Presentation 1 If

7/31/2019 Presentation 1 If

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1.1 Why Study International

Finance In today's world finance cannot beanything but international

Enormous growth in the volume ofinternational trade

Cross border capital flows and, in

particular, direct investment have alsogrown enormously


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1.1 Why Study InternationalFinance (contd.)

Veritable revolution has been taking place

in the money and capital markets around the

world

Liberalization, integration and innovation

have created a giant international financialmarket which is extremely dynamic and

complex


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Multilateral negotiations regarding phased

removal of trade barriers have made

considerable progress and WTO had emerged as

a meaningful platform

Post war, World trade has grown faster than

World GDP

Almost all countries getting integrated with

the global economy



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Indian economy needs substantial amountsof foreign capital to augment domesticsavings

Technology up-gradation in India willrequire continuing import of foreigntechnology, hardware and software

Indias increasing recourse to commercialborrowings and direct and portfolioinvestments by nonresidents


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The efforts of Indian companies to diversifyinto exports of engineering equipment andturnkey projects will have to be supported

by the ability to offer long term financing tobuyers

A number of companies particularly in theIndian IT sector have begun venturingabroad for strategic reasons either aspartners in joint ventures or by establishingforeign subsidiaries


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GLOBALIZATIONOn or Off?

Economic "globalization" refers to the increasing integration

of economies around the world, particularly through the

movement of goods, services, and capital across borders. The

term sometimes also refers to the movement of people (labor)

and knowledge (technology) across international borders.

The term "globalization" began to be used more commonly in

the 1980s, reflecting technological advances that made it

easier and quicker to complete international transactions

both trade and financial flows.


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There are countless indicators that illustrate how goods, capital,

and people, have become more globalized.

The value of trade (goods and services) as a percentage of worldGDP increased from 42.1 percent in 1980 to 62.1 percent in 2007.

Foreign direct investment increased from 6.5 percent of world

GDP in 1980 to 31.8 percent in 2006. The stock of international

claims (primarily bank loans), as a percentage of world GDP,increased from roughly 10 percent in 1980 to 48 percent in 2006.

All these trends have continued beyond 2006 but some reversal

is predicted after the current crisis and economic slowdown

The number of foreign workers has increased from 78 million

people (2.4 percent of the world population) in 1965 to

191 million people (3.0 percent of the world population) in 2005.


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FOREX MARKET TURNOVER (NET)

DAILY AVERAGE, APRIL 2011

(US$ BILLION)TOTAL 3988

SPOT 1305

OUTRIGHT FORWARDS 433

SWAPS 2250

US$ vs. OTHERS 2660.262

EURO vs. OTHERS 1139.406

JPY vs. OTHERS 509.731

GBP vs. OTHERS 460.779

CHF vs. OTHERS 208.790


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2.1 Objectives of The Firm

In modern theory of finance the

objective of the management of a firm is

to maximize the current value of

shareholders' wealth. Are we sure that:

Current value maximization objective does

not ignore the multi-period character of

financial (and other) decisionsIt incorporates uncertainty in some way


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2.1 Objectives of The Firm

(contd.)The concept of wealth maximization

incorporates a multi-period horizon with any

combination of dividends and capital gainsEquity shares are risky assets

The modern theory of finance as represented

by the famous Capital Asset Pricing Model

(CAPM) and the Arbitrage Pricing Theory

(APT) rests on the following three

propositions


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2.1 Objectives of The Firm(contd.)

Investors are "risk-averse"

A risky asset has two types of risksassociated with it viz. the unsystematic,

firm- specific risk and thesystematicriskRisk-averse investors will not worry about

firm-specific, unsystematic risks sincethese risks are diversifiable

Hence according to CAPMmitigating unsystematic risk wouldnot add shareholder value.


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2.2 Risk Management and Wealth

MaximizationWhat should be the attitude of the firm'smanagement regarding firm-specific risks?

Risks arising out of fluctuations in exchange

rates, interest rates and commodity prices arepervasive, however they affect different firms in

different ways and are therefore firm-specific or

idiosyncratic


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2.2 Risk Management and WealthMaximization (contd.)

