1 Explain Globalization, Advantages of Globalization and Disadvantages of


By the term globalisation we mean opening up of the economy for world market
by attaining international competitiveness. Thus the globalisation of the
economy simply indicates interaction of the country relating to production,
trading and financial transactions with the developed industrialized countries of
the world.
Accordingly, the term globalisation has four parameters:
(a) Permitting free flow of goods by removing or reducing trade barriers between
the countries,
(b) Creating environment for flow of capital between the countries,
(c) Allowing free flow in technology transfer and
(d) Creating environment for free movement of labour between the countries of
the world. Thus taking the entire world as global village, all the four components
are equally important for attaining a smooth path for globalisation.
The concept of Globalisation by integrating nation states within the frame work
of World Trade Organisation (WTO) is an alternative version of the ‘Theory of
Comparative Cost Advantage’ propagated by the classical economists for
assuming unrestricted flow of goods between the countries for mutual benefit,
especially from Great Britain to other less developed countries or to their
In this way, the imperialist nations gained much at the cost of the colonial
countries who had to suffer from the scar of stagnation and poverty. But the
advocates of the policy of globalisation argue that globalisation would help the
underdeveloped and developing countries to improve their competitive strength
and attain higher growth rates. Now it is to be seen how far the developing
countries would gain by adopting the path of globalisation in future.
In the mean time, various countries of the world have adopted the policy of
globalisation. Following the same path India had also adopted the same policy
since 1991 and started the process of dismantling trade barriers along with
abolishing quantitative restrictions (QRs) phase-wise.
Accordingly, the Government of India has been reducing the peak rate of
customs duty in its subsequent budgets and removed QRs on the remaining 715
items in the EXIM Policy 2001-2002. All these have resulted open access to new
markets and new technology for the country.
Advantages of Globalisation:

The following are some of the important advantages of globalisation for a
developing country like India:
(i) Globalisation helps to boost the long run average growth rate of the economy
of the country through:
(a) Improvement in the allocative efficiency of resources;
(b) Increase in labour productivity; and
(c) Reduction in capital-output ratio.
(ii) Globalisation paves the way for removing inefficiency in production system.
Prolonged protective scenario in the absence of globalisation makes the
production system careless about cost effectiveness which can be attained by
following the policy of globalisation.
(iii) Globalisation attracts entry of foreign capital along with foreign updated
technology which improves the quality of production.
(iv) Globalisation usually restructure production and trade pattern favouring
labour-intensive goods and labour-intensive techniques as well as expansion of
trade in services.

(v) In a globalized scenario, domestic industries of developing country become
conscious about price reduction and quality improvement to their products so as
to face foreign competition.
(vi) Globalisation discourages uneconomic import substitution and favour
cheaper imports of capital goods which reduces capital-output ratio in
manufacturing industries. Cost effectiveness and price reduction of
manufactured commodities will improve the terms of trade in favour of
(vii) Globalisation facilitates consumer goods industries to expand faster to meet
growing demand for these consumer goods which would result faster expansion
of employment opportunities over a period of time. This would result trickle down
effect to reduce the proportion of population living below the poverty line
(viii) Globalisation enhances the efficiency of the banking insurance and financial
sectors with the opening up to those areas to foreign capital, foreign banks and
insurance companies.
Disadvantages of Globalisation:
.The following are some of these disadvantages:

(i) Globalisation paves the way for redistribution of economic power at the world
level leading to domination by economically powerful nations over the poor
(ii) Globalisation usually results greater increase in imports than increase in
exports leading to growing trade deficit and balance of payments problem.
(iii) Although globalisation promote the idea that technological change and
increase in productivity would lead to more jobs and higher wages but during the
last few years, such technological changes occurring in some developing
countries have resulted more loss of jobs than they have created leading to fall
in employment growth rates.
(iv) Globalisation has alerted the village and small scale industries and sounded
death-knell to it as they cannot withstand the competition arising from well
organized MNCs.
(v) Globalisation has been showing down the process to poverty reduction in
some developing and underdeveloped countries of the world and thereby
enhances the problem of inequality.
(vi) Globalisation is also posing as a threat to agriculture in developing and
underdeveloped countries of the world. As with the WTO trading provisions,
agricultural commodities market of poor and developing countries will be flooded
farm goods from countries at a rate much lower than that indigenous farm
products leading to a death-blow to many farmers.
(vii) Implementation of globalisation principle becoming harder in many
industrially developed democratic countries to ask its people to bear the pains
and uncertainties of structural adjustment with the hope of getting benefits in
2 In foreign exchange market many types of transactions take place. Discuss the
meaning and role of forward, future and options market.
The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading
of currencies. This includes all aspects of buying, selling and exchanging currencies at current or determined
prices. In terms of volume of trading, it is by far the largest market in the world.[1] The main participants in this
market are the larger international banks. Financial centres around the world function as anchors of trading
between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends.

