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  1. 1. MF0006 INTERNATIONAL FINANCIAL MANAGEMENT 1. Explain the three types of foreign exchange exposures. (10 Marks) Answer: Foreign Exchange Exposures: According to Alan C. Shapiro the concept of exposures is referring to “the degree to which a company is affected by exchange rate changes”. This means that if a company through business with companies in foreign countries they are exposed for different types of exposures. There are different ways to measure the exposure as well as there are different exposures that a company can be affected by. The exposures the authors will look further into are; the transaction exposure, operation exposure and economic exposure. The first two exposures, transaction exposure and operating exposure together form economic exposure. 1. Transaction exposure When a company have made a transaction where an uncertainty concerning the real value appears it is called currency exposure. This appears when a company makes payments in one currency today and receives payments in another currency in the future. The insecurity of which the true value of the received payments in the future and whether they will cover the payments the company already made represents the transaction exposure. In order to deal with and try to reduce the risks of transaction externally when a company has a cash flow of foreign currency, the company can use certain derivative instruments. Transaction exposure is a result from transactions generating either cash inflows or outflows and that have a future that is bound in a contract. As the exchange rates continuously change the value of the transactions when they settle will be different from the value of the transactions now, leading to either losses or gains. Page 1 of 8
  2. 2. MF0006 INTERNATIONAL FINANCIAL MANAGEMENT 2. Operation exposure Operating costs measures to which extent fluctuations in currencies can alter future operation cash flows of a company, meaning the revenues and costs in the future. All companies whose revenues are affected by changes in currencies have operation exposure, even if their operations are denominated to its home currency. Transaction exposure and operation exposure together is called economic exposure. Economic exposure means how the value of a company, measured by the value of expected cash flows today, changes when the exchange rates changes. 3. Translation or Economic or Accounting exposure Accounting exposure, also called translation exposure, comes from the need to convert the financial statements of a foreign operation from the currency local to the foreign operation to the home currency. This is done for the purpose of reporting and consolidation. If the exchange rate of the foreign currency change from one reporting period to another the translation of those assets will result in wither foreign exchange rate losses or gains. Page 2 of 8
  3. 3. MF0006 INTERNATIONAL FINANCIAL MANAGEMENT 2. Write short notes on: a. SWIFT b. CURRENCY SWAPS c. NETTING d. PIP e. INTERNATIONAL FISHER EFFECT Answer: a. SWIFT: The Society for Worldwide Interbank Financial Telecommunication (quot;SWIFTquot;) operates a worldwide financial messaging network which exchanges messages between banks and other financial institutions. SWIFT also markets software and services to financial institutions, much of it for use on the SWIFTNet Network, and ISO 9362 bank identifier codes (BICs) are popularly known as quot;SWIFT codesquot;. The majority of international interbank messages use the SWIFT network. As of November 2008, SWIFT linked 8,740 financial institutions in 209 countries. SWIFT transports financial messages in a highly secure way, but does not hold accounts for its members and does not perform any form of clearing or settlement. SWIFT is a cooperative society under Belgian law and it is owned by its member financial institutions. SWIFT has offices around the world. SWIFT headquarters are located in La Hulpe, Belgium, near Brussels. Averages of 2.4 million messages, with aggregate value of $2 trillion, were processed by SWIFT per day in 1995. It was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to establish common for financial transactions and a shared data processing system and worldwide communications network. Page 3 of 8
