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INTERNATIONAL FINANCE AND

FOREIGN EXCHANGE

MANAGEMENT

BACKLOG 2011

Assignment Submitted by:

Sushan R. Boloor

PGDM Finance SEM III

Roll No. 52

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1)What is Foreign Exchange Risk and Exposure? Explain the types of

Exposure and how it is managed?

Foreign Exchange Risk:

The risk of an investment's value changing due to changes incurrency exchange rates.

The risk that an investor will have to close out a long or shortposition in a foreign currency at a loss due to an adverse movementin exchange rates. Also known as "currency risk" or "exchange-raterisk".

Probability of loss occurring from an adversemovementin foreignexchange rates.

This risk usually affects businesses that export and/or import, but it can alsoaffect investors making international investments. For example, if moneymust be converted to another currency to make a certain investment, thenany changes in the currency exchange rate will cause that investment'svalue to either decrease or increase when the investment is sold andconverted back into the original currency.

Foreign Exchange Exposure:

The risk of loss stemming from exposure to adverse foreignexchange rate movements.

Foreign exchange risk is related to the variability of the domestic currencyvalues of assets, liabilities or operating income due to unanticipated changesin exchange rates, whereas foreign exchange exposure is what is at risk.Foreign currency exposures and the attendant risk arise whenever acompany has an income or expenditure or an asset or liability in a currencyother than that of the balance-sheet currency. Indeed exposures can ariseeven for companies with no income, expenditure, asset or liability in acurrency different from the balance-sheet currency. When there is acondition prevalent where the exchange rates become extremely volatile theexchange rate movements destabilize the cash flows of a business

significantly. Such destabilization of cash flows that affects the profitability ofthe business is the risk from foreign currency exposures.

Types of Exposure and its Management:

Financial economists distinguish between three types of currency exposures transaction exposures, translation exposures, and economic exposures. All threeaffect the bottom- line of the business.

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a)Transaction ExposureTransaction exposure can be defined as the sensitivity of realized domesticcurrency values of the firms contractual cash flows denominated in foreigncurrencies to unexpected exchange rate changes. Transaction exposure is

sometimes regarded as a short-term economic exposure. Transactionexposure arises from fixed-price contracting in a world where exchange ratesare changing randomly.

Strategy to manage transaction exposure:

Hedging through invoice currencyWhile such financial hedging instruments as forward contract, swap, futureand option contracts are well known, hedging through the choice of invoicecurrency, an operational technique, has not received much attention. Thefirm can shift, share or diversify exchange risk by appropriately choosing the

currency of invoice. Firm can avoid exchange rate risk by invoicing indomestic currency, there by shifting exchange rate risk on buyer. As apractical matter, however, the firm may not be able to use risk shifting orsharing as much as it wishes to for fear of losing sales to competitors. Onlyan exporter with substantial market power can use this approach. Further, ifthe currencies of both the exporter and importer are not suitable for settlinginternational trade, neither party can resort to risk shifting to deal withexchange exposure.

Hedging via lead and lagAnother operational technique the firm can use to reduce transaction

exposure is leading and lagging foreign currency receipts and payments. Tolead means to pay or collect early, where as lag means to pay or collectlate. The firm would like to lead soft currency receivables and lag hardcurrency receivables to avoid the loss from depreciation of the soft currencyand benefit from the appreciation of the hard currency. For the same reason,the firm will attempt to lead the hard currency payables and lag soft currencypayables. To the extent that the firm can effectively implement the Lead/Lagstrategy, the transaction exposure the firm faces can be reduced.

b)Translation Exposure (Accounting Exposures)

Translation exposure is defined as the likely increase or decrease in theparent companys net worth caused by a change in exchange rates since lasttranslation. This arises when an asset or liability is valued at the current rate.No exposure arises in respect of assets/liabilities valued at historical rate, asthey are not affected by exchange rate differences. Translation exposure ismeasured as the net of the foreign currency denominated assets andliabilities valued at current rates of exchange. If exposed assets exceed theexposed liabilities, the concern has a positive or long or asset translation

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exposure, and exposure is equivalent to the net value. If the exposedliabilities exceed the exposed assets and results in negative or short orliabilities translation exposure to the extent of the net difference.

