A2. (1) Difference between the “current rate” translation method and the temporal method:
Most countries today specify the...
Operating exposure, also called economic exposure, competitive exposure, or strategic exposure,
measures any changes i...
A6. The steps in a typical letter of credit financed trade transaction are:
    1. The importer places an order with the e...
Tradecard is another type approach to financing foreign trade. TradeCard provides a hosted
technology platform comprised o...
Letter of credit (L/C): is a bank’s promise to pay issued by a bank at the request of an importer
(the applicant/buyer), i...
secondary market, or are presented by bills of exchange or promissory
Describe the uncovered interest arbitrage strategy proposed by the Mathieux brothers.
Your discussion of this st...
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C Users Eddie Desktop Fin643 Shuang


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C Users Eddie Desktop Fin643 Shuang

  1. 1. A2. (1) Difference between the “current rate” translation method and the temporal method: Most countries today specify the translation method used by a foreign subsidiary based on the subsidiary’s business operations. A foreign subsidiary’s business can be categorized as either an integrated foreign entity or a self-sustaining foreign entity. For international standard, if foreign operation is integral to parent operations, use temporal method, and exchange gains and losses are income; If foreign operation is self-sustaining, use current rate method and exchange differences are equity until disposal. The main differences between current date method and the temporal method are: (a) The current rate method. • Translate assets and liabilities using the current rate. • Translate revenues and expenses at the average rate • Translate equity and dividends at historical rate. • Calculate ending retained earnings and place in balance sheet. • Determine the translation adjustment in equity necessary to “balance” the balance sheet. (b) Temporal Method: • Translate cash, receivables, and liabilities at current rate • Translate inventory / CoGS, fixed assets / depreciation, and equity / dividends at historical rate • Translate revenues and other expenses at average rate • Calculate ending retained earnings and place in balance sheet. • Determine the remeasurement gain or loss in the income statement that will make retained earnings the amount that “balances” the balance sheet. However, the US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. • If the financial statements of the foreign subsidiary are maintained in US dollars, translation is not required. • If the statements are maintained in the local currency, and the local currency is the functional currency, they are translated by the current rate method. • If the statements are maintained in local currency, and the US dollar is the functional currency, they are remeasured by the temporal method. • If the statements are in local currency and neither the local currency nor the US dollar is the functional currency, the statements must first be remeasured into the functional currency by the temporal method, and then translated into US dollars by the current rate method. (2) For subsidiaries operating in low inflation countries, FAS #52 uses the current rate method as the basic translation rule. At the same time it mitigates the consequences by allowing companies to move translation losses directly to a special subaccount in the net worth section of the balance sheet, instead of adjusting current income. Solving the true profitability often disguised by exchange rate volatility under FAS#8. FAS#8 uses temporal method and report translation gains or loses on income statement. As a result, the net income is greatly affected by exchange rate volatility. A more significant innovation of FAS #52 is the quot;functionalquot; currency concept, which gives a company the opportunity to identify the primary economic environment and select the appropriate (functional) currency for each of the corporation's foreign entities. In essence, FAS 52 allows management much more flexibility to present the impact of exchange rate variations in accordance with perceived economic reality; by the same token, it provides greater scope for manipulation of reported earnings and it reduces comparability of financial data for different firms. However, FAS#52 has a special provision for translating statements of foreign subsidiaries of U.S. companies operating in countries where cumulative inflation has been approximately 100% or more over a three-year period. Financial statement of these subsidiaries must be translated into the reporting currency using the temporal method which is like under FAS#8.
  2. 2. A3. Operating exposure, also called economic exposure, competitive exposure, or strategic exposure, measures any changes in present values of a firm resulting from changes in future operating cash flows caused by any unexpected change in exchange rates. Operating exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. Six of the most commonly employed proactive policies are: Matching currency cash flows; Risk-sharing agreements; Back-to-back or parallel loans; Currency swaps; Leads and lags; Reinvoicing center. Numerical example: using a Cross-Currency Swap to hedge currency exposure Two companies in different countries; Japanese corporation and United States corporation. They want to hedge their revenues due to the change in exchange rates between Japanese yen and US dollars. Assume that now exchange rate between two currencies is 100 ¥ /1 $ and exchange become 90¥ /1$ one year later. Both the Japanese corporation and the US corporation would like to enter into cross- currency swap that would allow them to use foreign currency cash flows to service debt. Japanese corporation sale its products in US. They get US dollar for its revenues, but base on the assumption that dollar become weaker after one year period Japanese corporation want to hedge if the situation happens. For example the sales for Japanese corporation in US are 10 million they want swap with one US corporation which also worry about the devaluation of yen. Dealer will make money for some percentage The Japanese corporation pay dollar to dealer and receive yen given by the US corporation. Whatever the exchange rate is what after one year. Dealer can control the amount and timing of the desired swap. They make agreement that dealer will get dollars from the Japanese company for 10 million and give back the yen for forward exchange rate 95¥/1$ one year later. The total amount of Japanese company receives will be 950 million yen to pay its own debt. It is better when the exchange rate become 90¥/1$ because at that time they only get 900 million yen at the end of year. It same as forward contract, but they are entered in firm’s footnotes rather than as balance sheet items. The result is that both translation and operating exposures are avoided.
