Foreign Exchange Risk Management (Currency Risk Management)
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Foreign Exchange Risk Management (Currency Risk Management)

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  • When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. For example, suppose that Company X knows that in six months it will have to buy 20,000 ounces of silver to fulfill an order. Assume the spot price for silver is $12/ounce and the six-month futures price is $11/ounce. By buying the futures contract, Company X can lock in a price of $11/ounce. This reduces the company's risk because it will be able close its futures position and buy 20,000 ounces of silver for $11/ounce in six months. If a company knows that it will be selling a certain item, it should take a short positionin a futures contract to hedge its position. For example, Company X must fulfill a contract in six months that requires it to sell 20,000 ounces of silver. Assume the spot price for silver is $12/ounce and the futures price is $11/ounce. Company X would short futures contracts on silver and close out the futures position in six months. In this case, the company has reduced its risk by ensuring that it will receive $11 for each ounce of silver it sells. 

Foreign Exchange Risk Management (Currency Risk Management) Foreign Exchange Risk Management (Currency Risk Management) Presentation Transcript

  • INTERNATIONAL FINANCE F O R EIG N EXC H AN G E ( C U R R EN C Y ) R ISK MAN AG EM EN T & ST R AT EG IES FOR MAN AGIN G R EL AT ED EXPO SU R ES Hisham Ahmed Rizvi hisham.rzv@gmail.com +91-9999171299
  • INTRODUCTION • Risks faced by a firm • What is financial risk? • What is currency risk? • Exposure & risk: Are they same? • Measuring exposure • Measuring risk • Why should risk be managed? INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 2
  • • Peculiar to a firm Core Business Risks RISKS FACED BY A FIRM Unsuccessful product launch Labour problems Cyclical demand fluctuations Material supply problems And so forth.. • All pervasive and affect all firms in an industry • Financial risks are a subset of environmental risks Environmental Risks Exchange rate fluctuations Interest rate fluctuations Sudden price rise of goods Shifts in government policies And so forth.. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 3
  • Credit risk WHAT IS FINANCIAL RISK? RISK A situation involving exposure to danger. SOURCE: Investopedia Interest rate risk Currency risk Market risk Equity risk SOURCE: Oxford Dictionary Financial risk refers to the chance that an investment's Financial Risk actual return will be FINANCIAL different than expected. It RISK basically is exposure to the danger of financial loss on investments made by investors. Concentration risk Commodity risk Liquidity risk Refinancing risk Legal risk Model risk Operational risk Political risk Valuation risk INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 4
  • WHAT IS CURRENCY RISK? CURRENCY RISK It is a form of financial risk that arises from the change in price of one currency against another. Whenever investors or companies have assets or business operations across national borders, they face currency risk (or foreign exchange risk). For example, if you are a U.S. investor and you have stocks in Canada, the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the U.S. dollar. So, if you realize a 15% return in your Canadian stocks but the Canadian dollar depreciates 15% against the U.S. dollar, this will amount to no gain at all. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 5
  • EXPOSURE & RISK: ARE THEY SAME?* *IN FINANCIAL CONTEXT Each firm is “exposed” to unforeseen changes in a number of variables in its environment. These variables are called Risk Factors. E.g. Exchange rate fluctuation is a risk factor. It is the measure of the sensitivity of a firm’s performance to fluctuations in the relevant risk factor i.e. EXPOSURE whether or not a certain risk factor affects a firms performance. It is the measure of the extent of variability of the RISK performance attributable to the risk factor i.e. how much does a risk factor affect a firms performance. For example, between April 1992 and July 1995 the exchange rate between rupee and US dollar was rock steady. For an Indian firm involved in exports and imports from US, this meant that it had significant exposure to this exchange rate (because the exchange rate could have affected its performance) but it did not perceive significant risk because the exchange rate was stable. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 6
  • MEASURING EXPOSURE Exposure of a firm to a risk factor is the sensitivity of the real value of the firm’s assets, liabilities or operating income, expressed in its functional currency, to unanticipated changes in the risk factor. IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION: • Functional currency: It is the primary currency of the firm in which its financial statements are published. It is often the domestic currency of their country. • Real value: Values adjusted for inflation. (In practice though, it becomes difficult to adjust all values with an uncertain inflation rate, hence nominal values are only used) • Unanticipated changes: Only unanticipated changes in the relevant risk factor are to be considered because the market already makes allowances for anticipated changes. For e.g. an exported invoicing a foreign buyer in the buyer’s currency will build an allowance for the expected depreciation of that currency. This is anticipated change. INTERNATIONAL than expected, that becomes However if the depreciation is more FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 7
