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  • 1. International Finance THE RURITARIAN PROJECT Prepared By: Mustafa Mert Dikmen – 10252709 Module Leader: Edward Kerr Module Code: 7BSP0354 Word Count: 2439 Page 1
  • 2. Table of Contents1.0-Introduction ....................................................................................................... 32.0-Currency Exposure ........................................................................................... 3 2.1-Transaction Exposure ...................................................................................... 4 2.1-Translation Exposure ....................................................................................... 4 2.1-Economic Exposure ......................................................................................... 53.0-Potential Danger of Pegging the Crown ......................................................... 54.0- Political Risk ..................................................................................................... 65.0- Conclusion and Reccomendation ................................................................... 66.0 References and Bibliography ........................................................................... 8 Page 2
  • 3. 1. IntroductionWorld economy today, is not what it was decades ago. The economy is getting more globallyintegrated every day; thus creating opportunities for businesses to expand internationally and improvetheir sales and profits through overseas transactions. However, when businesses which have little or nointernational experience start to expand internationally, they encounter many adversities including anumber which could damage the organisation financially. Therefore, organisations which areexpanding by investing overseas should be managed well financially. It is the job of treasury managersto identify, assess and manage the potential risks the organisation is likely to face when entering a newfinancial market. According to Adrian Buckley (2004a), “the objectives of the treasury functionembrace the raising of funds as cheaply as possible, the investment of liquid funds to earn an adequatereturn, the control of currency and interest rate exposures and ensuring that the firm can meet itsliabilities as they fall due.” This reports objective is to outline the financial issues that may rise during or after theaforementioned investment decision is taken. Accordingly, the aim of this report is to measure thelevel of risk the organisation may incur and suggest feasible techniques to manage the exposuresappraised. The main financial risks that are going to be examined in the case of entering a developingEastern European country, Ruritania, are foreign exchange exposures (transaction, translation andeconomic) and country risks. 2. Currency ExposureGhoshal (1987), states that “managing risk is one of the primary objectives of firms operatinginternationally.” When considered that %10.9 of the total market capitalisation of the companyaccounting to £55 million is planned to be used as an investment to take advantage of the cheap labouropportunity in Ruritania, the management of cross-border payments and currency conversions is anecessity. Hedging against currency exposure is assumed to reduce the volatility of a firm’s profitsand/or cash generation (Buckley, 2004b). Ruritarian government switched from a managed floating exchange rate regime to a freefloating regime twelve years ago, around the same time another developing country Turkey, andshared almost exactly the same fate currency-wise (Akıncı et al, 2006). The over-valued Crownattained its real value after experiencing a quick fall after changing the system. However, despite thefact that Crown has been stable against major international currencies over the past few years, theexchange rate exposure in Ruritania is more prominent nowadays when compared to 12 years ago;when the Central Bank of Ruritania was controlling and stabilizing the exchange rate according torequirement. It was considerably safer for investors when the currency was centrally managed as firmswas not exposed to fluctuations in the currency. Due to the floating currency regime practisednowadays, companies are exposed to fluctuations. Whether the fluctuations are minor or major, theypose a threat to the financial assets of the company. There is a high possibility that even a smallfluctuation in the currency rate might mean a significant loss, especially if the amount of investment isas large as £55 million. Due to this reason, transaction, translation and economic exposures cannot beoverlooked. Page 3
  • 4. 2.1 Transaction ExposureIf setting up a manufacturing facility means getting involved with foreign suppliers, thereby gettinginvolved with foreign currency, it is likely that the company will be exposed to fluctuations in theforeign currency. This type of foreign exchange exposure, which impacts the cash flow of thecompany, is referred to as “transaction exposure” (EDC, 2010). There are two techniques (internal and external) in which the transaction risk of the companycan be minimized. The first technique is a way without the usage of hedging strategies. One of the twoways transaction exposure can be minimized without hedging is, transferring the exposure to anothercompany (Kelley, 2001). The sales price of the manufactured good can be denominated as theimporting countries currencies. Another option would be to demand immediate payment from theimporting company. Both ways, the company would be protected from the exposure level to a smallextent. However, considering the quantum of investment the company is planning the make, it wouldbe sensible to say that the company is going to be involved in high amount of foreign currencytransactions frequently. Therefore, reducing the transaction exposure by diversifying the transactionsinternationally in the future might aid the company but most likely not in the intended level. The other technique is hedging the currency risk. In fact, assuming that the financial market isnot rudimentary, hedging seems to be the only way for companies of this scale to reduce the exposureof currency. According to the survey conducted to 179 large British, American and Asia-Pacific firmsby Marshall (2000), the most popular method of managing transaction exposure