  4. 4. MF0006 INTERNATIONAL FINANCIAL MANAGEMENT b. CURRENCY SWAPS A swap is an agreement between two companies to exchange a specific amount of foreign currency. In which the currencies are returned at a specified date in the future. An interest rate swap is regularly used in combination with a currency swap. The second tool that a company can apply to decrease the risks of transaction exposure with foreign currencies is swaps. This tool is applied when two companies exchange interest and installments on foreign loans to insure that the principal amounts are exchanged back. c. NETTING: Internal currency risk management strategies are an instrument used when companies aspiration to minimize the currency risk within the corporate group itself. The internal hedging techniques use characteristics of the company’s trading relationships without recourse to the external currency or money markets and therefore are usually simple in theory and operation. The strategy of netting applies when the company and its foreign subsidiaries net off intra-organizational currency flows at the end of every period, leaving only the balance exposed to risk and hence in need of hedging. Netting is a tool for diminishing the number of transactions taking place internally in a group. An example is the one of A owing 10 to B and B owing 3 to A. While there should be two transactions taking place, Bs obligation towards A is netted and as the only transaction, A should pay B 7. Within a corporate group, internal cash flows are often processed locally by each unit leading to high costs for payments and currency management. Netting provides an instrument to make your payments more cost effective by reducing the number of payments and thus leading to greater efficiency. In general netting indicates to allow a positive value and a negative value to set- off and partially or entirely cancel each other out. Netting provides a common platform for all receivables between the various units of a group to regularly settle via a netting centre. All units participating in the netting process report their intra-group transactions to the netting centre. At the end of the netting cycle, each unit either pays or receives an amount in its domestic currency. Page 4 of 8
  5. 5. MF0006 INTERNATIONAL FINANCIAL MANAGEMENT d. PIP: In the foreign exchange market, prices are always quoted using five numbers (for example, JPY 134.85 / USD), the final digit of which is referred to as a point or a pip. A pip is the smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point- for most pairs this is the equivalent of 1/100th of one percent, or one basis point. For example, the smallest move the USD/CAD currency pair can make is $0.0001, or one basis point. The smallest move in a currency does not always need to be equal to one basis point, but this is generally the case with most currency pairs. e. International Fisher Effect: The international Fisher Effect (IFF) links the Purchasing Power Parity (PPP) and Fisher Effect (FE). If the inflation differential is equal to the interest rate differential then the equation for PPP can be written as: et / eo = (1 + rh) / (1 + rf) This is the equation for IFE. This equation can be approximated by the following equation: et – eo / eo = rh - rf IFE states that the spot rate adjusts to the interest rate differential between two countries. In equilibrium, the expected change in the spot exchange rate should be equal in magnitude but opposite in sign to the interest rate differential. Thus for investors to put money into a lower yielding security, they have to be convinced that they will be equally well off after adjusting for exchange rates. The implication of IFE is that the currency with the lower interest rate is expected to appreciate relative to one with a higher rate. Page 5 of 8
  6. 6. MF0006 INTERNATIONAL FINANCIAL MANAGEMENT CASE STUDY (10MARKS) 3. Foreign Direct Investment and Foreign Portfolio Investments are essential for economic development of any country. Discuss the flow of FDI into India from 2002-07 Also discuss the impact of U.S. economy recession on FDI flow into India. Answer: The inflow of Foreign Direct Investment (FDI) has registered robust growth in the current financial year. As per the latest report of UNCTAD, India surpassed South Korea to become the fourth largest recipient of FDI in the region. During April-September 2006, total FDI inflows (excluding ‘reinvested earnings’ and ‘other capital components’) were Rs.20,155 Crore (US$4.38 billion). Cumulative FDI inflows since August 1991 up to September 2006 were Rs.1,81,566 Crore (US$43.29 billion). Among sectors attracting high cumulative FDIs (Table 7.15), electrical equipments retained the first spot, followed by services and telecommunications. Services and telecommunications dislodged transportation industry to the fourth spot from the second spot held by it last year. An interesting observation is the gradual, steady growth in inward direct investment to India. At USD 5.3 billion in 2004 the numbers are dwarfed by the inflows to China and below FDI in Singapore, Hong Kong (China) and, more recently, Russia, but there may nevertheless be cause for celebration. First and foremost, Indian FDI data are systematically too low because the statistical definitions hitherto in force fail to include several transactions commonly considered as direct investment (e.g. non-cash acquisitions, reinvested earnings of indirectly held investment enterprises and short-term trade credits between related enterprises). India is now altering its measurement of FDI in accordance with internationally standard methodology and is expected soon to produce re-estimates for recent years that will be significantly higher than previously published figures. Secondly, the process of opening India to foreign direct investment started later than in China and certain other developing economies. Less than a decade ago FDI flows into India were paltry, so the levels attracted in 2003 and 2004 represent a major improvement over previous levels. If the national commitment to further economic and regulatory reform remains on track there is no reason why this growth in direct investment should not continue in the coming years. Page 6 of 8