Translation exposure arises from the need to translate foreign currency

assets or liabilities into the home currency for the purpose of finalizing theaccounts for any given period. A typical example of translation exposure isthe treatment of foreign currency borrowings. Consider that a company hasborrowed dollars to finance the import of capital goods worth $10000. Whenthe import materialized the exchange rate was say Rs 30 per dollar. Theimported fixed asset was therefore capitalized in the books of the companyfor Rs 300000.

In the ordinary course and assuming no change in the exchange rate thecompany would have provided depreciation on the asset valued at Rs 300000for finalizing its accounts for the year in which the asset was purchased. If at

the time of finalization of the accounts the exchange rate has moved to sayRs 35 per dollar, the dollar loan has to be translated involving translation lossof Rs50000. The book value of the asset thus becomes 350000 andconsequently higher depreciation has to be provided thus reducing the netprofit.

Thus, Translation loss or gain is measured by the difference between thevalue of assets and liabilities at the historical rate and current rate. Acompany which has a positive exposure will have translation gains if thecurrent rate for the foreign currency is higher than the historic rate. In thesame situation, a company with negative exposure will post translation loss.

The position will be reversed if the currency rate for foreign currency is lesserthan its historic rate of exchange. The translation gain/loss is shown as aseparate component of the shareholders equity in the balance-sheet. It doesnot affect the current earnings of the company.

c)Economic Exposure

Economic exposure can be defined as the extent to which the value of thefirm would be affected by unanticipated changes in exchange rates. Aneconomic exposure is more a managerial concept than a accounting concept.A company can have an economic exposure to say Yen: Rupee rates even if it

does not have any transaction or translation exposure in the Japanesecurrency. This would be the case for example, when the companyscompetitors are using Japanese imports. If the Yen weekends the companyloses its competitiveness (vice-versa is also possible). The companyscompetitor uses the cheap imports and can have competitive edge over thecompany in terms of his cost cutting. Therefore the companys exposed toJapanese Yen in an indirect way.

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In simple words, economic exposure to an exchange rate is the risk that achange in the rate affects the companys competitive position in the marketand hence, indirectly the bottom-line. Broadly speaking, economic exposureaffects the profitability over a longer time span than transaction and eventranslation exposure. Under the Indian exchange control, while translation

and transaction exposures can be hedged, economic exposure cannot behedged.

Economic exposure consists of mainly two types of exposures.

Asset exposure Operating exposure

Exposure to currency risk can be properly measured by the sensitivities of (1)the future home currency values of the firms assets (and liabilities) (2) thefirms operating cash flows to random changes in exchange rates.

Asset exposure:

Let us discuss the case of asset exposure. For convenience, assume thatdollar inflation is non random. Then, from the perspective of the U.S. firmthat owns an asset in Britain, the exposure can be measured by thecoefficient b in regressing the dollar value P of the British asset on thedollar/pound exchange rate S.

P = a + b * S + e

Where a is the regression constant and e is the random error term withmean zero, P = SP*, where P* is the local currency (pound) price of asset. It isobvious from the above equation that the regression coefficient b measuresthe sensitivity of the dollar value of asset (P) to the exchange rate (S). If theregression coefficient is zero, the dollar value of the asset is independent ofexchange rate movement, implying no exposure. On the basis of aboveanalysis, one can say that exposure is the regression coefficient. Statistically,the exposure coefficient, b, is defined as follows:

b = Cov (P,S)/ Var (S)

Where Cov (P,S) is the covariance between the dollar value of the asset andthe exchange rate, and Var (S) is the variance of the exchange rate.