  • MEASURING EXPOSURE Q. How do we separate a given change in the risk factor into anticipated and unanticipated components? Ans. One possible way is by using forward rate. FORWARD RATE A rate applicable to a financial transaction that will take place in the future. For example, suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 68.00 while the one month forward rate is Rs 68.20. However one month later the spot rate turns out to be Rs 68.30. In this case, the anticipated depreciation is 20 paise per pound in one month, while the unanticipated depreciation has been 10 paise per pound. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 8
  • MEASURING EXPOSURE: AN EXAMPLE A firm has a 90-day payable amounting to US $5,00,000 arising out of raw material import transaction. Current spot rate is Rs 40.60 per dollar. 3-month forward rate is Rs 40.80 per dollar. Actual rate 3 months later turns out to be Rs 41.00 per dollar. • Therefore, the unanticipated depreciation of rupee is Rs 0.20 per dollar. • The loss on account of increase in rupee value of the payable is (5,00,000*0.20) = Rs 1,00,000 According to the 3-month forward rate, the firm would have paid (40.80*5,00,000) = Rs 2,04,00,000 But actually it will pay (41*5,00,000) = Rs 2,05,00,000 INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM Rs 1,00,000 extra on account of unanticipated depreciation of rupee. 9
  • MEASURING EXPOSURE: AN EXAMPLE One straightforward way to define exposure is: “By how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollar?” In this case, the value of the payable changes by 1,00,000 on a 20 paise change of rupee-dollar rate, therefore it will change by 5,00,000 for a rupee change. Note here that the exposure is here is same as the value of the foreign currency. (5,00,000) A general rule is that if the foreign currency value of the exposed item is fixed, exposure identically equals that value. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 10
  • MEASURING RISK Risk is the measure of the extent of variability of the performance attributable to the risk factor (e.g. exchange rate). It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (e.g. exchange rate). In simple words, risk gives us a range within which the variation due to the risk factor can take place. It can be arrived by analyzing the bestcase and worst-case scenarios for a firm. For example, we have the following forecast by a financial consulting outfit: “In our view the most likely value of the spot rate three months from now is Rs 41.00 per dollar, but it could be as high as Rs 41.50. There is a small probability that the dollar could fall to Rs Scenario Best-case Worst-case 39.40.” 3-month spot rate Rs 39.40 Rs 41.50 Rupee outlay to settle the Rs 1,97,00,000 Rs 2,07,50,000 payable INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 11
  • WHY SHOULD RISK BE MANAGED? Leads to lower demand for returns by investors • Investors can manage unsystematic risks (peculiar to a company) by diversifying their portfolio (e.g. by buying stocks in oil as well as aviation industry), but they have no control over systematic risks (related to the industry and economy at large). Hence, greater the systematic risk greater is the return demanded by investors. Ensures better cash flows • If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities. External financing can be avoided • If risk is managed effectively, it will lead to ready availability of internal funds for investments, and lower the reliance on external funds like debt and new INTERNATIONAL FINANCE PRESENTATION |less preferred| equity, which are always HISHAM AHMED RIZVI HISHAM.RZV@GMAIL.COM 12
  • WHY SHOULD RISK BE MANAGED? Financial distress can be avoided • If not managed properly, the risks associated with a firm can lead to a liquidity crunch. This will lead to the bankers, customers, employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm. Creation of “corporate value” • Firms enhance shareholder wealth – create “corporate value” – by making good investments in areas of product development, R&D, advertising, promotion etc. This is possible only with a steady stream of cash flows. Increased investor confidence • A firm that manages its risk effectively and consistently over a period of time is well reputed by investors and bankers and considered creditworthy. This ensures availability of credit when| INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI HISHAM.RZV@GMAIL.COM and if required. 13
  • HEDGING • What is hedging? • To hedge or not to hedge? INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 14
  • WHAT IS HEDGING? INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 15
  • HEDGING • What is hedging? • To hedge or not to hedge? INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 16