The foreign exchange market does not determine the relative values of different currencies, but sets the current
market price of the value of one currency as demanded against another.
The foreign exchange market works through financial institutions, and it operates on several levels. Behind the
scenes banks turn to a smaller number of financial firms known as “dealers,” who are actively involved in large
quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes
market is sometimes called the “interbank market”, although a few insurance companies and other kinds of
financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of
millions of dollars. Because of the sovereignty issue when involving two currencies, forex has little (if any)
supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments by enabling currency conversion. For
example, it permits a business in the United States to import goods from European Union member states,
especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also
supports direct speculation and evaluation relative to the value of currencies, and the carry trade, speculation
based on the interest rate differential between two currencies.[2]
In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some
quantity of another currency. The modern foreign exchange market began forming during the 1970s after three
decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary
management established the rules for commercial and financial relations among the world's major industrial
states after World War II), when countries gradually switched to floating exchange rates from the
previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of the following characteristics:

its huge trading volume representing the largest asset class in the world leading to high liquidity;

its geographical dispersion;

its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on Sunday
(Sydney) until 22:00 GMT Friday (New York);

the variety of factors that affect exchange rates;

the low margins of relative profit compared with other markets of fixed income; and

the use of leverage to enhance profit and loss margins and with respect to account size.

As such, it has been referred to as the market closest to the ideal of perfect competition,
notwithstanding currency intervention by central banks.
According to the Bank for International Settlements,[3] the preliminary global results from the 2013 Triennial
Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign
exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April 2010 and $3.3
trillion in April 2007.

Non-bank foreign exchange companies
Non-bank foreign exchange companies offer currency exchange and international payments to private individuals
and companies. These are also known as foreign exchange brokers but are distinct in that they do not offer
speculative trading but rather currency exchange with payments (i.e., there is usually a physical delivery of
currency to a bank account).
It is estimated that in the UK, 14% of currency transfers/payments are made via Foreign Exchange Companies.

These companies' selling point is usually that they will offer better exchange rates or cheaper payments than

the customer's bank.[70] These companies differ from Money Transfer/Remittance Companies in that they
generally offer higher-value services.
Money transfer/remittance companies and bureaux de change
Money transfer companies/remittance companies perform high-volume low-value transfers generally by
economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of
remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and
the Philippines) receive $95 billion. The largest and best known provider isWestern Union with 345,000 agents
globally followed by UAE Exchange
Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers.
These are typically located at airports and stations or at tourist locations and allow physical notes to be
exchanged from one currency to another. They access the foreign exchange markets via banks or non bank
foreign exchange companies.

3 Explain Swap, its features and types of Swap.
Swaps are derivative instruments that involve an agreement between two parties to exchange a series of cash
flows over a specific period of time .(See related: An Introduction To Swaps.)

There are multiple reasons why parties agree to such an exchange:
Investment objectives or repayment scenarios may have changed.
It may be financially beneficial to switch to newly available alternate stream of
cash flows compared to the existing one.
Hedging can be achieved through swaps, like mitigation of risk associated with a
floating rate loan repayment.
Being OTC products, swaps offer great flexibility to design and structure
contracts based on mutual agreement. This flexibility leads to a lot of swap
variations, each serving a specific purpose. We will look at different types of
swaps and how each participant in the swap benefits.

Interest Rate Swaps

The most popular types of swaps are plain vanilla interest rate swaps. They allow
two parties to exchange fixed and floating cash flows on an interest-bearing
investment or loan.
Businesses or individuals take loans from the markets in which they have an
advantage in order to secure a cost-effective loan. However, their selected
market may not offer their preferred loan or loan structure. For instance, an
investor may get cheaper loan in a floating rate market, but he prefers a fixed
rate. Interest rate swaps enable the investor to switch the cash flows, as desired.

