for steeper fall in the rupee to maintain their competitive position. How can firms cope with this?
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT19 A Swiss pharmaceutical firm has a US subsidiary. Financial statements of the subsidiary are denominated in US dollars. The financial year of the Swiss parent firm is September-August. On the balance sheet date it must translate the balance sheet and P-L account of its US subsidiary from dollars to Swiss francs. During the last few months the US dollar has been weakening against the Swiss franc. On translation, the value of assets and liabilities would show a decline; if assets exceed liabilities, there would be a net loss. Can anything be done about it? Should anything be done? How should the gains/losses be accounted for?
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT22 3.1 The Nature of Exposure and Risk fMacroeconomic environmental risks fCore business risks fWhile core business risks are specific to a firm, macroeconomic uncertainties affect all firms in the economy fExtent and nature of impact of even macroeconomic risks crucially depend upon the nature of a firm's business
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT23 3.1 The Nature of Exposure and Risk (contd.) fThe firm is "exposed" to uncertain changes in a number of variables in its environment - Risk Factors fLong run response of the firm to these risks can involve significant changes in the firm's strategic posture fExchange rates and interest rates are two of the key macroeconomic risk factors
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT24 3.1 The Nature of Exposure and Risk (contd.) XExchange rates, interest rates and inflation rates are intimately interrelated XExposure and Risk fExposure is a measure of the sensitivity of the value of a performance measure to changes in the relevant risk factor frisk is a measure of the variability of the value of the performance measure attributable to the risk factor
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT25 3.1 The Nature of Exposure and Risk (contd.) fThe magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor e.g. fExchange rate risk depends on how sensitive is the performance indicator to exchange rate fluctuations and what is the extent of likely fluctuations in the exchange rate.
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT26 Risk Management and Wealth Maximization What should be the attitude of the firm's management regarding firm-specific risks? Risks arising out of fluctuations in exchange rates, interest rates and commodity prices are pervasive; however they affect different firms in different ways and are therefore firm-specific or idiosyncratic. Should the firm spend resources to manage such risks?
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT27 Why Hedge? The value of a firm, according to financial theory, is the net present value of all expected future cash flows. Currency risk is defined roughly as the variance in expected cash flows arising from unexpected exchange rate changes. A firm that hedges these exposures reduces some of the variance in the value of its future expected cash flows.
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT28 Arguments against active hedging: Removing unsystematic risks does not add value. Stockholders can diversify M&M thesis: Shareholders can do it themselves Firm cannot beat efficient markets Risk removal is costly those who take on the risk must be compensated. Will there be value addition after paying these costs? Active risk management must alter character of cash flows in a manner beneficial to shareholders and do it cheaper than what they can do on their own.
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT29 Why Hedge? Reasons not to hedge However, is a reduction in the variability of cash flows sufficient reason for currency risk management? Opponents of hedging state (among other things): Currency risk management reduces the variance of the cash flows of the firm, but also uses valuable resources. Management often conducts hedging activities that benefit management at the expense of the shareholders (agency conflict), i.e., large FX loss are more embarrassing than the large cost of hedging.
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT30 Arguments for Hedging: Investment-Internal Finance linkage Costs of being perceived as being in financial distress Agency theoretic arguments Convex tax schedules Managers have better information and access to various financial markets than shareholders For an MNC with global shareholders with different currency habitats it is not clear that hedging benefits all shareholders
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT31 Why Hedge? Reasons to hedge Proponents of hedging cite: Reduction in risk in future cash flows improves the planning capability of the firm Reduction of risk in future cash flows reduces the likelihood that the firms cash flows will fall below a necessary minimum (the point of financial distress) Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm Management is in better position to take advantage of disequilibrium conditions in the market
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  • P.G.Apte INTERNATIONAL FINANCIAL MANAGEMENT32 Is Exchange Rate Risk Relevant? Purchasi