Chapter37 internationalfinancialmanagement

494 views
396 views

Published on

Published in: Economy & Finance, Business
0 Comments
0 Likes
Statistics
Notes
  • Be the first to comment

  • Be the first to like this

No Downloads
Views
Total views
494
On SlideShare
0
From Embeds
0
Number of Embeds
1
Actions
Shares
0
Downloads
12
Comments
0
Likes
0
Embeds 0
No embeds

No notes for slide

Chapter37 internationalfinancialmanagement

  1. 1. Chapter 37 INTERNATIONAL FINANCIAL MANAGEMENT © Centre for Financial Management , Bangalore
  2. 2. 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 © Centre for Financial Management , Bangalore
  3. 3. 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. © Centre for Financial Management , Bangalore
  4. 4. 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. © Centre for Financial Management , Bangalore
  5. 5. 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,©thanksfor Financial Management , Bangalore Centre to massive privatisation initiatives.
  6. 6. MULTINATIONAL CORPORATIONS Companies go global for the following reasons: • Trade barriers • Imperfect labour markets • Intangible assets • Vertical integration • Product life cycle • Diversification • Shareholder diversification © Centre for Financial Management , Bangalore
  7. 7. 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 ($) , the Japanese Yen (¥), the Euro (€), the British pound sterling (£) , and the Swiss franc (SF), Exhibit 37.1 lists some of the currencies along with their symbols © Centre for Financial Management , Bangalore
  8. 8. CURRENCIES AND THEIR SYMBOLS Country Australia Canada Denmark EMU Finland India Iran Japan Kuwait Mexico Norway Saudi Arabia Singapore South Africa Sweden Switzerland United Kingdom United States Currency Dollar Dollar Krone Euro Markka Rupee Rial Yen Dinar Peso Krone Riyal Dollar Rand Krona Franc Pound Dollar Symbol A$ Can $ Dkr € FM Rs Rl ¥ KD Ps NKr SR S$ R Skr SF £ $ © Centre for Financial Management , Bangalore
  9. 9. 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 © Centre for Financial Management , Bangalore
  10. 10. 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 © Centre for Financial Management , Bangalore
  11. 11. CROSS-CURRENCY RATES © Centre for Financial Management , Bangalore
  12. 12. SPOT RATES In 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. © Centre for Financial Management , Bangalore
  13. 13. • 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. © Centre for Financial Management , Bangalore
  14. 14. 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 Bid price x 100 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 45,5000 X 100 = 0.088 percent © Centre for Financial Management , Bangalore
  15. 15. 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 © Centre for Financial Management , Bangalore
  16. 16. 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. © Centre for Financial Management , Bangalore
  17. 17. FORWARD RATE QUOTATION In 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. © Centre for Financial Management , Bangalore
  18. 18. SWAP POINTS In 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 1 month swap 46.5015 / 46.5020 : 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. © Centre for Financial Management , Bangalore
  19. 19. 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 © Centre for Financial Management , Bangalore
  20. 20. FORWARD PREMIUMS AND DISCOUNTS Consider the following spot and forward quotes USD/INR Spot : USD/INR 1-month forward : 46.5020 / 46.5120 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 Spot (USD/INR)mid x 12 x 100 © Centre for Financial Management , Bangalore
  21. 21. FORWARD PREMIUMS AND DISCOUNTS In 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 46.5070 = 1.16 percent This means that the annual forward premium on US dollar in relation to Indian rupee is 1.16 percent. © Centre for Financial Management , Bangalore
  22. 22. FORWARD PREMIUM OR DISCOUNT Forward rate – Spot rate Forward premium = or discount 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 Forward premium = 12 x 43.26 3 = 0.0499 or 4.99 percent © Centre for Financial Management , Bangalore
  23. 23. 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. © Centre for Financial Management , Bangalore
  24. 24. 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 nonrefundable premium to enjoy the option. © Centre for Financial Management , Bangalore
  25. 25. INTERNATIONAL PARITY RELATIONSHIP • Interest rate parity • Purchasing power parity • Expectations theory and forward exchange rates • Fisher effect and international Fisher effect © Centre for Financial Management , Bangalore
  26. 26. 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 where F 1 + rf = direct quote forward rate So = direct quote spot rate rh = home (or domestic) interest rate rf = foreign interest rate © Centre for Financial Management , Bangalore
  27. 27. 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. © Centre for Financial Management , Bangalore
  28. 28. 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. © Centre for Financial Management , Bangalore
  29. 29. RELATIVE PURCHASING POWER PARITY A 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 S 1 += i o f where Se1 = expected spot rate a year from now So = current spot rate ih = expected inflation rate in home country if = expected inflation rate in foreign country. © Centre for Financial Management , Bangalore
  30. 30. 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? S e1 1 + 0.06 = 45.0 S e1 1+ 0.02 = Rs.46.75 © Centre for Financial Management , Bangalore
  31. 31. 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 (Se1) 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 Se1, market participants would buy dollars forward, thereby pushing F1 upward till it equals Se1. On the other hand, if F1 were higher than Se1, market participants would sell dollars forward, thereby pushing F1 downward till it equals Se1. © Centre for Financial Management , Bangalore
  32. 32. 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. © Centre for Financial Management , Bangalore
  33. 33. 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 © Centre for Financial Management , Bangalore
  34. 34. GENERALISED FISHER EFFECT If 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. © Centre for Financial Management , Bangalore
  35. 35. INTERNATIONAL FISHER EFFECT If we combine purchasing power parity with generalised Fisher effect, the result is the international Fisher effect. Se1 Purchasing power parity : 1 + ih = So 1 + if 1 + rh Generalised Fisher effect : 1 + ih = 1 + rf 1 + if Se1 International Fisher effect : 1 + rh = So 1 + rf © Centre for Financial Management , Bangalore