  • TO HEDGE OR NOT TO HEDGE? • Hedging is the taking of a position, either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position. • Hedging, therefore, protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure). INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 17
  • TO HEDGE OR NOT TO HEDGE? Stockholders are much more capable of diversifying currency risk than the management of the firm. Opponents of Hedging Currency risk management does not add value to the firm and it incurs costs. Hedging might benefit corporate management more than shareholders. Reduction in risk in future cash flows improves the planning capability of the firm. Proponents of Hedging Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm. Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 18
  • CURRENCY • Transactions exposure EXPOSURE • Translation exposure • Operating exposure • Economic exposure INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 19
  • TYPES OF CURRENCY EXPOSURES Currency Exposure Long-Term Short-Term Accounting (Translation Exposure) Anticipated Changes Cash Flow Operating Exposure Strategic Exposure Unanticipated Changes (Transactions Exposure) INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 20
  • TYPES OF CURRENCY EXPOSURESaffect firm value through: Changes in exchange rate can INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 21
  • TYPES OF CURRENCY EXPOSURES ILLUSTRATIVE EXAMPLES: A Taiwanese company has the following USD exposures: 1. Owns a factory in Texas worth US$5 million. 2. Agreement to buy goods worth US$2 million. 3. Biggest competitor is a US company. What happens if the NT dollar appreciates? 1. NT$ value of US factory goes down (translation). 2. NT$ cost of buying goods goes down (transaction). 3. Global competitiveness of Taiwanese company decreases (operating). INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 22
  • TRANSLATION • Introduction & example EXPOSURE • Methods • Strategies to manage translational exposure INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 23
  • TRANSLATION EXPOSURE Translation exposure, also called Accounting Exposure or Balance Sheet exposure, arises because TRANSLATION financial statements of foreign subsidiaries – which are EXPOSURE stated in foreign currency – must be restated in the parent’s reporting currency for the firm to prepare consolidated financial statements. • Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported net income caused by a change in exchange rates since the last translation. • The accounting process of translation, involves converting these foreign subsidiaries financial statements into home currencydenominated statements. • It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future. • It has no direct impact on cash flows of aPRESENTATION firm. INTERNATIONAL FINANCE | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 24
  • TRANSLATION EXPOSURE • No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent company's stock. Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company, unless the foreign operations are an integral part of the parent business for e.g. a branch. • However, major stock exchanges require it as one of their listing requirements. • As more and more Indian firms are going multinational, they are increasingly considering translation and consolidation of foreign subsidiaries, and hence are becoming vulnerable to translational exposure. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 25
  • TRANSLATION EXPOSURE: AN EXAMPLE AN INDIAN COMPANY WITH A U.K. Financial details of U.K. Subsidiary SUBSIDIARY Particular March 31, 2012 (£1=Rs85) March 31, 2013 (£1=Rs70) Value in £ Translated value Real Estate £1,000,000 Rs 85,000,000 £950,000 Rs 66,500,000 Inventories £200,000 Rs 17,000,000 £250,000 Rs 17,500,000 Cash £150,000 Rs 12,750,000 £160,000 Rs 11,200,000 Total £1,350,000 Rs 102,000,000 £1,360,000 Rs 95,200,000 Value in £ Translated value INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 26
  • TRANSLATION • Introduction & example EXPOSURE • Methods • Strategies to manage translational exposure Regardless of which method is employed, a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured, but also designate where any imbalance is to be recorded (current income or an equity reserve account). INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 27
  • CURRENT/NONCURRENT METHOD • The underlying principle is that assets and liabilities should be translated based on their maturity.  Current assets (like Cash) translated at the spot rate. e.g. DM2=$1  Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books. e.g. DM3=$1 Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Current/ Currency Noncurrent 2,100 DM $1,050 1,500 DM $750 3,000 DM $1,000 6,600 DM $2,800 1,200 DM $600 1,800 DM $600 2,700 DM $900 900 DM $700 --------------6,600 DM $2,800 INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 28