  3. 3. A6. The steps in a typical letter of credit financed trade transaction are: 1. The importer places an order with the exporter, asking if the exporter is willing to ship under an L/C. 2. The exporter agrees to ship under an L/C and specifies relevant information such as prices and terms. 3. The importer applies to the issuing bank for an L/C to be issued in favor of the exporter for the merchandise it wishes to buy. 4. The importer’s bank(the issuing bank) issues the L/C in favor of the exporter and sends it to the exporter’s bank. 5. The exporter’s bank advises the exporter of the opening of an L/C in the exporter’s favor. It may or may not confirm the L/C to add its own guarantee to the document. 6. The exporter ships the goods to the importer and gets the bill of lading from the carrier of the goods. 7. The exporter presents to exporter’s bank a time draft and other documents as required, including the bill of lading. 8. The exporter’s bank presents the draft and documents to the importer’s bank for acceptance. 9. The importer’s bank returns the accepted draft to the exporter’s bank. 10. The exporter’s bank, having received the accepted draft, may sell the acceptance in the open market at a discount to a portfolio investor or hold the acceptance in its own portfolio. 11. The exporter’s bank pays exporter. The exporter can receive the discounted cash value of the acceptance at once or receive the amount of the acceptance when it is maturity. 12. The importer’s bank notifies the importer of the arrival of the documents. The importer signs a note to pay the importer’s bank in the maturity day. The importer’s bank releases shipment. 13. On the maturity day, this bank receives from the importer funds to pay the maturing acceptance. 14. On the same day, the holder of the matured acceptance presents it for payment and receives its face value.
  4. 4. Tradecard is another type approach to financing foreign trade. TradeCard provides a hosted technology platform comprised of online services and a global network of trade experts that connect buyers, suppliers and service providers. This unique offering ensures members have the data and tools needed to automate and optimize transactions in the extended supply chain. The buyer creates and sends TradeCard a purchase order through their EDI, ERP, or user interface on their Internet browser. The seller receives an automatic email notice from TradeCard stating that a purchase order is quot;pendingquot;. The seller then approves the purchase order or renegotiates its terms with the buyer, if necessary. Upon approval by the seller, the purchase order is stored in TradeCard. At this point in the transaction, the seller can select payment protection, if available. Once the goods are ready for shipment, the seller creates an invoice and packing list on TradeCard. Since most of the invoice data are found on the original purchase order, TradeCard automatically pre-populates the invoice document, so that the seller only needs to fill in new data. The TradeCard compliance engine then matches the invoice and other optional documents such as the packing list, proof of delivery and proof of inspection against the purchase order to confirm documentary compliance. Both buyer and seller are notified if there are any discrepancies and have the option of negotiating them free of charge online. Once documentary compliance has been achieved, TradeCard automatically sends payment instructions to a participating financial institution, which debits the buyer's account and credits the seller's account Compared to LC-based trade finance, Tradecard approach can  Reduces transaction times and avoiding delays caused by paper-based bank operations  Eliminates costs associated with traditional L/Cs, including charges for transfer, amendments and checks, protecting the interests of clients and suppliers’ profit margins  Reduces the need for repeated data entry, allows information to be accessed instantly, increases productivity and efficiency of operations
  5. 5. Letter of credit (L/C): is a bank’s promise to pay issued by a bank at the request of an importer (the applicant/buyer), in which the bank promises to pay an exporter (the beneficiary of the letter) upon presentation of documents specified in the L/C. An L/C reduces the risk of noncompletion, because the bank agrees to pay against documents rather than actual merchandise. Forfaiting: is a specialized technique to eliminate the risk of nonpayment by importers in instanced where the importing firm and/or its government is perceived by the exporter to be too risky for open account credit. International Financial Tools Preferred Condition Forfaiting When the exporter has difficulty in ensuring that the a importer will make payment regard for the uncertain risk such as political risk, and credit risk. Forfaiting is Non-recourse. Letter of Credit When both side (exporter and importer) have good credit line. Strengths-Forfaiting • Exporter can offer credit to buyer but receive cash payment. Exporter • Exporter receives cash immediately upon delivery of the goods or services. • No country of origin restrictions as required by Sovereign Export Promotion Agencies. • Up to 100% of sale can be financed. • Forfait financing is 100% non-recourse to the Exporter. • Eliminates the two key risks – political and commercial credit risks. • Protects exporter from foreign exchange fluctuations, interest rate increases. • Simple documentation, rapid, flexible deal structuring. • Improves competitive advantage by providing vendor financing. • Facilitates expansion of markets to riskier countries. • Commitments can be received within a few days depending on country of import. • No credit administration, collection efforts with related costs. • No contingent liability, enhances balance sheet ratios. • Eliminates export credit insurance premiums and commercial banking fees. • Financing is transacted confidentially, unlike commercial loans. • Importer gains access to extended term financing with fixed or Importer floating interest rates. • Forfait financing has simple documentation and is very flexible. • Can receive financing for up to 100% of cost of goods. • Provides access to major hard currency financing. • Repayment can be tailored to the buyer’s cash flow profile. • Goods from a variety of sources can be financed. • There is no acceleration clause in the case of non-payment of one bill, which is traditionally featured in commercial loan agreements. Investor The receivable becomes a form of debt instrument that can be sold on the