  36. 36. AN INTEGRATED PICTURE OF INTERNATIONAL PARITY RELATIONSHIP Forward Rate as an unbiased estimator of the future spot rate Forward premium or discount on foreign currency (observed) - 5% Interest rate parity Forecasted future spot exchange rate - 5% rupee weakens; $ appreciates International fisher effect Difference in nominal interest rates (observed) + 5% Relative purchasing power parity Difference in expected inflation rates (forecasted) + 5% Fisher effect © Centre for Financial Management , Bangalore
  37. 37. INTERNATIONAL CAPITAL BUDGTING There are two ways of analysing a foreign investment proposal: Home Currency Approach • Convert all the dollar cash flows into rupees (use forecasted Foreign Currency Approach • Calculate the NPV in dollars (use the dollar discount rate) exchange rates) • Calculate the NPV in rupees (using the rupee discount rate) • Convert the dollar NPV into rupees(use the spot exchange rate) © Centre for Financial Management , Bangalore
  38. 38. 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 © Centre for Financial Management , Bangalore
  39. 39. RAISING FOREIGN CURRENCY FINANCE • Foreign currency term loans from financial institutions • Export credit schemes • External currency borrowings • Euroissues • Issues in foreign domestic markets © Centre for Financial Management , Bangalore
  40. 40. 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. © Centre for Financial Management , Bangalore
  41. 41. 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. © Centre for Financial Management , Bangalore
  42. 42. 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. © Centre for Financial Management , Bangalore
  43. 43. 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. © Centre for Financial Management , Bangalore
  44. 44. 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 © Centre for Financial Management , Bangalore
  45. 45. 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. © Centre for Financial Management , Bangalore
  46. 46. 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. © Centre for Financial Management , Bangalore
  47. 47. 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. © Centre for Financial Management , Bangalore
  48. 48. 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). © Centre for Financial Management , Bangalore
  49. 49. 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. © Centre for Financial Management , Bangalore
  50. 50. 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). © Centre for Financial Management , Bangalore
  51. 51. DOCUMENTS IN INTERNATIONAL TRADE • Trade draft • Bill of lading • Letter of credit © Centre for Financial Management , Bangalore
  52. 52. 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). © Centre for Financial Management , Bangalore
  53. 53. 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. © Centre for Financial Management , Bangalore
  54. 54. 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. © Centre for Financial Management , Bangalore
  55. 55. 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”. © Centre for Financial Management , Bangalore
  56. 56. 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. © Centre for Financial Management , Bangalore
  57. 57. 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. © Centre for Financial Management , Bangalore
  58. 58. 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. © Centre for Financial Management , Bangalore
  59. 59. TRANSLATION EXPOSURE 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. © Centre for Financial Management , Bangalore
  60. 60. TRANSLATION EXPOSURE 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. © Centre for Financial Management , Bangalore
  61. 61. TRANSLATION EXPOSURE 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. © Centre for Financial Management , Bangalore
  62. 62. 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 © Centre for Financial Management , Bangalore
  63. 63. FACTORS INFLUENCING TRANSLATION GAINS/LOSSES Foreign currency depreciates Exposed Translation loss Exposed vis-à-vis rupee occurs Liabilities Foreign currency appreciates Translation gain vis-à-vis rupee occurs Foreign currency depreciates Translation gain Exposed vis-à-vis rupee occurs Liabilities Foreign currency appreciates Translation loss vis-à-vis rupee occurs > Assets Exposed < Assets © Centre for Financial Management , Bangalore
  64. 64. 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. © Centre for Financial Management , Bangalore
  65. 65. 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). © Centre for Financial Management , Bangalore
  66. 66. 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 © Centre for Financial Management , Bangalore
  67. 67. 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). © Centre for Financial Management , Bangalore
  68. 68. ROLLOVER CONTRACT In the foreign exchange market in India, a forward contract for a maturity period exceeding six months is not ordinarily possible because in the interbank 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. © Centre for Financial Management , Bangalore
  69. 69. 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. © Centre for Financial Management , Bangalore
  70. 70. MONEY MARKET HEDGE In 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.) © Centre for Financial Management , Bangalore
  71. 71. 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. © Centre for Financial Management , Bangalore
  72. 72. 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. © Centre for Financial Management , Bangalore
  73. 73. 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." © Centre for Financial Management , Bangalore
  74. 74. 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. © Centre for Financial Management , Bangalore
  75. 75. 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. © Centre for Financial Management , Bangalore
  76. 76. LEVERS FOR MANAGING OPERATING EXPOSURE The important levers for managing operating exposure are: • Product strategy • Pricing strategy • Plant location • Sourcing • Product cycle • Liability structure © Centre for Financial Management , Bangalore
  77. 77. 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. © Centre for Financial Management , Bangalore
  78. 78. 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 © Centre for Financial Management , Bangalore
  79. 79. 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. © Centre for Financial Management , Bangalore
  80. 80. • 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. © Centre for Financial Management , Bangalore
  81. 81. • 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. © Centre for Financial Management , Bangalore
  82. 82. • 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. © Centre for Financial Management , Bangalore
  83. 83. • 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 preshipment 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. © Centre for Financial Management , Bangalore
  84. 84. • 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. © Centre for Financial Management , Bangalore
  85. 85. • 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. © Centre for Financial Management , Bangalore

×