INTERNATIONAL FINANCIAL MANAGEMENT
CHAPTER 1: INTRODUCTION TO INTERNATIONAL FINANCE
International finance is the economic interaction among different nations that studies the dynamics of:
- Exchange rates
- Global financial system
- Foreign investment
And how these affect the international trade.
Role of a finance manager is to acquire funds at appropriate time, at minimum costs and deploy the funds to get maximum returns with minimum risks. With the objective to increase the wealth of the shareholders.
Sources of raising funds
- IMF (International Monetary Fund)
- Monitors balance of payments (BOP – accounting record of all monetary transactions between a country and rest of the world).
- Plays a role of lender of last resort for countries facing financial crisis.
- WORLD BANK
- Funds the development of projects (mainly developing countries)
- CREDIT RATING AGENCIES
- Assigns credit which rate the debtor’s ability to pay back the debt by making timely interest payments and likelihood of default.
- E.g. Standard and poor, MOODY’s, FITCH
- AAA (highest credit quality – lowest default risk)
- Exceptionally strong capacity for payments of financial commitments
- Unlikely to be affected adversely by foreseeable events
- AA (very high credit quality – very low default risk)
- Very strong capacity for payments of financial commitments
- Not significantly affected adversely by foreseeable events
- A (high credit quality – low default risk)
- Strong capacity for payments of financial commitments
- Vulnerable to be affected adversely by foreseeable events
- BBB (good credit quality – currently low default risk)
- BB (speculative – vulnerable to default risk)
- B (highly speculative – default risk present)
- CCC (substantial – default possible)
- CC (high risk – default probable)
- C (very high risk – default inevitable)
International Financial Market
FOREX MARKET (FX / Currency Market)
Decentralised over-the-counter financial market for trading currencies
Bond issued in currency other than currency of country in which its issues.
EURO CURRENCY MARKET
Eurobanks accept deposits and provide loans in various currencies
Negotiable certificate representing no. of shares in foreign stock
ADR – American Depository Receipts
GDR – Global Depository Receipts
FCCB (Foreign Currency Convertible Bonds)
Convertible bonds – mix of debt and equity – allows bonds to be converted to stock.
2 types of markets in international finance:
- Rate of exchange of currency
- Buy / Sell rate
- SPOT / Forward rate
- Rate of interest (annualized %)
- Function of demand and supply of money
- Higher demand = higher interest rate
- Higher supply = lower interest rate
- Bid rate – bank pays interest to depositors
- Offer rate – bank recovers from depositors
E.g. Bank of India has quoted interest rate as 4.00/10.00 p.a. (per annum).
- is the Bid rate – bank pays to depositors
10.00 is the Offer rate – bank recovers from borrowers.
Bank has 2 major functions of accepting deposits (bank pays interest to customer) and lending loans (customer pays interest to bank).
Net Interest Income (NIA) of the bank is difference between the 2 rates of interest (Spread margin).
Role of Information Technology in financial integration and globalization
Technology has enabled software experts to work together from around the world.
- Fewer trade and investment restrictions
- Lower tariffs
- Lower transport and communication costs
- Growth in FDI (foreign direct investment)
- Mergers and acquisitions
- Business Process Outsourcing (BRO)
- Importance of World Trade Organizations (WTO)
IT is an important catalyst for transforming business, society and government. The world is shifting from manufacturing based industrial economy to service dominated and network based knowledge economy.
It is no longer necessary for providers and users to be physically close to each other. To be a multi-national company in the past, one had to be huge. One needed offices around the world to handle not only the corporate affairs but also local laws, customs, government functionaries and distribution of products. Today people in different locations can form a virtual company and access the global market.
Investing in funds of foreign countries
- To meet requirements of foreign currency for import/ export/ expansion …
- To lower cost of capital as international resources are likely to be cheaper than in India
- Fund provider and borrower are directly connected (long-term financing)
- Financial intermediary (bank) functions as fund supplier to borrower
- Simple and predictable process
Issues in overseas funding
- Financing can be in any currency - prevent forex risk by choosing right currency
- Consider market arbitrage
- Interest rate
- Interest rates in each country need to be reviewed – fixed / variable
- Maturity can depend on:
- Forecast cash balance
- Funding conditions
- Up-front fees
- Agent fees
- Legal costs
- Registration fees
- Rating fees
- Commitment fees
- Stamp duty
- Local taxes
- Debt-Equity ratio
- Convertible bonds can improve financial structure by partially recognizing as equity
- Funding stability
- Necessary amount can be funded at time when the company wants
- Funding diversification
- Multiple financial institutions
- Fewer deal participants = more confidential, deal structure stable and commitment from institutions
- Legal matters should be reviewed beforehand
- Approved and discussed with related government bodies
- Consider private contract rather than standard one to receive better terms
- Capital markets development
- Liquidity / price discovery / market situation
Risk of investing or lending in a country. Arises from changes in business environment which may affect profits or value of assets in a country.
