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Published by: Riddhi Bhatt on Mar 05, 2011
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Chapter ± 9 and 10

International finance

Real operating exposure
‡ ROE means change in inflation adjusted future cash flow of firm following exchange rate changes. ‡ RER=NER-Inflation differentiation. ‡ if proportion change in appreciation and depreciation of currency = change in inflation differentiation , then ZERO ROE

‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ ‡ Impact of inflation and change in exchange rate on future CF may vary under different market condition. As far as revenue is concerned, the impact may vary if firm produce:For the export market. For domestic market but competition from import present. For domestic market but competition from abroad is absent. As far as cost is concern the impact may very if firm:Imports inputs Gets inputs from domestic recourses but competition from foreign supplier present. Gets inputs from domestic recourses but competition from foreign supplier absent.

Impact of inflation on revenue For the export market ‡ Must able to pass impact of inflation on consumers if demand for goods is price inelastic. ‡ If firms done it. Revenue will stream large. if demand is highly elastic and imports will meet domestic demand-inflation may reduce the revenue. exporter enjoy monopoly. the revenue of firms increase but if firm fail it to pass the revenue is decrease. For domestic market but competition from abroad is absent.1. ‡ . For domestic market but competition from import present.

can raise the price to the extent of inflation ± Cost will raise in post inflation.Impact of inflation on Cost ‡ IF firm:Imports inputs ‡ If firm imports goods and foreign supplier is in monopoly position. Gets inputs from domestic recourses but competition from foreign supplier absent ‡ Local supplier will raise the price ± cost will raise .‡ 2. Gets inputs from domestic recourses but competition from foreign supplier present ‡ foreign supplier will not raise the price becoz there is competition with local supplier ± cost will not raise.

‡ Import becomes more costlier so selling in domestic market increase ± Revenue is increase. 4 Impact of depreciation on cost. For domestic market but competition from abroad is absent.3 Impact of depreciation on Revenue For the export market. . ‡ If demand is price inelastic the firm can raise the price ± revenue is increase. For domestic market but competition from import present. ‡ Depreciation in currency will result in increase the exports if demand is elastics so revenue is increased.

‡ Parents firm interested to overall financial position and overall profit of firm. ‡ It done through translating al items of the FS of subsidiaries denominated in different currency Into domestic currency of parent company. ‡ So Translation Exposure means ³mismatch between translated value of assets and liabilities following exchange rate change´ .Translation Exposure.. ‡ Mainly emerge on account of consolidate financial statements of different unit of multination firm.

Methods of TE ‡ ‡ ‡ ‡ Current rate Method Current/Non-current Method Monetary/non-monetary Method Temporal Method .

. ‡ It is also known as Closing rate method ‡ It is the method in which all the items of financial statements are translated at Current Rate ‡ Demerit Fix assets also translate at current rate which against accounting principles. Historical rate= 40/$.Cont. CR = 42/$ Cash = 40000 At CR firm Receive $952 .

Cont. ‡ 2.change rate.. ‡ FA&LL translated at historical rate or pre. . The criticism of this method is long term debt which is also exposed to change rate which is ignored. ‡ All the items of income statement is translated at average rate. ‡ CA & CL translated at Current Rate. Current/Non current method.

long term investment comes under NM ‡ Monetary Translate at CR ‡ NM Translate at Historical rate .. inventory. ‡ Fixed assets. Monetary/Non-monetary ‡ Under this methods assets and liabilities are classified under monetary and NM. 3.Cont. ‡ All liabilities and CA except Inventory comes under Monetary.

Cont. ‡ Temporal method ‡ In this method all liabilities and CA if inventory shown at Market price translate at CRM. ‡ FA and Inventory if not shown Market price translate at Historical method.. .


Chapter 10 ‡ Management of foreign exchange exposure .

Marketing strategy 2.Financial strategy .Hedging of Real operating exposure ‡ There are main three strategies to hedge real operating exposure. 1.Production strategy 3.