  7. 7. MF0006 INTERNATIONAL FINANCIAL MANAGEMENT A comprehensive review of the FDI policy was undertaken during the current year vide Press Note 4 dated February 10, 2006, to consolidate the liberalization already effected and further rationalize the FDI policy governing various activities. The major policy initiatives taken are: • Change of route: FDI has been allowed up to 100 per cent under the automatic route for distillation and brewing of potable alcohol, manufacture of industrial explosives, manufacture of hazardous chemicals, manufacturing activities located within 25 kms., of the Standard Urban Area limits requiring industrial license under the IDR(Act) 1951, setting up of Greenfield airport projects, laying of natural gas/LNG pipelines, market study and formulation and investment financing in the petroleum sector, and cash and carry wholesale trading and export trading. • Increase in equity caps: FDI caps have been increased to 100 per cent and automatic route extended to coal and lignite mining for captive consumption, setting up of infrastructure relating to marketing in petroleum and natural gas sector and exploration and mining of diamonds and precious stones. • FDI in new activities: FDI has been allowed up to 100 per cent on the automatic route in power trading and processing and warehousing of coffee and rubber. FDI has also been allowed up to 51 per cent for ‘single brand’ product retailing which requires prior approval of Government. Specific guidelines have been issued for governing FDI for ‘single brand’ product retailing. • Removal of restrictive conditions: Mandatory divestment conditions for Business to Business e-commerce have been dispensed with. • Procedural simplification: The transfer of shares from resident to non-resident including acquisition of shares in an existing company has been placed on the automatic route subject to sectoral policy on FDI. Page 7 of 8
  8. 8. MF0006 INTERNATIONAL FINANCIAL MANAGEMENT Deepening global recession impacts India The U.S. is likely to increase further spending on defense and on rebuilding the infrastructure that has been destroyed. This would ultimately create a positive sentiment in an already lethargic American economy. Since Indian markets are increasingly dependent on the U.S. economy and its markets, it is imperative to analyze the impact on US economy which is manifold. ``Consumer spending and confidence which was holding well thus far will receive a severe setback. The U.S. recovery is likely to be delayed,'' stated a report of Tata TD Waterhouse Securities. Other impacts are: Investor sentiment will take a beating and result in further declines in stock markets in the U.S.; money flows in the U.S. could experience a shift towards safer avenues, like, bonds, and away from equities; There could be redemption pressure from U.S. investors which may trigger withdrawal of monies from non-U.S. markets; The U.S. dollar could weaken against the other major currencies following the setback to its safe haven image. Upon closer analysis the Indian economy does not present a very encouraging picture. With continuing demand recession, lower industrial growth, investment slow down and lower export prospects, it is expected that the Indian economy is unlikely to fare much better this fiscal vis-a-vis last fiscal. We believe that the Indian economy is unlikely to grow by more than 5.4 per cent during the current fiscal. Ever since the fall of the stock markets around the globe, Indian authorities were mostly worried about, how to prop up the stock markets. Expecting a positive reaction from the market participants the Government decided to increase the investment limit of foreign funds to the level of foreign direct investment set in various sectors by the Ministry of Industries. Stock prices are falling not because of lack of sentiment boosting measures by the Government. The prices are falling because of several other factors which are affecting the global economy and other events. But the sad fact is that while the government has taken care to address issues concerning the capital market, scant attention has been paid to the economy and pivotal institutions. Further, there is a lack of clarity on the part of Government in formulating policies which have far reaching effects on the economy. It seems the Government is not sure about the fact that a free fall in rupee will affect the sentiments of foreign funds. Page 8 of 8