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 Contents
1.0-Introduction ....................................................................................................... 3
2.0-Currency Exposure ........................................................................................... 3
2.1-Transaction Exposure ...................................................................................... 4
2.1-Translation Exposure ....................................................................................... 4
2.1-Economic Exposure ......................................................................................... 5
3.0-Potential Danger of Pegging the Crown ......................................................... 5
4.0- Political Risk ..................................................................................................... 6
5.0- Conclusion and Reccomendation ................................................................... 6
6.0 References and Bibliography ........................................................................... 8
Page 2

3. 1. Introduction
World economy today, is not what it was decades ago. The economy is getting more globally
integrated every day; thus creating opportunities for businesses to expand internationally and improve
their sales and profits through overseas transactions. However, when businesses which have little or no
international experience start to expand internationally, they encounter many adversities including a
number which could damage the organisation financially. Therefore, organisations which are
expanding by investing overseas should be managed well financially. It is the job of treasury managers
to identify, assess and manage the potential risks the organisation is likely to face when entering a new
financial market. According to Adrian Buckley (2004a), “the objectives of the treasury function
embrace the raising of funds as cheaply as possible, the investment of liquid funds to earn an adequate
return, the control of currency and interest rate exposures and ensuring that the firm can meet its
liabilities as they fall due.”
This reports objective is to outline the financial issues that may rise during or after the
aforementioned investment decision is taken. Accordingly, the aim of this report is to measure the
level of risk the organisation may incur and suggest feasible techniques to manage the exposures
appraised. The main financial risks that are going to be examined in the case of entering a developing
Eastern European country, Ruritania, are foreign exchange exposures (transaction, translation and
economic) and country risks.
2. Currency Exposure
Ghoshal (1987), states that “managing risk is one of the primary objectives of firms operating
internationally.” When considered that %10.9 of the total market capitalisation of the company
accounting to £55 million is planned to be used as an investment to take advantage of the cheap labour
opportunity in Ruritania, the management of cross-border payments and currency conversions is a
necessity. Hedging against currency exposure is assumed to reduce the volatility of a firm’s profits
and/or cash generation (Buckley, 2004b).
Ruritarian government switched from a managed floating exchange rate regime to a free
floating regime twelve years ago, around the same time another developing country Turkey, and
shared almost exactly the same fate currency-wise (Akıncı et al, 2006). The over-valued Crown
attained its real value after experiencing a quick fall after changing the system. However, despite the
fact that Crown has been stable against major international currencies over the past few years, the
exchange 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 to
requirement. It was considerably safer for investors when the currency was centrally managed as firms
was not exposed to fluctuations in the currency. Due to the floating currency regime practised
nowadays, companies are exposed to fluctuations. Whether the fluctuations are minor or major, they
pose a threat to the financial assets of the company. There is a high possibility that even a small
fluctuation in the currency rate might mean a significant loss, especially if the amount of investment is
as large as £55 million. Due to this reason, transaction, translation and economic exposures cannot be
overlooked.
Page 3