- Economic risk
- Political risk
- Social risk
- Financial risk
Country risk analysis is assessment of potential risks and rewards from doing business in a country.
- Used to monitor countries where the fim is presently engaged in international business
- Used by the firm as a screening device to avoid countries with excessive risk
- Used to assess risk for a proposed project in a foreign country
Techniques of risk analysis:
- Weigh and rate all factors to produce overall assessment
- Collect independent opinions and average and measure their dispersion
- Quantitative analysis
- Regression analysis on historic data to asses sensitivity of business to various factors
- Inspection visits
- Travel to country and meet with officials/ executives/ consumers to clarify uncertainties
Purchasing Power Parity (PPP)
Demand for a country’s currency is derived from demand for the goods that the country produced.
- So the exchange rate of a currency depends on demand of goods produced in that country.
- If prices of goods are lower than other countries, exchange rate will be high
Relative PPP: S = P1 / P2
- S = exchange rate of currency 1 to currency 2
- P1 = cost of good ‘x’ in currency 1
- P2 = cost of good ‘x’ in currency 2
Forex traders may use PPP to find overvalued or undervalued currencies.
Investors may use PPP to predict the impact of exchange-rate fluctuations on a country's economy, and thus the impact on their investment.
GDP paired with PPP
- Suppose a shirt costs - $10 in the U.S., and €8.00 in Germany.
- Convert € to $, the shirt costs $15 in Germany
- PPP = 15/10 = 1.5.
- i.e. for every $1 spent on the shirt in the U.S., it takes $1.50 to obtain the same shirt in Germany buying it with the euro.
- Goods that are unavailable locally must be imported, resulting in transport costs.
- These costs include not only fuel but import duties as well.
- Imported goods will consequently sell at a relatively higher price than do identical locally sourced goods.
- Government sales tax VAT (value added tax) can spike prices in one country relative to another
- Insurance, utility costs, labour costs
- Goods may be deliberately priced higher for competitive advantage
CHAPTER 2: FOREIGN EXCHANGE MARKETS
Foreign exchange market is the market in which foreign currencies are bought and sold.
Exchange rate forecasting
It means to estimate the rate of currency at a future date.
It’s useful for:
- Hedging decisions
- Short-term financing
- Short-term investment
- Capital budgeting
- Long-term financing
Factors affecting exchange rates
- Inflation rates
- Low inflation = appreciating currency
- High inflation = depreciating currency and high interest rates
- Interest rates
- High interest rate = higher rate to lender, so attracts foreign capital = currency appreciates
- Balance of Payments (BOP)
- Deficit in current account can cause depreciation
- Spending more on imports than its earning on exports
- Government debt
- Terms of trade
- Appreciates if exports rise at a greater rate than imports – high revenue = higher demand for that country’s currency
- Political stability and performance
- Less risk attracts foreign capital = appreciation of currency
- Interest rates fall = less foreign capital = depreciation
- If value is expected to rise, demand will increase = appreciation
Functions of foreign exchange market
- Transfer function
- Conversion of one currency to another
- Credit function
- Provide credit, both national and international, to promote foreign trade
- Hedging function
- Avoid forex risk – forward contract, bills of exchange, bank draft, letter of credit etc.
- OPEN position (RISKY)
- LONG – one who has the underlying assets (exporter)
- SHORT – one who wants the underlying assets (importers)
- SQUARE position (SAFE)
- Exporters go from long position to square position in forex by entering into forward contract with bank
- Fixed stream
- Rate of interest remains same throughout the tenure of the deposit/ loan.
- Floating stream
- Changes from time to time depending upon market conditions
- Rate of interest in a combination of a benchmark rate (e.g. MCLR) and spread.
Exchange rate systems
- Fixed exchange rate system
- Exchange rates between home currency and all foreign currencies are fixed by central bank of the country.
- Other players in the market do not have any scope to modify the rates.
- This system is generally associated with the countries having shortage of forex reserves.
- The rates are fixed in such a way to encourage inflow of forex and discourage outflow of forex.
- Floating exchange rate system
- Exchange rates between home currency and various foreign currencies are determined by market forces i.e. demand for/ supply of a currency in forex market.
- Higher the demand, stronger the currency
- Higher the supply, weaker the currency.
- Exchange rates are determined exclusively by market forces
- This system is generally associated with developed countries
Managed float system
- Exchange rates on day to day basis are determined by market forces.
- In-case the home currency either appreciates or depreciates beyond a particular band, then the central bank (RBI in India) intervenes in forex market to manage the rates.
- At present, in India, this system is being followed.