Currency Swaps

Assume an Australian company is setting up business in the UK and needs GBP
10 million. Assuming AUD/GBP exchange rate at 0.5, the total comes to AUD 20
million. Similarly, a UK-based company wants to setup a plant in Australia and
needs AUD 20 million. The cost of a loan in the UK is 10% for foreigners and 6%
for locals, while that in Australia is 9% for foreigners and 5% for locals. Apart
from high cost of a loan for foreign companies, it might be difficult to easily get
the loan due to procedural difficulties. Both companies have the competitive
advantage in their domestic loan markets. The Australian firm can take a lowcost loan of AUD 20 million in Australia, while the English firm can take a loan of
GBP 10 million in the UK. Assume both loans need six monthly repayments. Both
companies can get into a currency swap agreement.
At the start, the Australian firm gives AUD 20 million to the English firm, and
receives GBP 10 million, enabling both firms to start business in their respective
foreign lands. Every six months, the Australian firm pays the English firm the
interest payment for the English loan = (notional GBP amount * interest rate *
period) = (10 million * 6% * 0.5) = GBP 300,000. While the English firm pays the
Australian firm the interest payment for the Australian loan = (notional AUD
amount * interest rate * period) = (20 million * 5% * 0.5) = AUD 500,000. Such
interest payments continue until the end of the swap agreement, at which time,
the original notional forex amounts will be exchanged back to each other.

Commodity Swaps

Commodity swaps are common among people or companies that use raw
material to produce goods or finished products. Profit from a finished product
may take a hit if the commodity prices vary, as output prices may not
necessarily change in sync with the commodity prices. A commodity swap allows
receipt of payment linked to the commodity price against a fixed rate.
Assume two parties get into a commodity swap over one million barrels of crude
oil. One party agrees to make six-monthly payments at a fixed price of $60 per
barrel and receive the existing (floating) price. The other party will receive the
fixed and pay the floating.
Benefits: The first party has locked in the price of commodity using a currency
swap, achieving a price hedge. Commodity swaps are effective hedging tools
against variations in commodity prices or against variation in spreads between
the final product and the raw material prices.

Credit Default Swaps (CDS)

Another popular type of swap, the credit default swap, offers insurance in case of
default on part of a third-party borrower. Assume Peter bought a 15-year long
bond issued by ABC, Inc. The bond is worth $1,000 and pays annual interest of
$50 (i.e., 5% coupon rate). Peter worries that ABC, Inc. may default, so he gets
into a credit default swap contract with Paul. Under the swap agreement, Peter
(CDS buyer) agrees to pay $15 per year to Paul (CDS seller). Paul trusts ABC, Inc.
and is ready to take the default risk on its behalf. For the $15 receipt per year,
Paul will offer insurance to Peter for his investment and returns. In case ABC, Inc.
defaults, Paul will pay Peter $1,000 plus any remaining interest payments. In
case ABC, Inc. does not default throughout the 15-year long bond duration, Paul
benefits by keeping the $15 per year without any payables to Peter.

Benefits: CDS work as insurance to protect the lenders and bondholders from
borrowers’ default risk. (Related: Credit Default Swaps: An Introduction)
Zero Coupon Swaps (ZCS)
Similar to the interest rate swap, the zero coupon swap offers flexibility to one of
the parties in the swap transaction. In a fixed-to-floating zero coupon swap, the
fixed rate cash flows are not paid periodically, but only once at the end of the
maturity of the swap contract. The other party paying floating rate keeps paying
regular periodic payments following the standard swap payment schedule.
A fixed-fixed zero coupon swap is also available, wherein one party does not
make any interim payments, but the other party keeps paying fixed payments as
per the schedule.
Benefits: Such zero coupon swaps are primarily used for hedging. ZCS are often
entered into by businesses to hedge a loan in which the interest is to be paid at
maturity, or by banks that issue bonds with end-of-maturity interest payments.
Total Return Swaps (TRS)
A total return swap allows an investor all the benefits of owning a security,
without actually owning it. A TRS is a contract between a total return payer and
total return receiver. The payer usually pays the total return of an agreed
security to the receiver, and receives a fixed/floating rate payment in exchange.
The agreed (or referenced) security can be a bond, index, equity, loan, or
commodity. The total return will include all generated income and capital
4 Explain in detail the types of exposure and measuring economic exposure
In the present era of increasing globalization and heightened currency volatility, changes in exchange rates have
a substantial influence on companies’ operations and profitability. Exchange rate volatility affects not just
multinationals and large corporations, but small and medium-sized enterprises as well, even those who only
operate in their home country. While understanding and managing exchange rate risk is a subject of obvious
importance to business owners, investors should be familiar with it as well because of the huge impact it can
have on their investments.
Economic or Operating Exposure
Companies are exposed to three types of risk caused by currency volatility:

Transaction exposure – This arises from the effect that exchange rate fluctuations have on a company’s
obligations to make or receive payments denominated in foreign currency in future. This type of
exposure is short-term to medium-term in nature.