Next, we show how to apply the exposure measurement technique usingnumerical examples. Suppose that a U.S. firm has an asset in Britain whoselocal currency price is random. For simplicity, let us assume that there arethree states of the world, with each state equally likely to occur. The future

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local currency price of this British asset as well as the future exchange ratewill be determined, depending on the realized state of the world.

Operating exposure:

Operating exposure can be defined as the extent to which the firmsoperating cash flows would be affected by random changes in exchangerates. Operating exposure may affect in two different ways to the firm, viz.,competitive effect and conversion effect. Adverse exchange rate changeincrease cost of import which makes firms product costly thus firms positionbecomes less competitive, which is competitive effect. Adverse exchangerate change may reduce value of receivable to the exporting firm which iscalled conversion effect.

Some strategy to manage operating exposure

Selecting low cost production sites:

When the domestic currency is strong or expected to become strong, erodingthe competitive position of the firm, it can choose to locate productionfacilities in a foreign country where costs are low due to either theundervalued currency or under priced factors of production. Recently, Japanese car makers, including Nissan and Toyota, have been increasinglyshifting production to U.S. manufacturing facilities in order to mitigate thenegative effect of the strong yen on U.S. sales. German car makers such asDaimler Benz and BMW also decided to establish manufacturing facilities inthe U.S. for the same reason. Also, the firm can choose to establish and

maintain production facilities in multiple countries to deal with the effect ofexchange rate changes. Consider Nissan, which has manufacturing facilitiesin the U.S. and Mexico, as well as in Japan. Multiple manufacturing sitesprovide Nissan with great deal of flexibility regarding where to produce, giventhe prevailing exchange rates. When the yen appreciated substantiallyagainst the dollar, the Mexican peso depreciated against the dollar in recentyears. Under this sort of exchange rate development, Nissan may choose toincrease production in the U.S. and especially in Mexico, in order to serve theU.S. market. This is, in fact, how Nissan has reacted to the rising yen inrecent years. Maintaining multiple manufacturing sites, however, mayprevent the firm from taking advantage of economies of scale, raising its cost

of production. The resultant higher cost can partially offset the advantages ofmaintaining multiple production sites.

Flexible sourcing policy:

Even if the firm manufacturing facilities only in the domestic country, it cansubstantially lessen the effect of exchange rate changes by sourcing fromwhere input costs are low. Facing the strong yen in recent years, many

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2)What is International Finance? State its importance and riskinvolved.

International finance is the branch of economics that studies thedynamics of exchange rates, foreign investment, global financialsystem, and how these affect international trade. It also studiesinternational projects, international investments and capital flows,and trade deficits. It includes the study of futures, options andcurrency swaps. International finance is a branch of internationaleconomics.

Importance of International Finance :

International Finance is an important input in the decision making process ofdifferent entities. It affects all aspects of economic activity.

1. Every firm is confronted with four financial decision making areas, namelyinvestment decision i.e decisions regarding where to set up a newplant,financing decision i.e what the capital structure should be and wherefinances should be raised, dividend decision i.e whether dividend should bepaid or not and working capital management decision i.e how much cash tohold, in what currency should receivables and payables be denominated.

2. Commercial banks play an extremely active role in foreign exchange

markets all over the world. They buy, sell and hold various foreign currencieson behalf of their clients, central bank and their own behalf. As agents oftheir client, they fulfill client requirements for foreign exchange or conversionof foreign exchange into domestic currency. Sometimes, a commercial bankmay be asked to buy or sell foreign exchange on behalf of the central bank.In many countries around the world, commercial banks are the only entitiesthat offer foreign exchange risk management solutions to corporateclients.Banks also arrange foreign exchange loans, underwrite the corporateissue of securities in the euro currency and international bond markets andparticipate in bailing out countries that are in an economic crisis.

3. Speculators take short term positions in foreign currency with a view tomaking a profit. Speculators play an important role in the foreign exchangemarket by imparting liquidity.