The investment-financing inter-linkage predicts

that firms with more growth opportunities are

more likely to be hedgers than those with more

stable businessesUnsystematic risks like exchange rate risks, if

left unmanaged, increase the probability of the

firm getting into financial distress

This can have adverse long term consequences


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2.2 Risk Management and Wealth

Maximization (contd.)In the case of a multinational firm whoseshareholders are scattered around the world, it

is not clear exactly how hedging serves

shareholder interests.Different shareholders have different currency

habitats. A US multinational protecting its

income measured in US dollars may actually

hurt its German stockholders


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SOME TYPICAL CURRENCYRISK SITUATIONS


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It is December 1, 2009. An Indian pharmaceutical company

has cleared a shipment of imported chemicals. The invoice is

for $500,000 payable on March 3, 2010. The current

exchange rate is Rs.46.60 per dollar. The recent history of

the exchange rate shows a mixed trend with moderate

volatility. During the latter half of 2007 dollar had shown

considerable weakness against all currencies including the

rupee. During early 2008, the rate was almost flat around

Rs.40.00. Dollar was rising against the rupee in early 2009.

An adverse movement in exchange rate will affect the firms

cash flows. There is also the problem of how to value theimports for the purpose of product costing and pricing

decisions. What should the firm do?


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A US firm has exported some computer peripherals to

a German buyer. For customer relationship reasons the

sale has been invoiced in buyers currency viz. Euro.The invoice is for1,000,000 to be settled 90 days from

now. The current exchange rate is $1.4715 per Euro. The

recent history of the dollar-euro rate shows a mixed

down - up trend with some fluctuations. The firmsbankers are fairly bullish about the Euro despite the

recessionary conditions in the major European

economies viz. Germany and France. However US

treasury secretary has expressed concern about the

weak dollar.

What should the firm do?


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Caterpillar is an American firm which manufactures

heavy construction equipment. At the start of the

1980s all its manufacturing operations were located

in the US while it sold its products around the world

priced in local currencies. Its nearest competitor was

Komatsu of Japan. Around mid-1981 the US dollar

started rising against all currencies and continuedrising month after month. Caterpillar found that its

revenues measured in dollars were shrinking while

costs kept pace with US inflation. Margins shrank. It

could not compensate by raising local currency pricesin export markets because Komatsu was holding the

price line.

How could Caterpillar cope with this?


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3.1 The Nature of Exposure andRisk

Macroeconomic environmentalrisks

Core business risks

While core business risks are specific to afirm, macroeconomic uncertainties affect allfirms in the economy

Extent and nature of impact of even

macroeconomic risks crucially depend uponthe nature of a firm's business


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3.1 The Nature of Exposure andRisk (contd.)

The firm is "exposed" to uncertain changes in

a number of variables in its environment -

Risk Factors

Long run response of the firm to these risks

can involve significant changes in the firm's

strategic posture

Exchange rates and interest rates are two ofthe key macroeconomic risk factors


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3.1 The Nature of Exposure andRisk (contd.)

Exchange rates, interest rates and inflation ratesare intimately interrelated

Exposure and Risk

Exposure is a measure of the sensitivity ofthe value of a performance measure tochanges in the relevant risk factor

risk is a measure of the variability of the

value of the performance measure attributableto the risk factor


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3.1 The Nature of Exposure and

Risk (contd.)The magnitude of risk is determined by the

magnitude of exposure and the degree of

variability in the relevant risk factor e.g.Exchange rate risk depends on how sensitive

is the performance indicator to exchange rate

fluctuations and what is the extent of likely

fluctuations in the exchange rate.


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Risk Management and WealthMaximization

What should be the attitude of the firm'smanagement regarding firm-specificrisks?

Risks arising out of fluctuations inexchange rates, interest rates andcommodity prices are pervasive; howeverthey affect different firms in different waysand are therefore firm-specific oridiosyncratic.

Should the firm spend resources to

manage such risks?


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Why Hedge?

The value of a firm, according to financial

theory, is the net present value of all

expected future cash flows.

Currency risk is defined roughly as thevariance in expected cash flows arising from

unexpected exchange rate changes.

A firm that hedges these exposures reducessome of the variance in the value of its

future expected cash flows.


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Arguments against active hedging:

Removing unsystematic risks does not add value.

Stockholders can diversify

M&M thesis: Shareholders can do it themselves

Firm cannot beat efficient markets

Risk removal is costlythose who take on the risk

must be compensated. Will there be value addition

after paying these costs?

Active risk management must alter character of cash

flows in a manner beneficial to shareholders and do it

cheaper than what they can do on their own.


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Why Hedge? Reasons not to hedge

However, is a reduction in the variability ofcash flows sufficient reason for currency risk

management? Opponents of hedging state

(among other things):

Currency risk management reduces the varianceof the cash flows of the firm, but also usesvaluable resources.