4. 2.1 Transaction Exposure
If setting up a manufacturing facility means getting involved with foreign suppliers, thereby getting
involved with foreign currency, it is likely that the company will be exposed to fluctuations in the
foreign currency. This type of foreign exchange exposure, which impacts the cash flow of the
company, is referred to as “transaction exposure” (EDC, 2010).
There are two techniques (internal and external) in which the transaction risk of the company
can be minimized. The first technique is a way without the usage of hedging strategies. One of the two
ways transaction exposure can be minimized without hedging is, transferring the exposure to another
company (Kelley, 2001). The sales price of the manufactured good can be denominated as the
importing countries currencies. Another option would be to demand immediate payment from the
importing company. Both ways, the company would be protected from the exposure level to a small
extent. However, considering the quantum of investment the company is planning the make, it would
be sensible to say that the company is going to be involved in high amount of foreign currency
transactions frequently. Therefore, reducing the transaction exposure by diversifying the transactions
internationally 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 is
not rudimentary, hedging seems to be the only way for companies of this scale to reduce the exposure
of currency. According to the survey conducted to 179 large British, American and Asia-Pacific firms
by Marshall (2000), the most popular method of managing transaction exposure was forward
contracts. 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 rate
contract; however, considering the creditability of the company, hedging the risk with a forward
contract might be a good method of reducing the risk. Swaps may also be worthwhile to look at if a
bank agrees to accept GBP deposits in exchange for the Crown or if companies whose needs offset
one another can be found.
2.2 Translation Exposure
As Houston (1990) puts it, “translation exposure refers to the possibility that a gain or loss may arise
as a result of a change in the exchange rate used to translate the foreign currency balance sheet of a
subsidiary.” Unlike the transaction exposure, translation exposure does not impact the cash flow of the
company. 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, still
remains contentious. While some believe that translation exposure is an accounting based measure due
to the reason that it is not directly related with cash flow (Shapiro, 1993), some stress that more
emphasis should be placed on it referring to the importance of responding to the demands of the
environment (Ensor and Muller, 1981). There are several methods to measure the translation exposure
of 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 all
foreign 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 and
the firm’s ability to raise capital. Thereby managing the translation is thought out to be important for
the 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 the
company is not operating multinationally. Thus, hedging the exposure will be the most suitable step to
take. For the reason that it can be available in most major currencies it allows the company to
speculate on the movement of the Crown, forward contracts would be most appropriate to use. For
example, if the company has 10 million Crowns worth of translation exposure (Crown assets exceeds
Crown liabilities by 10 million Crowns), the company based in UK will be able to eliminate the
exposure by selling 10 million Crowns to buy equivalent value of GBP.
2.3 Economic Exposure
Buckley (2004d) refers to economic exposure as the possibility that the value of future operating cash
flows of a business, expressed in the parent currency, may change because of a change in foreign
exchange rates. Thus, “Economic exposure refers to the firm’s market value, whereas accounting
exposure concerns book values (Capel, 1997).” This indicates that the level economic exposure is
more capable of judging the long-term chance of survival for the company. Economic exposure
comprises from the decisions on market selection, plant location, product diversification and many
more (Aggarwal and Soenen, 1989). The management of economic exposure should be an important
part of a firm’s strategic management; however, the role of financial executives in the management of
economic exposure is subordinate (Capel, 1997).
Nevertheless, role of financial executives are important as long-term strategic management
plans requires assurance of future cash flows (Moffet and Karlsen, 1994). As future transactions are
uncertain and the movement of the Crown is unpredictable in the long-term, financial hedging
instruments prove to be impractical. In fact it is a possibility that they may cause even more cash flow
volatility then there is. It is a better possibility that diversifying the cash flow of the firm across
currencies will reduce the economic exposure of the firm in the long-term.
3. Potential Danger of Pegging the Crown
The potential pegging decision that government may take in Ruritania may expose the company to a
great deal of risk. According to Frederick Mishkin (1998), a former member of the Board of
Governors of the FED (Federal Reserve System) in USA, states that exchange rate pegging in
emerging-market countries “entails the loss of an independent monetary policy, exposes the country to
the transmission of shocks from the anchor country, increases the likelihood of speculative attacks and
potentially weakens the accountability of policymakers to pursue anti-inflationary policies for
financial crises more likely.” Mishkin stresses out the most damaging outcome of an exchange rate
pegging as financial fragility and a potential financial crisis. A Financial Crisis may get ahead of the
firm’s ability to manage the above exposures. Therefore, it can be said that the speculation may pose a
threat to the firm in the long-term. However, if Ruritania pegs the Crown to one of the major
currencies and the policy turns out to be successful, this may bring about stability. Moreover, if
Ruritania adopts the Euro as a full member of the Eurozone, right after the inclusion in ERM II, not
only will the financial crisis risk be avoided but it will lead to better management of the currency
exposures the company will be facing.
Page 5