  6. 6. secondary market, or are presented by bills of exchange or promissory note. Weakness-Forfaiting • Forfait financing does not cover pre-delivery risks. Exporter • An export shipment is effectively open account until a commitment is obtained from the forfaiter and exporter fulfills their obligations. • Exporter has the responsibility to ensure that the debt is legal and enforceable. • Exporter must insure that the debt instrument is properly guaranteed. • The cost of forfait financing can be higher than commercial bank financing. • The importer must pay for both forfait financing and the fee for Importer bank’s guarantee. • Cost for financing and bank guarantee can be more than direct credit loan. • The bank aval or guarantee may be counted against and reduce availability of Importers bank credit lines. • Importer may need to cover foreign exchange risk over repayment period. Investor Have to bear all risks. Strengths-L/C Exporter 1. The L/C can reduce the risk- the exporter can sell against at bank’s promise to pay rather than against the promise of a commercial firm. 2. The exporter is in a more secure position as to the availability of foreign exchange to pay for the sale. 3. an exporter may find that an order backed by an irrevocable L/C will facilitate obtaining pre-export financing in the home country. Importer Importer need not pay out finds until the documents have arrived at a local port or airfield and unless all conditions stated in the credit have been fulfilled. Investor (Banks) Earning service fee and interest fee. If the amount is not collected, the bank can perform recourse to quire the exporter to repay all funds. Weakness-L/C Exporter 1. Should pay service fee and interest fee to the bank. 2. If the documents don’t comply with the terms or conditions of L/C, the seller should subject fines. It’s a competitive disadvantage for the exporter to demand automatically an L/C from an importer who has a good credit record and there is no concern regarding the economic or political conditions of the importer’s country Importer The quality of goods can’t be guaranteed. If all export documents are complied with the terms of L/C, importer should pay all the amount of the goods. The main disadvantages are the fee charged by the importer’s bank for issuing its L/C and the possibility that the L/C reduces the importer’s borrowing line of credit with its bank. Investor More and more customers transact by telegraphic transfer (T/T)
  7. 7. Crosswell Describe the uncovered interest arbitrage strategy proposed by the Mathieux brothers. Your discussion of this strategy should be in reference to information provided on pp.99-101 of the case. Mathieux brother’s proposal is to combine extended credit terms to local distributors with Brazil’s high domestic interest rates to effectively lower the diaper’s price to Brazilian consumers. Foreign corporations (i.e., European automobile manufacturers and Chinese textile firms) were successfully undercutting national companies’ prices by taking advantage of Brazil’s high interest rates. Borrowing rates in the U.S. were substantially lower than deposit rates in Brazil, and given the stable exchange rate, this created an opportunity for uncovered interest rate arbitrage gains. The basic strategy was based on the ability to get extended terms from the seller, Crosswell International, and get paid for the goods quickly from the local Brazilian distributor. If the distributor could obtain 180-day credit terms, or a standard 180-day letter of credit from Crosswell, the firm could sell the goods into the local market for cash within 30 days of receiving the diapers at port. The cash proceeds from the resale could then be invested in the relatively “high-yielding” Real-denominated deposit rates. At the end of the following four to five months when the payment on the goods to Crosswell was due, the deposits could be closed and the profits taken to offset the cost of financing the purchase. This would reduce the R$6.86 per case financing cost of the distributor as described in the baseline analysis in this case. Of course, this was only true if the Real/dollar exchange rate was stable over the period. What were the potential benefits and risks of this strategy to Crosswell. The potential benefits and risks of this strategy to Crosswell are: Benefit: Using UIA to offsetting the distributor’s cost in order to lower diapers’ price could effectively made Crosswell enter in the Brazil’s diaper market and gain profit for the long-run. Risk: a.) The Real/dollar exchange rate couldn’t be stable forever. If the Real are depreciate significantly against the dollar, there will be less or even no profit for the distributor to offset its cost. b.) The collection of the cash proceeds from the resale could be late, if the sales of diaper are not good. c.) The interest rate differentials couldn’t persist over the long-run. Suggest business approaches which might modify the strategy to reduce risk elements. For the unstable exchange rate, I suggest The Mathiuex brothers should take on more exchange rate risk themselves by selling the diapers at a fixed price in Brazilian Real. This will reduce the risk to the Brazilian distributor. With less risk, the distributor cannot require such a large margin. To assure the diaper sales for generating cash proceeds, Mathiuex brothers should find a distributor who has more experience about grocery store instead of the one who involved in hospital and disposable hygiene markets. To avoid long-run interest rate decreasing, Crosswell could export goods into Uruguay and truck goods into Brazil for paying the lower import tariffs in order to reduce prices.