was forwardcontracts. However, swaps were also popular with British firms. If the company was uncreditworthy,banks would have taken the risk considering that the company would not fulfil the forward ratecontract; however, considering the creditability of the company, hedging the risk with a forwardcontract might be a good method of reducing the risk. Swaps may also be worthwhile to look at if abank agrees to accept GBP deposits in exchange for the Crown or if companies whose needs offsetone another can be found.2.2 Translation ExposureAs Houston (1990) puts it, “translation exposure refers to the possibility that a gain or loss may ariseas a result of a change in the exchange rate used to translate the foreign currency balance sheet of asubsidiary.” Unlike the transaction exposure, translation exposure does not impact the cash flow of thecompany. The exposure arises when the stock variables are measured in different points in time.However, Nazarboland (2003), states that the question of whether to hedge or not, this exposure, stillremains contentious. While some believe that translation exposure is an accounting based measure dueto the reason that it is not directly related with cash flow (Shapiro, 1993), some stress that moreemphasis should be placed on it referring to the importance of responding to the demands of theenvironment (Ensor and Muller, 1981). There are several methods to measure the translation exposureof the firm: current/non-current, monetary/non-monetary, all-current and temporal methods. However,out of the four methods, the all-current method will be most appropriate to use as it translates allforeign currency denominated items at the closing rate of exchange. (Buckley, 2004c). The fluctuation in the Crown is predicted to have a significant impact on the stock price andthe firm’s ability to raise capital. Thereby managing the translation is thought out to be important forthe company. Also, considering that all business activities have been in UK since now, the company Page 4
  • 5. cannot benefit from risk diversity. Also exposure netting cannot be an option assuming that thecompany is not operating multinationally. Thus, hedging the exposure will be the most suitable step totake. For the reason that it can be available in most major currencies it allows the company tospeculate on the movement of the Crown, forward contracts would be most appropriate to use. Forexample, if the company has 10 million Crowns worth of translation exposure (Crown assets exceedsCrown liabilities by 10 million Crowns), the company based in UK will be able to eliminate theexposure by selling 10 million Crowns to buy equivalent value of GBP.2.3 Economic ExposureBuckley (2004d) refers to economic exposure as the possibility that the value of future operating cashflows of a business, expressed in the parent currency, may change because of a change in foreignexchange rates. Thus, “Economic exposure refers to the firm’s market value, whereas accountingexposure concerns book values (Capel, 1997).” This indicates that the level economic exposure ismore capable of judging the long-term chance of survival for the company. Economic exposurecomprises from the decisions on market selection, plant location, product diversification and manymore (Aggarwal and Soenen, 1989). The management of economic exposure should be an importantpart of a firm’s strategic management; however, the role of financial executives in the management ofeconomic exposure is subordinate (Capel, 1997). Nevertheless, role of financial executives are important as long-term strategic managementplans requires assurance of future cash flows (Moffet and Karlsen, 1994). As future transactions areuncertain and the movement of the Crown is unpredictable in the long-term, financial hedginginstruments prove to be impractical. In fact it is a possibility that they may cause even more cash flowvolatility then there is. It is a better possibility that diversifying the cash flow of the firm acrosscurrencies will reduce the economic exposure of the firm in the long-term. 3. Potential Danger of Pegging the CrownThe potential pegging decision that government may take in Ruritania may expose the company to agreat deal of risk. According to Frederick Mishkin (1998), a former member of the Board ofGovernors of the FED (Federal Reserve System) in USA, states that exchange rate pegging inemerging-market countries “entails the loss of an independent monetary policy, exposes the country tothe transmission of shocks from the anchor country, increases the likelihood of speculative attacks andpotentially weakens the accountability of policymakers to pursue anti-inflationary policies forfinancial crises more likely.” Mishkin stresses out the most damaging outcome of an exchange ratepegging as financial fragility and a potential financial crisis. A Financial Crisis may get ahead of thefirm’s ability to manage the above exposures. Therefore, it can be said that the speculation may pose athreat to the firm in the long-term. However, if Ruritania pegs the Crown to one of the majorcurrencies and the policy turns out to be successful, this may bring about stability. Moreover, ifRuritania adopts the Euro as a full member of the Eurozone, right after the inclusion in ERM II, notonly will the financial crisis risk be avoided but it will lead to better management of the currencyexposures the company will be facing. Page 5