- Pegged exchange rate system: (Peg means a fixed measure)
- No. of units of home currency are fixed/pegged to 1 unit of one of the internationally recognized currency ($/Pound/Euro/Yen).
In respect of China
Pegged currency $ 1 = Yuan 8 Home currency
Pound, Euro and Yen are the third currency of China.
- However the rate between home currency and foreign currency is determined on the basis of rate between home currency and pegged currency prevailing in local market and rate between pegged currency and third currency prevailing in international market.
If Pound 1 = $ 2, Then Pound 1 = 16 Yuan
If Pound 1 = $ 3, Then Pound 1 = 24 Yuan
- The drawback of this system is that the performance of home currency depends upon the performance of pegged currency in international market.
Exposure: being affected by something because of being in a particular situation or place
International exposure: being affected by something because of undertaking cross-border transaction
- Movement of goods (trade)
- Geographically, no country is self-sufficient. E.g. Japan is richest in world but they would be deprived of oil and petroleum products without international trade.
- Theory of absolute advantage
- Developed countries will have absolute advantage over underdeveloped countries in terms of capital requirements.
- Vice Versa Underdeveloped countries will have absolute advantage over developed countries in terms of labour requirements.
- Theory of comparative advantage
- Silk products and PC’s can be produced by both USA and India. But India has advantage in silk because of climate conditions and USA has advantage in technology.
- Movement of people
- Higher studies
- Medical treatment
- Movement of knowledge (technology)
To undertake R&D activities and technology upgradation (funded in developed countries).
- Consultancy services
- Software exports
- BPO (Business process outsourcing)
- KPO (Knowledge process outsourcing)
- Movement of funds (Capital)
- There are capital rich countries (developed) and capital starved countries (underdeveloped).
- Funds will move from capital rich countries to capital starved countries.
- High returns will be offered by developing countries (capital starved countries).
- So developed countries will invest in capital starved countries for higher returns.
- FDI (Foreign Direct Investment)
- FPI (Foreign Portfolio Investment)
- NRI (Non-Resident Indian Investments)
Investors can be of 2 types – Indian origin and foreign origin.
- Indian – Resident and Non-resident Indians
- Foreign – FDI or FPI
Foreign investment has a parent country (country where the investor resides) and a host country (country which receives investment).
Foreign Direct Investment (FDI)
- Investment results in creation of physical assets in host country
- FDI is quite stable in host country (long-term investment).
E.g. Suzuki from Japan has invested in Maruti from India. This investment is for physical assets (cars manufacturing). So it is an FDI.
Foreign Portfolio Investment (FPI)
- Investment results in creation of monetary assets in host country
- FPI is volatile in nature because the investors will take away the investments at a short notice.
E.g. JP Morgan USA has invested in stock market in India. This investment is for monetary assets (cars manufacturing). So it is an FDI.
As far as host country is concerned, FDI is preferable than FPI because it is more stable.
Type of international exchange exposures / risks
- Transaction exposure
- Inflow or outflow of foreign currency: changes in exchange rates between date of contract and actual date of transaction
- Company may incur a loss or make a gain
- Translation exposure
- Gain or loss arising from conversion of financial statements for subsidiary located in another country
- Companies in India are required to revalue their foreign currency assets and foreign currency liabilities on the date of closure of books of accounts, at the rate prevailing in the market on that day.
- In doing so, the company may incur a loss or make a gain. This is called as translation exposure.
- The exercise of revaluation (a.k.a. mark-to-market) is compulsory for banks and companies in India to display exact financial position to the stakeholders and prospective investors.
- Translation exposure is more relevant in respect of multinational companies at the time of compilation of balance sheet by the parent company.
- Economic / operational exposure
- Long term effect of forex transaction exposure
- Companies in India which are dealing exclusively in domestic market also have an exposure due to fluctuation of exchange rates because their competitors (dealing in international market) may change their price depending upon changes in exchange rates.
- This will force the companies dealing exclusively in domestic market to change the selling price, which will affect operating income of both companies. This is known as economic exposure.
Minimize economic exposure
1) By carefully selecting production sites with a mind for lowering costs
2) Flexible sourcing in its supply chain management
3) Diversifying its export market across a greater number of countries,
Managing exchange risks
- Forward contracts
- Commitment to buy / sell a specific amount of foreign currency at a later date or within a specific period of time at an exchange rate specified when the transaction is struck
- If forward price > spot rate = forward premium
- If forward price < sport rate = forward discount
- % premium/discount = [(forward rate - spot rate)/spot rate] * 360/no. of days under forward contract
Disadvantages / drawbacks
- The company can’t take advantage of a favourable spot rate prevailing in market on the date of transaction
- Even if the underlying trade transaction gets cancelled, the company must honour the forward contract entered with the bank, which may result in a loss to the company
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