Product planning: (Product differentiation and R&D). 1. Strategy should reduce future cost also. ‡ Firm should Modify product its product strategy: ‡ innovate and introduce new product in foreign market ‡ add new feature in its existing product (introduce new Variety of product) These all things generate new demand for the product and firm cane respond to EX rate change.. The Volvo .a Swedish car maker is building highly safe cars as compare to other. 1. ‡ For example. Marketing strategy ‡ Firm has to frame such marketing strategy that hedge against loss of future earning. ‡ Currency appreciate at time revenue decline but hear due to this product sales increase and ultimately revenue are not adversely affected.. .Cont.

if price of product is 100 in foreign market and Rs. Appreciate from 45 to 40 Rs per dollar.. 3. ‡ I.Cont. 2. ‡ It means to increase or to decrease the price of product due to exchange rate change.Market selection:- .Pricing policy.e. there may be loss to exporter in such case to maintain same profit Indian firm has to raise PRICE of product.

‡ choose flexible sources for input. 1. Production Strategy: Production strategy involves following strategy. ..Cont. ‡ if the currency of input supplying firm appreciate. ‡ Hear labor cost should be consider by firms therefore MNC establish their plant in developing country where labor are cheap.Product sources. B. the firm has to find alternative supplier where inputs are cheaper. ‡ Some times firm keep Multiple sources of inputs to hedge.

.Input mixing: ‡ if firm unable to buy cheaper input from any sources. it can protect against rise in the cost of production through mixing local inputs which may be cheaper.Cont.. 50% input from domestic. ‡ like 50% input from abroad. 2.

Cont.. ‡ In such situation. 3.Plant location: ‡ when domestic currency is strong or expected to become strong resulting high cost of production. the MNC can establish its plant in those countries whose currency is week ( depreciates) against home currency where inputs are available. .

parallel loan. ‡ Matching of liabilities with assets . ‡ 3 Financial strategy: ‡ Long term forward contract.Cont. currency swaps..

Hedging of Transaction Exposure ‡ Contractual hedge Natural hedge ‡ Forward Market hedge Leads and Legs Currency diversification ‡ Future Market hedge Risk sharing ‡ Option Market hedge Cross hedging ‡ Money Market Hedge Exposure netting ‡ Invoice currency hedging .

Leads and lags:‡ leads means advancing or accelerating the timing of receipt or of payment of foreign currency. 1. Indian currency is weak as compared to US dollar. ‡ E.Indo ± US. Indian importer has to use leads becoz there is possibility in future US dollar appreciate and the firm has to pay more therefore better for the firm to pay in advance or at time of transaction to hedge against foreign exchange change.Cont« ‡ Natural hedge (Operational technique):Natural hedge is applied when contractual hedge fail to give good result. .G.

.It just reverse process of leads means decelerating or postponing the amount of receipt and payment. ‡ Lags :. Here due to this risk sharing it has to pay only 1 Rs more and 1 Rs risk is taken by exporter. E. 2. Risk Sharing:It means loss/gain being shared by both of the transacting parties if exchange rate moves.S.the Indian importer has loss of 2 Rs if exchange rate move from 40 Rs to 42 Rs per $.. .Cont.

If the quantity of currency is large. .. the risk is lower. ‡ Currency diversification:‡ It means firm has to transact with more currency ( with more country).Cont. ‡ If one currency depreciate at same time other currency appreciate. ‡ In this situation risk might be less.

future. 4.forward.option. It can hedge through financial market hedge. their currency quite impossible to hedge. yen. ‡ It includes hedging in an other foreign currency which is positive correlated with our desired foreign currency. ‡ It sell receivable in yen. Say. .KW is quite impossible to hedge becoz not development of financial market. ‡ Here US firm has to identify correlated currency with won and it can be hedge i.Cont..e. the financial market are not well developed.koriean won ‡ US firm has receivable in KW. Cross-hedging:‡ In some developing or underdeveloped country.

‡ The firm require to hedge only the net amount remaining after adjusting receivables against payables. ..Cont.The US firm has receivables of RS 100000 and payables Rs 60000. ‡ Ex.Exposure netting (net): ‡ A MNC may have both receivables and payables in same foreign currency. ‡ 5. it has to hedge only 40000 Rs against dollar. ‡ The transaction exposure in account of receivables will naturally offset by the transaction on account of payables. . ‡ In such situation it is not necessary to hedge receivables and payables in same currency.