Management often conducts hedging activities

that benefit management at the expense of theshareholders (agency conflict), i.e., large FX loss

are more embarrassing than the large cost of

hedging.


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Arguments for Hedging:

Investment-Internal Finance linkage

Costs of being perceived as being in financial distress

Agency theoretic arguments

Convex tax schedules

Managers have better information and access to

various financial markets than shareholders

For an MNC with global shareholders with differentcurrency habitats it is not clear that hedging benefits

allshareholders


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Why Hedge? Reasons to hedge

Proponents of hedging cite:

Reduction in risk in future cash flows improves the

planning capability of the firm

Reduction of risk in future cash flows reduces the

likelihood that the firms cash flows will fall below

a necessary minimum (the point offinancial

distress)

Management has a comparative advantage over the

individual shareholder in knowing the actualcurrency risk of the firm

Management is in better position to take advantage

of disequilibrium conditions in the market


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Is Exchange Rate Risk Relevant?

Purchasing Power Parity Argument:Exchange rate movements will be matched by

price movements.

PPP does not necessarily hold.

The Investor Hedge Argument:

MNC shareholders can hedge against exchange

rate fluctuations on their own.The investors may not have complete

information on corporate exposure. They may

not have the capabilities to correctly insulate

themselves too.


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Is Exchange Rate Risk Relevant?

Currency Diversification Argument:An MNC that is well diversified should not be

affected by exchange rate movements because of

offsetting effects.

This is a naive presumption.

Stakeholder Diversification Argument:

Well diversified stakeholders will be somewhatinsulated against losses experienced by an MNC

due to exchange rate risk.

MNCs may be affected in the same way because

of exchange rate risk.


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An Example : A company has a US$ 500000 receivable from an

American customer to be received 3 months from today. The

current rupee-dollar rate is 47.50; The market is quoting a 3-

month forward rate at 48.00;The forward rate can be taken as markets expectation of what

the rupee-dollar rate will be 3 months from now. Thus the

expected change in exchange rate is (48.00-47.50) or +0.50.

Three months later, the rupee-dollar rate falls to 46.80.

Total change: (46.80-47.50) = -0.70; Expected change : +0.50

Unexpected change : -1.20

Change in the value of receivable: (46.80-48.00)(500000)

Exposure : [(46.80-48.00)($500000)]/(-1.20) = $500000


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Taxonomy of Currency Exposure

Contractual(Transactions)

Anticipated

Cash Flow Accounting(Translation)

Short Term

Strategic Operating

LongTerm

Currency Exopsure

C C i f i


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Moment in time when

exchange rate changes

Translation exposure

Transaction exposure

Operating exposure

Time

Changes in reported owners equity

in consolidated financial statements

caused by a change in exchange rates

Change in expected future cash flows

arising from an unexpected change in

exchange rates

Impact of settling outstanding obligations entered into before change

in exchange rates but to be settled after change in exchange rates

Conceptual Comparison of Transaction,

Operating and Accounting Foreign Exchange

Exposure


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t1 t2 t3 t4Seller quotes

a price to buyer(in verbal or

written form)

Buyer places

firm order withseller at price

offered at time t1

Seller ships

product andbills buyer

(becomes A/R)

Buyer settles A/R

with cash inamount of currency

quoted at time t1

QuotationExposure

BacklogExposure

BillingExposure

Time between quoting

a price and reaching a

contractual sale

Time it takes to

fill the order after

contract is signed

Time it takes to

get paid in cash after

A/R is issued

Time and Events

The life span of a transaction exposure


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3.4 Classification of Foreign ExchangeExposure and Risk (contd.)

Transactions Exposures result from anunanticipated change in the exchange rate

which has an impact - favorable or adverse - on

thefirms

cash flows during the upcomingaccounting period. Most often, the term is used

to denote exposures on items the foreign

currency values of which are contractually fixed

export receivables, import payables, interestpayable etc.


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Transaction risk can be defined as a measureof variability in the value of assets and liabilities

when they are liquidated

Points to be noted areTransactions exposures usually have short

time horizons;

Operating cash flows are affected; exchange

gains/losses have tax implications


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Translation exposure arises when a firm has

A foreign operation such as a branch, a joint venture or

100% subsidiary in a foreign currency.

The home country law requires that the parent must

translate financial statements of foreign operations from

foreign to home currency and consolidate with parent

financial statements. Foreign currency fluctuations lead to translation gains

or losses. No cash flow implications

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