  • MONETARY/NONMONETA RY METHOD • The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes. Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Monetary/ Currency Nonmonetary 2,100 DM $1,050 1,500 DM $500 3,000 DM $1,000 6,600 DM $2,550 1,200 DM $600 1,800 DM $900 2,700 DM $900 900 DM $0 --------------6,600 DM $2,400 • All monetary balance sheet accounts (cash, marketable securities, accounts receivable, etc.) of a foreign subsidiary are translated at the current exchange rate. e.g. All other (nonmonetary) balance sheet accounts (common stock) are DM2=$1 translated at the historical exchange rate in effect when the account was first recorded. e.g.DM3=$1 INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | 29 HISHAM.RZV@GMAIL.COM
  • TEMPORAL METHOD • The underlying principle is that assets and liabilities should be translated based on how they are carried on the firm’s books. • Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value. • Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books. • Gains or losses resulting from remeasurement are carried directly to current consolidated income, and not to equity reserves (increased variability of consolidated earnings). INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 30
  • CURRENT RATE METHOD • All balance sheet items (except for stockholder’s equity) are translated at the current exchange rate. DM2=$1 • Very simple method in application. • The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings). Balance Sheet Cash Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings CTA Total Liabilities and Equity Local Currency DM2,100 DM1,500 DM3,000 DM6,600 DM1,200 DM1,800 DM2,700 DM900 -------DM6,600 Current Rate $1,050 $750 $1,500 $3,300 $600 $900 $900 $360 $540 $3,300 INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 31
  • HOW VARIOUS TRANSLATION METHODS Balance Sheet WITH A CHANGE FROM Local Current/ Monetary/ DEAL Currency Noncurrent Nonmonetary Temporal Current Rate DM3 TO DM2 $1,050 = $1 $1,050 $1,050 $1,050 Cash 2,100 DM Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity 1,500 DM 3,000 DM 6,600 DM 1,200 DM $750 $1,000 $2,800 $600 $500 $1,000 $2,550 $600 $900 $1,000 $2,950 $600 $750 $1,500 $3,300 $600 1,800 DM $600 $900 $900 $900 2,700 DM 900 DM -------6,600 DM $900 $700 -------$2,800 $900 $150 -------$2,550 $900 $550 -------$2,950 $900 $360 $540 $3,300 Spot exchange rate INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 32
  • HOW VARIOUS TRANSLATION METHODS Balance Sheet WITH A CHANGE FROM Local Current/ Monetary/ DEAL Currency Noncurrent Nonmonetary Temporal Current Rate DM3 TO DM2 $1,050 = $1 $1,050 $1,050 $1,050 Cash 2,100 DM Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500 Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Book Current 1,200 DM $600 $600 $600 $600 value of liabilities inventory Long-Term 1,800 DM $600 historic $900 $900 $900 debt rate Common stock 2,700 DM $900 $900 $900 $900 Retained earnings 900 DM $700 $150 $550 $360 earnings CTA ----------------------------$540 Total 6,600 DM $2,800 $2,550 $2,950 $3,300 Liabilities and Book value of inventory Current value of inventory INTERNATIONAL FINANCE at spot exchange rate PRESENTATION| at spot 33 exchange rate. Equity | HISHAM AHMED RIZVI HISHAM.RZV@GMAIL.COM
  • HOW VARIOUS TRANSLATION METHODS Balance Sheet WITH A CHANGE FROM Local Current/ Monetary/ DEAL Currency Noncurrent Nonmonetary Temporal Current Rate DM3 TO DM2 $1,050 = $1 $1,050 $1,050 $1,050 Cash 2,100 DM Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity 1,500 DM 3,000 DM 6,600 DM 1,200 DM $750 $1,000 $2,800 $600 $500 $1,000 $2,550 $600 $900 $1,000 $2,950 $600 $750 $1,500 $3,300 $600 1,800 DM $600 $900 $900 $900 2,700 DM 900 DM -------6,600 DM $900 $900 $900 $900 $700 $150 $550 $360 ---------------------$540 $2,800 $2,550 $2,950 $3,300 historic spot exchange rate. INTERNATIONAL FINANCE PRESENTATION rate | HISHAM AHMED RIZVI | 34 HISHAM.RZV@GMAIL.COM
  • HOW VARIOUS TRANSLATION METHODS Balance Sheet WITH A CHANGE FROM Local Current/ Monetary/ DEAL Currency Noncurrent Nonmonetary Temporal Current Rate DM3 TO DM2 $1,050 = $1 $1,050 $1,050 $1,050 Cash 2,100 DM Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity 1,500 DM 3,000 DM 6,600 DM 1,200 DM $750 $1,000 $2,800 $600 $500 $1,000 $2,550 $600 $900 $1,000 $2,950 $600 $750 $1,500 $3,300 $600 1,800 DM $600 $900 $900 $900 2,700 DM 900 DM -------6,600 DM $900 $700 -------$2,800 spot rate $900 $150 -------$2,550 $900 $550 -------$2,950 $900 $360 $540 $3,300 INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 35
  • HOW VARIOUS TRANSLATION METHODS Balance Sheet WITH A CHANGE FROM Local Current/ Monetary/ DEAL Currency Noncurrent Nonmonetary Temporal Current Rate DM3 TO DM2 $1,050 = $1 $1,050 $1,050 $1,050 Cash 2,100 DM Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity 1,500 DM 3,000 DM 6,600 DM 1,200 DM $750 $1,000 $2,800 $600 $500 $1,000 $2,550 $600 $900 $1,000 $2,950 $600 $750 $1,500 $3,300 $600 1,800 DM $600 $900 $900 $900 2,700 DM 900 DM -------6,600 DM $900 $700 -------$2,800 $900 $150 -------$2,550 $900 $550 -------$2,950 $900 $360 $540 $3,300 historical rate spot rate INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 36
  • HOW VARIOUS TRANSLATION METHODS Balance Sheet WITH A CHANGE FROM Local Current/ Monetary/ DEAL Currency Noncurrent Nonmonetary Temporal Current Rate DM3 TO DM2 $1,050 = $1 $1,050 $1,050 $1,050 Cash 2,100 DM Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity 1,500 DM 3,000 DM 6,600 DM 1,200 DM $750 $1,000 $2,800 $600 $500 $1,000 $2,550 $600 $900 $1,000 $2,950 $600 $750 $1,500 $3,300 $600 1,800 DM $600 $900 $900 $900 2,700 DM 900 DM -------6,600 DM $900 $700 -------$2,800 $900 $150 -------$2,550 $900 $550 -------$2,950 $900 $360 $540 $3,300 historical rate INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 37