Hedging through invoice currency ‡ Normally trade between developed country and less developed country tends to be invoiced in the currency of developed country. ‡ Say for in India.Cont. 6. . ‡ Hence a firm will be able to shift the transaction exposure to the other party by invoicing its transactions in its home currency.. more thane 85% of its foreign transaction (E/I) are being invoiced in US dollar. ‡ Transaction exposure arise only because of invoicing of transaction is in a foreign currency.

currency ( at money Receive time) ( at money payment time) . Currency Purchase of Fo. Sales of FO.. Here export creates long position in FX and Import creates short position in FX market.. With any... Export (Exporter) Importer Contract Contract With any.Contractual tech. (Financing) ‡ Forward Market Hedge:‡ Exporter and importer use FMH technique to hedge against foreign exchange..

‡ But after 3 month there is forward contract ( sales of foreign currency) so Exporter not convert $1000 into Indian RS but it sales $1000 to the forward contract party at Forward rate=40Rs/$. ER-40/$ ( For exporter) The Indian exporter export goods to US party worth $1000.. The exporter fear from depreciation of Dollar to 1 Rs. ‡ After 3 month if ER = 39/$ then it has loss of 1000 RS. (Sport rate and Forward rate=40Rs/$. It enter in 3 month forward contract at 40 Rs. ‡ At ends receive 40000 Rs and save loss of 1000 Rs through this technique. Receivables in foreign invoice after 3 month. ‡ ‡ ‡ ‡ . ‡ An example of Long position.Cont.

The Indian Indian importer import goods to US party worth $1000. Payable in foreign invoice after 3 month. (Sport rate and Forward rate=40Rs/$. ‡ But after 3 month there is forward contract ( purchase of foreign currency) so importer not pay 41000 Rs for $1000 but it purchase $1000 through forward contract at Forward rate=40Rs/$. (for importer). The importer fear from appreciation of Dollar to 1 Rs. An example of short position.Cont. ‡ After 3 month if ER = 41/$ then it has to pay more 1000 RS. ER-40/$. ‡ ‡ ‡ ‡ ‡ . It enter in 3 month forward contract ( purhase of foreign currency) at 40 Rs..

Borrow the currency in which receivables are dominated. ‡ How exporter hedge the risk by using this technique:1. Invests converted amount for the period matching with the payment of import. Convert the borrowed currency into into local currency.Cont. Borrow the local currency. Invests converted amount for the period matching with the receivables of export. 3.. 2. ‡ Money market hedge:‡ This hedge involves money market position to cover a future payables and receivables. Convert the borrowed currency into currency of payables. 2. . ‡ How importer hedge the risk by using this technique:1. 3.

.‡ Investment includes principle + interest Borrowing amt<Receivables (payables) So.Import of $1000 by Indian firm and it has to pay after 3 month (90 days) so to hedge this amt it has to borrow amount in local currency (Rs) so« BA= $1000/1.03 (if interest rate 12% in India). Borrow amount is equals to:BA = forward proceeds (amt of Receivables & Payables)/1+r Say.

IMPORTER ± BUY A CALL OPTION EXPORTER ± BUY A PUT OPTION FX.Hedging through purchase of option Here.Indian firm importing goods for $1000 and amt to be paid after 3 month. If strike price 80Rs/$. It can buy $1000 by paying 80*1000$=80000Rs+50 .it can hedge through BUY A CALL OPTION. if the importer expect depreciation of Rs value.05 and Spot rate 82Rs/$.premium 0.‡ Option market hedge:1.

S ± 82. ‡ Hedging through selling of option: Importer ± Sell a put option Exporter ± Sell call option FX.it can hedge through sell put option.05 but received premium 0.. if the importer expect depreciation of Rs value. ‡ If strike price 83.cont.premium 0. ‡ If strike price 80Rs/$.15± ‡ loss to sell of put option .15 ‡ Net benefit is .Indian firm importing goods for $1000 and amt to be paid after 3 month.95 and p -0.10 .05 ‡ If spot rate is 81 than holder not exercise contract and importer has benefit of premium amt.

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