4. The flow of capital between countries has been facilitated by the removalof controls that impede such flows. The complete removal on movements ofcapital into and out of a country is termed Capital Account Convertibility. One

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of the biggest dangers of regulation is that there is a need for a continuingfine-tuning and there is no guarantee that it will always work.

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Risk Involved

When an organization decides to engage in international financing activities,

they also take on additional risk as well as opportunities. The main risks thatare associated with businesses engaging in international finance includeforeign exchange risk and political risk. These risks may sometimesmake it difficult to maintain constant and reliable revenue.

Foreign exchange riskoccurs when the value of investment fluctuates dueto changes in a currency's exchange rate. When a domestic currencyappreciates against a foreign currency, profit or returns earned in the foreigncountry will decrease after being exchanged back to the domestic currency.Due to the somewhat volatile nature of the exchange rate, it can be quitedifficult to protect against this kind of risk, which can harm sales and

revenues.

Political risk transpires when a countrys government unexpectedly

changes its policies, which now negatively affect the foreign company. These

policy changes can include such things as trade barriers, which serve to limit

or prevent international trade. Some governments will request additional

funds or tariffs in exchange for the right to export items into their country.

Tariffs and quotas are used to protect domestic producers from foreign

competition. This also can have a huge effect on the profits of an

organization because it either cuts revenues from the result of a tax on

exports or restricts the amount of revenues that can be earned. Although the

amount of trade barriers have diminished due to free-trade agreements and

other similar measures, the everyday differences in the laws of foreign

countries can influence the profits and overall success of a company doing

business transactions abroad.

In general, organizations engaging in international finance activities can

experience much greater uncertainty in their revenues. An unsteady and

unpredictable stream of revenue can make it hard to operate a business

effectively. Despite these negative exposures, international business canopen up opportunities for reduced resource costs and larger lucrative

markets. There are also ways in which a company can overcome some of

these risk exposures.

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3)Write Short Notes:

a) EURO NOTES

Euro banknotes are the banknotes of the euro, the currency of the eurozone(see European Union) and have been in circulation since 2002. They are

issued by the national central banks of the euro area or the European Central

Bank (ECB). Denominations of notes range from 5 to 500 and, unlike euro

coins, the design is identical across the whole of the eurozone, although they

are issued and printed in various member states.

There are seven different denominations, each having a distinctive colourand size. The design for each of them has a common theme of Europeanarchitecture in various artistic periods. The front (or recto) of the note

features windows or gateways while the back (or verso) has bridges. Thearchitectural examples are stylised illustrations, not representations ofexisting monuments.

Common to all notes are the European flag, the initials of the EuropeanCentral Bank in five versions (BCE, ECB, EZB, , EKP), a map of Europe onthe back, the name "euro" in both Latin and Greek script (EURO / ) andthe signature of the current president of the ECB. The 12 stars from theEuropean Flag are also incorporated into every note.

The euro banknote designs were chosen from 44 proposals in a design

competition, launched by The Council of the European Monetary Institute(EMI) on 12 February 1996. The winning entry, created by Robert Kalina fromthe Oesterreichische Nationalbank, was selected on 3 December 1996.

The paper used for euro banknotes is 100% pure cotton fibre, which improvestheir durability as well as imparting a distinctive feel.

Owing to the ubiquity of countless historic bridges, arches, and gatewaysthroughout the continent, all the structures represented on the banknotesare entirely fictional syntheses of the relevant architectural styles, merelydesigned to evoke the landmarks within the EU,representing variousEuropean ages and styles. For example, the 5 banknote has a genericrendition of the Classical Period, the 10 ofRomanesque, the 20 ofGothic,the 50 of the Renaissance, the 100 of Baroque and Rococo, 200 of ArtNouveau and the 500 ofModern style. However, in a survey conducted bythe Dutch NCB (De Nederlandsche Bank), only 2% of the population was ableto identify the theme of the 5, and 1% correctly identified the 50 theme.While the designs are supposed to be devoid of any identifiable

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characteristics, the initial designs by Robert Kalina were of actual bridges,including the Rialto bridge in Venice and the Pont de Neuilly in Paris, andwere subsequently rendered more generic; the final designs still bear veryclose similarities to their specific prototypes; thus they are not truly generic.The Dutch town ofSpijkenisse has started with a project where replicas of all

the bridges will be built as pedestrian bridges.