  • HOW VARIOUS TRANSLATION METHODS Balance Sheet WITH A CHANGE FROM Local Current/ Monetary/ DEAL Currency Noncurrent Nonmonetary Temporal Current Rate DM3 TO DM2 $1,050 = $1 $1,050 $1,050 $1,050 Cash 2,100 DM Inventory Net fixed assets Total Assets Current liabilities Long-Term debt Common stock Retained earnings earnings CTA Total Liabilities and Equity 1,500 DM 3,000 DM 6,600 DM 1,200 DM $750 $1,000 $2,800 $600 $500 $1,000 $2,550 $600 $900 $1,000 $2,950 $600 $750 $1,500 $3,300 $600 1,800 DM $600 $900 $900 $900 2,700 DM 900 DM -------6,600 DM $900 $700 -------$2,800 $900 $150 -------$2,550 $900 $550 -------$2,950 $900 $360 $540 $3,300 From income statement INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 38
  • HOW VARIOUS TRANSLATION METHODS Balance Sheet WITH A CHANGE FROM Local Current/ Monetary/ DEAL Currency Noncurrent Nonmonetary Temporal Current Rate DM3 TO DM2 $1,050 = $1 $1,050 $1,050 $1,050 Cash 2,100 DM Inventory 1,500 DM $750 $500 $900 $750 Net fixed assets 3,000 DM $1,000 $1,000 $1,000 $1,500 Total Assets 6,600 DM $2,800 $2,550 $2,950 $3,300 Current 1,200 DM $600 $600 $600 $600 liabilities Long-Term 1,800 DM $600 $900 $900 $900 debt Common stock 2,700 DM $900 $900 $900 $900 Retained earnings 900 DM $700 $150 $550 $360 earnings CTA ----------------------------$540 Total 6,600 DM $2,800 $2,550 $2,950 $3,300 Liabilities and Under the current rate method, a “plug” equity account named INTERNATIONAL FINANCE PRESENTATION Equity cumulative translation adjustment makes the balance sheet balance. | HISHAM AHMED RIZVI | 39 HISHAM.RZV@GMAIL.COM
  • TRANSLATION • Introduction & example EXPOSURE • Methods • Strategies to manage translational exposure INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 40
  • MANAGING TRANSLATION EXPOSURE: • Two common methods used for managing translation exposure are BALANCE SHEET HEDGE called balance sheet hedge and derivates hedge. Making an investment to reduce or control risk. HEDGE Investors use this strategy when they are unsure of what the market will do. • In simple language, a hedge is used to reduce any substantial losses/gains. A hedge can be constructed from many types of financial instruments, including stocks, derivative products, futures contracts etc. It involves equating the amount of exposed assets in an BALANCE exposure currency to exposed liabilities in that currency, SHEET HEDGE so that the net exposure is zero. • To create a balance sheet hedge, once transaction exposure has been controlled, often means creating new transaction exposure. Hence this is not always a very wise option. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 41
  • MANAGING TRANSLATION EXPOSURE: A derivative is a DERIVATIVESfinancial ofcontract which such as an HEDGE derives its DERIVATIVES value from the performance another entity asset, index, or interest rate, called the "underlying". • Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another. • For example, a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future. • Both parties have reduced a future risk: for the wheat farmer, the uncertainty of the price, and for the miller, the availability of wheat. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 42
  • SHOULD FIRMS HEDGE TRANSLATION EXPOSURE? YES NO - Investors don’t have - The value of the firm is enough information to the PV of cash flows. estimate cash flows and - Translation exposure instead must rely on doesn’t effect cash flows, reported earnings. so we should ignore it. - If reported earnings are distorted by translation issues, investors will misvalue the firm. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 43
  • TRANSACTION • Introduction & example EXPOSURE • Strategies to manage transaction exposure INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 44
  • TRANSACTION EXPOSURE The risk, faced by companies involved in international TRANSACTION trade, that currency exchange rates will change after the EXPOSURE companies have already entered into financial obligations. • It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency. • Transaction exposure is short term in nature. • It has a direct impact on cash flows of a firm. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 45
  • TRANSACTION EXPOSURE: EXAMPLES • A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future; • A currency has to be converted to repay a loan or make an interest payment on a particular date in future; • A currency has to converted to make a dividend payment, royalty payment etc. whose foreign currency amount is fixed. For e.g. suppose a firm receives an export order. It fixes a price, manufactures the product, makes the shipment and gives 90 days credit to the buyer who will pay in his currency. Then, the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 46