6. 4. Political Risk
Simon (1982) defines political risk as governmental actions and policies which negatively affect
foreign business operations and investments. Before taking an investment decision the political risk of
the company has to be measured. There are various political risk forecasting services and techniques
available which analyses both, the stability of the current political environment and the possible future
environment. It has been stated that according to a national poll in Ruritania, the current government
enjoys a %7 lead over their over the other major party. Even though a change of power does not seem
likely at this point, it still possesses a risk. However it is a known fact that the political risk has
different impacts on different types of firms. If the company’s operations benefit the host country or if
the operations are way too costly to replace with local firms, it is possible that the government may
take more cautious actions towards the company.
The Investment decision should be taken after thoroughly analysing the risk in Ruritania and
assessing the possible implications of the risk to the company. If the investment decision is decided to
be taken, the investment should be structured to evade the political risk as much as possible. One
option in Ruritania can be to insure the assets against political risk. Hereby, the investment would be
insured against any kind of unforeseen change in action or policy and the company would be able to
function without wasting any more resources to avoid risk. The fee will vary according to the size of
the investment and to the country; however, it is expected to be tolerable since the two political parties
roughly share the same view. Alternatively, the company may try to agree with the government in
Ruritania before making the investment. This agreement which defines the rights and responsibilities
of both the firm and the host government is called “concession agreement” (Buckley, 2004e). This
might help the company avoid the risk a bit; at least until the elections. It is likely that if the
government 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 the
risk of future changes in corporate and personal income taxation. Although these risks can be avoided
at 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 the
new government is expected to affect the value of the firm. On the other hand, if the potential new
government actually provides additional funds for social expenditure, labour skill will be improved
and this will benefit the company in the long term. Similarly, the improvements in the transport system
would boost the productivity and the competitiveness of the company (Riley, 2006).
5. Conclusion and Recommendation
Various risks have been identified concerning the investment decision the company is considering
taking. One of the major risks that have been identified is the currency exposure. This consists of
transaction, translation and economic exposures. In addition, the speculation that the government is
going to peg the currency to a major currency generates risk. Although these exposures are common
with firms which are entering the fray of global business in general, the fact that Ruritania is a
developing country and not a developed country makes the firm volatile to these kinds of exposures
even more. The company is advised to hedge against the foreign currency to reduce transaction and
translation exposures. Frequently, the company should diversify its cash flow across currencies to
minimize 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 the
reason that the possible rate of “return on investment” is thought out to compensate the risk. In
addition, 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 important
amount of the risk it is thought to be faced; however, it would be better if the company waits until the
elections are held to make sure of eliminating the taxation risk before making a conclusive investment
decision. Furthermore it would be to the point to add that if Ruritania joins EU in 2014, low labour
cost will not be an advantage anymore due to the reason that the new currency of Ruritania (Euro) will
be significantly stronger than their current currency. To conclude, if the current government gets
elected as it is predicted, avoiding Ruritania might mean ignoring high return on investment.
Page 7

8. 6. References and Bibliography
Aggarwal, R., Soenen L. (1989), "Managing Peristent Real Changes in Currency Values: The Role of
Multinational Operating Strategies," Columbia Journal of World Business, pp. 60-67.
Akıncı, Ö., Çulha, O., Özlale, Ü., Şahinbeyoğlu, G. (2006). The effectiveness of foreign exchange
interventions under a floating exchange rate regime for the Turkish economy: a post-crisis period
analysis. Applied Economics, 38: pp.1371-1388.
Buckley, A. (2004a), Treasury management performance, In: Multinational Finance, Essex: Pearson
Education 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: Pearson
Education Limited, pp 137.
Buckley, A. (2004d), Economic Exposure, In: Multinational Finance, Essex: Pearson Education
Limited, pp 171.
Buckley, A. (2004e), Managing political risk, In: Multinational Finance, Essex: Pearson Education
Limited, pp 493.
Capel, J. (1997), A Real Options Approach to Economic Exposure Management, Journal of
International Financial Management and Accounting, 8:2, pp.87-113.
EDC [online] (2010), Available from:
http://www.edc.ca/english/docs/fx_managing_foreign_exchange_risk_e.pdf [Accessed 16 April 2011].
Ensor, R., Muller, P. (1981), The Essentials of Treasury Management, London: Euromoney
Publications Ltd.
Ghoshal, S. (1987), Global Strategy: An organizing framework. Strategic Management Journal, 8:
425-40.
Kelley, M. (2001), Virginia State Bar [online]. Available from:
http://www.vsb.org/docs/valawyermagazine/jj01kelley.pdf [Accessed 16 April 2011].
Marshall, A.P. (2000), Foreign Exchange Risk Management in UK, USA and Asia Pacific
Multinational 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.157-175
Nazarboland, 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: http://tutor2u.net/economics/revision-notes/a2-
macro-fiscal-policy-effects.html [Accessed 18 April 2011].
Page 8

9. Shapiro, A. (2002), Foundations of multinational financial management, 4th. ed. United States of
America: John Wiley and Sons Inc.
Simon, J. D. (1982), Political Risk Assessment: Past Trends and Future Prospects, Columbia Journal
of World Business, 8: 62–71.
WorldAcademyOnline [online]. (2011), Available from:
http://worldacademyonline.com/article/33/471/nature_and_consequences_of_political_risk.html
[Accessed 18 April 2011].
Page 9