The design of euro banknotes include several characteristics suggested in co-operation with organisations representing blind people. These characteristicsaid both people who are visually impaired (people who can see thebanknotes, but cannot necessarily read the printing on them) and those whoare entirely blind.

Euro banknotes increase in size with increasing denominations, which helpsboth the visually impaired and the blind. The predominant colouring of thenotes alternates between warm and cool hues in adjacent denominations

(see the chart above), making it still harder to confuse two similardenominations for those who can see the colour. The printing of thedenominations is intaglio printing, which allows the ink to be felt by sensitivefingers, allowing some people to distinguish the printed denominations bytouch alone. Lower denominations (5, 10, 20) have smooth bands along oneside of the note containing holograms; higher denominations have smooth,square patches with holograms. Finally, the 200 and 500 notes havedistinctive tactile patterns along the edges of the notes: the 200 note hasvertical lines running from the bottom centre to the right-hand corner, andthe 500 note has diagonal lines running down the right-hand edge.

Although there have been other currencies pre-dating the euro that werespecifically designed in similar ways (different sizes, colours, and ridges) toaid the visually impaired, the introduction of the euro constitutes the firsttime that authorities have consulted associations representing the blindbefore, rather than after, the release of the currency.

b) FUTURES

A financial contract obligating the buyer to purchase an asset (or

the seller to sell an asset), such as a physical commodity or afinancial instrument, at a predetermined future date and price.

In finance, a futures contract is a standardized contract between two partiesto exchange a specified asset of standardized quantity and quality for a priceagreed today (the futures price or the strike price) with delivery occurring ata specified future date, the delivery date. The contracts are traded on afutures exchange. The party agreeing to buy the underlying asset in the

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future, the "buyer" of the contract, is said to be "long", and the partyagreeing to sell the asset in the future, the "seller" of the contract, is said tobe "short". The terminology reflects the expectations of the parties -- thebuyer hopes or expects that the asset price is going to increase, while theseller hopes or expects that it will decrease. Note that the contract itself

costs nothing to enter; the buy/sell terminology is a linguistic conveniencereflecting the position each party is taking (long or short).

In many cases, the underlying asset to a futures contract may not betraditional commodities at all that is, for financial futures the underlyingasset or item can be currencies, securities or financial instruments andintangible assets or referenced items such as stock indexes and interestrates.

While the futures contract specifies a trade taking place in the future, thepurpose of the futures exchange institution is to act as intermediary and

minimize the risk of default by either party. Thus the exchange requires bothparties to put up an initial amount of cash, the margin. Additionally, since thefutures price will generally change daily, the difference in the prior agreed-upon price and the daily futures price is settled daily also. The exchange willdraw money out of one party's margin account and put it into the other's sothat each party has the appropriate daily loss or profit. If the margin accountgoes below a certain value, then a margin call is made and the accountowner must replenish the margin account. This process is known as markingto market. Thus on the delivery date, the amount exchanged is not thespecified price on the contract but the spot value (since any gain or loss hasalready been previously settled by marking to market).

A closely related contract is a forward contract. A forward is like a futures inthat it specifies the exchange of goods for a specified price at a specifiedfuture date. However, a forward is not traded on an exchange and thus doesnot have the interim partial payments due to marking to market. Nor is thecontract standardized, as on the exchange.