  • TRANSACTION EXPOSURE: EXAMPLES Suppose a U.S. firm, Trident, sells merchandise on account to a Belgian buyer for €1,800,000 payment to be made in 60 days. (S0 = $0.90/€) The U.S. seller expects to exchange the €1,800,000 for $1,620,000 when payment is received. • Transaction exposure arises because of the risk that the U.S. seller will receive something other than $1,620,000. • If the euro weakens to $0.8500/€, then Trident will receive $1,530,000 • If the euro strengthens to $0.9600/€, then Trident will receive $1,728,000 • Thus, exposure is the chance of either a loss or a gain. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 47
  • TRANSACTION • Introduction & example EXPOSURE • Strategies to manage transaction exposure INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 48
  • MANAGING TRANSACTION EXPOSURE Strategies Contractual Hedges Forward Market Hedge Financial Hedges Swaps Operating Strategies Risk Shifting Money Market Hedge Price adjustment clauses Options Market Hedge Exposure Netting Futures Market Hedge Risk Sharing INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 49
  • MANAGING TRANSACTION EXPOSURE: FORWARD MARKET An over-the-counter marketplace that sets the price of a HEDGE instrument or asset for future delivery. FORWARD financial MARKET Contracts entered into in the forward market are binding on the parties involved. • If you are going to owe a foreign currency on future, agree to buy the foreign currency now by entering into long position in a forward contract. • If you are going to receive a foreign currency on future, agree to sell the foreign currency now by entering into short position in a forward The buying of a security such as a stock, commodity or currency, with contract. the expectation that the asset will rise in value is called long position. The sale of a borrowed security, commodity or currency with the expectation that the asset will fall in value is called short position. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 50
  • MANAGING TRANSACTION EXPOSURE: FORWARD MARKET EXAMPLE: You are a US importer of British woolens and you have just HEDGEinventory. Payment of £100M is due in one year. How ordered next year’s can you fix the cash outflow in dollars? Answer: One way is to put yourself in a position that delivers £100M in one year – a long forward contract on the pound. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 51
  • MANAGING TRANSACTION EXPOSURE: FORWARD MARKET HEDGE INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 52
  • MANAGING TRANSACTION EXPOSURE: FORWARD MARKET HEDGE INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 53
  • MANAGING TRANSACTION EXPOSURE: •MONEY currency payable, buy the foreign currency today To hedge a foreign MARKET HEDGE &hold it. 1. Buy the present value of the foreign currency payable today 2. Invest that amount at the foreign rate 3. At maturity your investment will have grown enough to cover for your foreign currency payable. A US based importer of Italian bicycles. What can he do in this situation? • In one year owes €100,000 to an Italian supplier • The spot exchange rate is $1.25 = €1.00 • The one year interest rate in Italy is 4% Can hedge this payable by buying €96,153.85 = €100,000/(1.04) today and investing it at 4% in Italy for one year. At maturity he will have €100,000 = €96,153.85*(1.04) INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 54
  • MANAGING TRANSACTION EXPOSURE: A US based importer of Italian bicycles. What can he do in this MONEY MARKET HEDGE situation? • In one year owes €100,000 to an Italian supplier • The spot exchange rate is $1.25 = €1.00 • The one year interest rate in Italy is 4% INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 55
  • MANAGING TRANSACTION EXPOSURE: OPTIONS isMARKET buyer the right, but An option a contract that gives the OPTIONS not buy HEDGEthe obligation,ortobeforeora sell an underlying asset at a specific price on certain date. • To hedge a foreign currency payable buy calls on the currency. • If the call currency appreciates, your call option lets you buy the currency at the exercise price of the call. • To hedge a foreign currency receivable buy puts on the currency • If the currency depreciates, your put options lets you sell the Two types of options are: currency for the exercise price. • A call gives the holder the right to buy an asset at a certain price within a specific period of time. • A put gives the holder the right to sell an asset at a certain price within a specific period of time. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 56
  • MANAGING TRANSACTION EXPOSURE: OPTIONS MARKET HEDGE INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 57
  • MANAGING TRANSACTION EXPOSURE: OPTIONS MARKET HEDGE INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 58
  • MANAGING TRANSACTION EXPOSURE: OPTIONS MARKET HEDGE INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 59
  • MANAGING TRANSACTION EXPOSURE: OPTIONS MARKET HEDGE INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 60
  • MANAGING TRANSACTION EXPOSURE: OPTIONS MARKET HEDGE INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 61
  • MANAGING TRANSACTION EXPOSURE: FUTUREScontract is as an arrangement between two MARKET A futures FUTURES parties to an asset HEDGE for abuy or sell price. at a particular time in the CONTRACT future particular • Futures contracts are one of the most common derivatives used to hedge risk. The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price. • When a company knows that it will be making a purchase in the future for a particular item, it should take a long position in a futures contract to hedge its position. • If a company knows that it will be selling a certain item, it should take a short position in a futures contract to hedge its position. • Futures market hedge is similar to hedging with forwards INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 62