  • 6. 4. Political RiskSimon (1982) defines political risk as governmental actions and policies which negatively affectforeign business operations and investments. Before taking an investment decision the political risk ofthe company has to be measured. There are various political risk forecasting services and techniquesavailable which analyses both, the stability of the current political environment and the possible futureenvironment. It has been stated that according to a national poll in Ruritania, the current governmentenjoys a %7 lead over their over the other major party. Even though a change of power does not seemlikely at this point, it still possesses a risk. However it is a known fact that the political risk hasdifferent impacts on different types of firms. If the company’s operations benefit the host country or ifthe operations are way too costly to replace with local firms, it is possible that the government maytake more cautious actions towards the company. The Investment decision should be taken after thoroughly analysing the risk in Ruritania andassessing the possible implications of the risk to the company. If the investment decision is decided tobe taken, the investment should be structured to evade the political risk as much as possible. Oneoption in Ruritania can be to insure the assets against political risk. Hereby, the investment would beinsured against any kind of unforeseen change in action or policy and the company would be able tofunction without wasting any more resources to avoid risk. The fee will vary according to the size ofthe investment and to the country; however, it is expected to be tolerable since the two political partiesroughly share the same view. Alternatively, the company may try to agree with the government inRuritania before making the investment. This agreement which defines the rights and responsibilitiesof both the firm and the host government is called “concession agreement” (Buckley, 2004e). Thismight help the company avoid the risk a bit; at least until the elections. It is likely that if thegovernment changes, the new government will rule out the prior agreement. Perhaps the largest political risk that can affect the investment decision at the moment is therisk of future changes in corporate and personal income taxation. Although these risks can be avoidedat a certain degree by altering the rules on capital gains and deductibility of interest(WorldAcademyOnline, 2011); however, a potential change in the tax law that is brought up by thenew government is expected to affect the value of the firm. On the other hand, if the potential newgovernment actually provides additional funds for social expenditure, labour skill will be improvedand this will benefit the company in the long term. Similarly, the improvements in the transport systemwould boost the productivity and the competitiveness of the company (Riley, 2006). 5. Conclusion and RecommendationVarious risks have been identified concerning the investment decision the company is consideringtaking. One of the major risks that have been identified is the currency exposure. This consists oftransaction, translation and economic exposures. In addition, the speculation that the government isgoing to peg the currency to a major currency generates risk. Although these exposures are commonwith firms which are entering the fray of global business in general, the fact that Ruritania is adeveloping country and not a developed country makes the firm volatile to these kinds of exposureseven more. The company is advised to hedge against the foreign currency to reduce transaction andtranslation exposures. Frequently, the company should diversify its cash flow across currencies tominimize the economic exposure. Moreover, it is believed that the potential pegging decision of the Page 6
  • 7. Crown is not to bring about a risk which could affect the investment decision heavily; due to thereason that the possible rate of “return on investment” is thought out to compensate the risk. Inaddition, the level of political risk seems to need more observation but appears to be manageable. Overall, there seems to be a strong possibility that the company can manage an importantamount of the risk it is thought to be faced; however, it would be better if the company waits until theelections are held to make sure of eliminating the taxation risk before making a conclusive investmentdecision. Furthermore it would be to the point to add that if Ruritania joins EU in 2014, low labourcost will not be an advantage anymore due to the reason that the new currency of Ruritania (Euro) willbe significantly stronger than their current currency. To conclude, if the current government getselected as it is predicted, avoiding Ruritania might mean ignoring high return on investment. Page 7
  • 8. 6. References and BibliographyAggarwal, R., Soenen L. (1989), "Managing Peristent Real Changes in Currency Values: The Role ofMultinational Operating Strategies," Columbia Journal of World Business, pp. 60-67.Akıncı, Ö., Çulha, O., Özlale, Ü., Şahinbeyoğlu, G. (2006). The effectiveness of foreign exchangeinterventions under a floating exchange rate regime for the Turkish economy: a post-crisis periodanalysis. Applied Economics, 38: pp.1371-1388.Buckley, A. (2004a), Treasury management performance, In: Multinational Finance, Essex: PearsonEducation Limited, pp 644.Buckley, A. (2004b), What does exposure management aim to achieve? In: Multinational Finance,Essex: Pearson Education Limited, pp 180.Buckley, A. (2004c), The all-current (closing rate) method, In: Multinational Finance, Essex: PearsonEducation Limited, pp 137.Buckley, A. (2004d), Economic Exposure, In: Multinational Finance, Essex: Pearson EducationLimited, pp 171.Buckley, A. (2004e), Managing political risk, In: Multinational Finance, Essex: Pearson EducationLimited, pp 493.Capel, J. (1997), A Real Options Approach to Economic Exposure Management, Journal ofInternational Financial Management and Accounting, 8:2, pp.87-113.EDC [online] (2010), Available from: [Accessed 16 April 2011].Ensor, R., Muller, P. (1981), The Essentials of Treasury Management, London: EuromoneyPublications Ltd.Ghoshal, S. (1987), Global Strategy: An organizing framework. Strategic Management Journal, 8:425-40.Kelley, M. (2001), Virginia State Bar [online]. Available from: [Accessed 16 April 2011].Marshall, A.P. (2000), Foreign Exchange Risk Management in UK, USA and Asia PacificMultinational Companies, Journal of Multinational Financial Management, 10: 185-211.Moffett, M., Karlsen, J. (1994), Journal of International Financial Management and Accounting,Managing Foreign Exchange Rate Economic Exposure, 5:2, pp.157-175Nazarboland, G. (2003), The Attitude of Top UK Multinationals towards Translation Exposure,Journal of Management Research, 3:3, pp.119-126.Riley, G. (2006), Tutor2u [online]. Available from: [Accessed 18 April 2011]. Page 8
  • 9. Shapiro, A. (2002), Foundations of multinational financial management, 4th. ed. United States ofAmerica: John Wiley and Sons Inc.Simon, J. D. (1982), Political Risk Assessment: Past Trends and Future Prospects, Columbia Journalof World Business, 8: 62–71.WorldAcademyOnline [online]. (2011), Available from:[Accessed 18 April 2011]. Page 9