Unlike an option, both parties of a futures contract must fulfill the contract onthe delivery date. The seller delivers the underlying asset to the buyer, or, ifit is a cash-settled futures contract, then cash is transferred from the futurestrader who sustained a loss to the one who made a profit. To exit the

commitment prior to the settlement date, the holder of a futures position canclose out its contract obligations by taking the opposite position on anotherfutures contract on the same asset and settlement date. The difference infutures prices is then a profit or loss.

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4) What is SWAP transaction? Explain the types of SWAP.

SWAP transaction is a financial transaction in which two counterparties agree

to exchange streams of payments over a period of time according to apredetermined rule. For example, the counterparties may swap interestpayments, with each paying the other's interest on the same amount ofprincipal. Usually a fixed rate interest obligation is swapped for a floating rateinterest obligation, so that both parties can match the form of interest theyowe on their debts with the form of interest income they expect to receive ontheir assets -- fixed with fixed, or floating with floating. Or, the counterpartiesmay swap payments in one denomination of currency for payments inanother country's currency. Both interest rate swaps and currency swaps aredesigned to lessen market exposure of paying off debt in an environment ofpotentially changing interest rates .

Types of SWAP

a) Bond option

One party grants to the other party the right to purchase (if a call) or sell (if aput) a bond at an agreed strike price. Where the transaction is cash settled,the seller of the option would pay to the buyer the difference between themarket price of that quantity of the commodity on the exercise date and thestrike price.

b) Cap/floor transaction

One party pays a single or periodic fixed amounts and the other pays theexcess (if any) of e.g. a specified floating rate, commodity price over anagreed rate or commodity price.

c) Collar transaction

A collar is the combination of a cap and a floor and one party will be thepayer on the cap and the other party is the payer on the floor.

d) Commodity option

One party grants to the other, in consideration for a premium) the right topurchase (if a call) or sell (of a put) a specified quantity at a specified strikeprice.

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e) Commodity swap

One party pays periodic amounts of a given currency based on a fixed priceand the other party pays periodic amounts of the same currency based onthe price of a commodity or a future contract on a commodity. All

calculations are based on a notional quantity of the commodity.

f) Cross currency rate swap

One party pays periodic fixed amounts in one currency and the other partypays periodic floating amounts in another currency

g) Currency option

One party grants to another the right to purchase (if a call) or sell (of a put)an agreed amount of a currency at an agreed strike price

h) Currency swap

One party pays the fixed amount of one currency and the other party pays afixed amount of another currency. There may be initial and final exchange ofthe currency notional amounts.

i) Equity or equity index swap

One party periodically pays a fixed amount and the other party pays an

amount based on the performance of a reference share, a basket of shares ora share index.

j) Interest rate swap (IRS)

One party periodically pays a fixed amount calculated based on a specifiedcurrency and fixed rate and the other party pays a floating amount based onthe same currency but a floating rate. The fixed rate and the floating rate arereset periodically and all calculations are based on a notional amount of thespecified currency

k) Equity index option

One party grants to the other party the right to receive a payment equal tothe amount by which a share index either exceeds (if a call) or is less than (ifaput) a specified strike price.

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l) Equity option

One party grants to another the right to purchase (if a call) or sell (of a put)shares or a basket of shares at a specified strike price. Where the transactionis cash settled, the seller of the option would pay to the buyer the difference

between the market price of that quantity of the commodity on the exercisedate and the strike price.

m)Foreign exchange transaction

One party purchases one currency with another currency with settlementeither on a spot or a specified future date.

n) Forward rate

One party agrees to pay a fixed rate for a defined period and the other party

agrees to pay a rate to be set on a specified date in the future. The payment

calculation is based on a notional rate and is settled based on the difference

between the agreed forward rate and the prevailing market rate at the time

of settlement.

o) Interest rate option

One party grants to another the right to receive a payment equal to the

amount by which an interest rate either exceeds (if a call) or is less than (if a

put) an agreed strike price.

p) Swap option or swaption

One party grants to another party the right to enter into a swap with pre-agreed terms. The underlying swap may be settled at the time of exercise of

the option.