  • MANAGING TRANSACTION EXPOSURE: OPERATING STRATEGIES • Strategy for risk shifting Risk Shifting • Denominating exports in a strong currency. • Denominating imports in a weak currency. • Outcome depends on: • Bargaining power or parties involved. • Competitiveness of firm’s particular business Exposure Netting • Offsetting exposures in one currency with exposures in the same or another currency, when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure. • A firm’s currency exposures can be viewed as a portfolio. • Exposure netting depends on the correlation between currencies. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 63
  • MANAGING TRANSACTION EXPOSURE: OPERATING Risk Sharing STRATEGIES • Both parties reach agreement to share the currency risk associated with a deal. • Risk sharing arrangements • Price adjustment clause • Neutral zone • Outside neutral Currency Collarszone • Providing protection if the currency moves outside an agreed-on range. This agreement is arrived on both parties at the time of the financial deal. Leading and Lagging • leading (accelerate timing of depreciating currency) • lagging (delay timing of appreciating currency) INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 64
  • OPERATING • Introduction & example EXPOSURE • Strategies to manage operating exposure INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 65
  • OPERATING EXPOSURE OPERATING EXPOSURE Operating exposure, also called economic exposure, competitive exposure, and even strategic exposure on occasion, measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates. • Measuring the operating exposure of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposures of all the firm’s competitors and potential competitors worldwide. • Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 66
  • ATTRIBUTES OF OPERATING EXPOSURE • The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows. • Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables, rent and lease payments, royalty and license fees and assorted management fees. • Financing cash flows are payments for loans (principal and interest), equity injections and dividends of an inter and intracompany nature. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 67
  • FINANCIAL & OPERATING CASH FLOWS BETWEEN PARENT & SUBSIDIARY INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 68
  • MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firm’s expected cash flows at four levels, depending on the time horizon used:  Short run  Medium run: Equilibrium case  Medium run: Disequilibrium case  Long run INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 69
  • MEASURING THE IMPACT OF OPERATING EXPOSURE SHORT RUN IMPACT • The first level impact is on the one-year operating budget; the gain or loss depends on the currency of denomination (currency of expected cash flows) • In the short run, it is difficult to change the exposure due to implied obligations, such as purchase or sales commitments, because the currency of denomination cannot be changed. • It is also difficult to change sales prices or to renegotiate factor costs INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 70
  • MEASURING THE IMPACT OF OPERATING EXPOSURE MEDIUM RUN – PARITY CONDITIONS HOLD • The second level impact is on expected medium-term cash flows. • If parity conditions hold, the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows, if no real variables have changed. • The country of cash flow origination and its monetary, fiscal, and balance of payments policies will determine whether firms can adjust prices and costs. • Example: If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises, Volvo will be protected if it can raise its DM prices, so that the Krona price is maintained. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 71
  • MEASURING THE IMPACT OF OPERATING EXPOSURE MEDIUM RUN – CHANGE IN REAL VARIABLES • If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes, so that relative prices have been altered. • Example: If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden, the wealth of German investors has dropped, the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately. There is less than perfect pass-through. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 72
  • MEASURING THE IMPACT OF OPERATING EXPOSURE LONG RUN • Long-run cash flows beyond five years could be affected. Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected. • In principle, all firms subject to international competition, domestic or multinational, are subject to foreign exchange operating exposure in the long run, whenever real variables are affected. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 73
  • OPERATING EXPOSURE: AN EXAMPLE INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 74
  • OPERATING • Introduction & example EXPOSURE • Strategies to manage operating exposure INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 75
  • MANAGEMENT OF OPERATING EXPOSURE: STRATEGIC •DIVERSIFICATION The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows, rather than merely hoping for the best. • To meet this objective, management can diversify the firm’s operating and financing base. • Management can also change the firm’s operating and financing policies. • If a firm’s operations are diversified internationally, management is prepositioned both to recognize disequilibrium when it occurs and to react competitively. • Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 76
  • MANAGEMENT OF OPERATING EXPOSURE: STRATEGIC • If a firm’s financing sources are diversified, it will be prepositioned to DIVERSIFICATION international Fisher take advantage of temporary deviations from the effect. • However, to switch financing sources a firm must already be wellknown in the international investment community. • Again, this would not be an option for a domestic firm (if it has limited its financing to one capital EFFECT: INTERNATIONAL FISHERmarket). An economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. Calculated as: "E" represents the % change in the exchange rate "i1" represents country A's interest rate "i2" represents country B's interest rate FINANCE PRESENTATION INTERNATIONAL | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 77
  • MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures. The four most commonly employed proactive policies are:  Matching currency cash flows  Risk-sharing agreements  Back-to-back or parallel loans  Currency swaps INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 78
  • MANAGEMENT OF OPERATING EXPOSURE: MATCHING CURRENCY CASH-FLOWS EXAMPLE: A US firm has continuing export sales to Canada. In order to compete effectively in Canadian markets, the firm invoices all export sales in Canadian dollars. This policy results in a continuing receipt of Canadian dollars month after month. This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 79
  • MANAGEMENT OF OPERATING EXPOSURE: MATCHING CURRENCY CASH-FLOWS Exposure: The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollars Hedge: The Canadian dollar debt payments act as a financial hedge by requiring debt service, an outflow of Canadian dollars INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 80
  • MANAGEMENT OF OPERATING EXPOSURE: MATCHING CURRENCY CASH-FLOWS  One way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching).  Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms.  In addition, the company could engage in currency switching, in which the company would pay foreign suppliers with Canadian dollars. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 81
  • MANAGEMENT OF OPERATING EXPOSURE: RISK SHARING AGREEMENTS Currency Clauses: Risk-Sharing  An alternate method for managing a long-term cash flow exposure between firms is risk sharing.  This is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments between them.  This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 82
  • MANAGEMENT OF OPERATING EXPOSURE: BACK TO BACK LOANS Back-to-Back Loans:  A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two business firms in separate countries arrange to borrow each other’s currency for a specific period of time.  At an agreed terminal date they return the borrowed currencies.  Such a swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 83
  • MANAGEMENT OF OPERATING EXPOSURE: BACK TO BACK LOANS The back-to-back loan provides a method for parent-subsidiary crossborder financing without incurring direct currency exposure. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 84
  • MANAGEMENT OF OPERATING EXPOSURE: BACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan:  It is difficult for a firm to find a partner, termed a counterparty for the currency amount and timing desired.  A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity – although each party has 100% collateral (denominated in a different currency). INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 85
  • MANAGEMENT OF OPERATING EXPOSURE: CURRENCY SWAPS Currency Swaps:  A currency swap resembles a back-to-back loan except that it does not appear on a firm’s balance sheet.  In a currency swap, a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time. For Example: A Japanese corporation and U.S. corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt. INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 86
  • MANAGEMENT OF OPERATING EXPOSURE: CURRENCY SWAPS INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 87
  • MANAGEMENT OF OPERATING EXPOSURE: OTHER STRATEGIES • Use of Marketing Strategies • Market Selection • Pricing Strategy/Product Strategy • Promotional Strategy • Use of Production Management • Input mix • Plant Location & Shifting production among plants • Raising Productivity (i.e. lowering costs) • Financial Hedging techniques may also be used INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 88
  • THANK YOU ARUSHI SHARMA | arushi.sharma888@gmail.com DIVIK GIRDHAR | divikgirdhar@gmail.com DIVYA GUPTA | gupta.divya2310@gmail.com INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAM.RZV@GMAIL.COM 89