Translation exposure – This exposure arises from the effect of currency fluctuations on a company’s
consolidated financial statements, particularly when it has foreign subsidiaries. This type of exposure is
medium-term to long-term.

Economic (or operating) exposure – This is lesser known than the previous two, but is a significant risk
nevertheless. It is caused by the effect of unexpected currency fluctuations on a company’s future cash
flows and market value, and is long-term in nature. The impact can be substantial, as unanticipated
exchange rate changes can greatly affect a company’s competitive position, even if it does not operate
or sell overseas. For example, a U.S. furniture manufacturer who only sells locally still has to contend
with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar
strengthens markedly.

Note that economic exposure deals with unexpected changes in exchange rates - which by definition are
impossible to predict - since a company’s management base their budgets and forecasts on certain exchange
rate assumptions, which represents their expected change in currency rates. In addition, while transaction and
translation exposure can be accurately estimated and therefore hedged, economic exposure is difficult to quantify
precisely and as a result is challenging to hedge.

An example of economic exposure
Here’s a hypothetical example of economic exposure. Consider a large U.S. pharmaceutical with subsidiaries
and operations in a number of countries around the world. The company’s largest export markets are Europe and
Japan, which together account for 40% of its annual revenues. Management had factored in an average decline
of 3% for the dollar versus the euro and Japanese yen for the current year and next two years. Their bearish view
on the dollar was based on issues such as the recurring U.S. budget deadlock, as well as the nation’s growing
fiscal and current account deficits, which they expected would weigh on the greenback going forward.
However, a rapidly improving U.S. economy has triggered speculation that the Federal Reserve may be poised to
tighten monetary policy much sooner than expected. The dollar has been rallying as a result, and over the past
few months, has gained about 5% against the euro and yen. The outlook for the next two years suggests further
gains in store for the dollar, as monetary policy in Japan remains very stimulative and the European economy is
just emerging out of recession.
The U.S. pharmaceutical company is faced not just with transaction exposure (because of its large export sales)
and translation exposure (as it has subsidiaries worldwide), but also with economic exposure. Recall that
management had expected the dollar to decline about 3% annually against the euro and yen over a three-year
period, but the greenback has already gained 5% versus these currencies, a variance of 8 percentage points and
growing. This will obviously have a negative effect on the company’s sales and cash flows. Savvy investors have
already cottoned on to the challenges facing the company due to these currency fluctuations and the stock has
declined 7% in recent months.
P = a + (b x S) + e
where a is the regression constant, b is the regression coefficient, and e is a random error term with a mean of
zero. The regression coefficient b is a measure of economic exposure, and measures the sensitivity of the
asset’s dollar value to the exchange rate.
The regression coefficient is defined as the ratio of the covariance between the asset value and the exchange
rate, to the variance of the spot rate. Mathematically it is defined as:
b = Cov (P,S) / Var (S)
A numerical example
A U.S. pharmaceutical (call it USMed) has a 10% stake in a fast-growing European company – let’s call it
EuroMax. USMed is concerned about a potential long-term decline in the euro, and since it wants to maximize
the dollar value of its EuroMax stake, would like to estimate its economic exposure.
USMed thinks the possibility of a stronger or weaker euro is even, i.e. 50-50. In the strong-euro scenario, the
currency would appreciate to 1.50 against the dollar, which would have a negative impact on EuroMax (as it
exports most of its products). As a result, EuroMax would have a market value of EUR 800 million, valuing
USMed’s 10% stake at EUR 80 million (or $120 million). In the weak-euro scenario, the currency would decline to
1.25; EuroMax would have a market value of EUR 1.2 billion, valuing USMed’s 10% stake at EUR 120 million (or
$150 million).
If P represents the value of USMed’s 10% stake in EuroMax in dollar terms, and S represents the euro spot rate,
then the covariance between P and S (i.e. the way they move together) is:
Cov (P,S) = -1.875
Var (S) = 0.015625
Therefore, b = -1.875/ (0.015625) = -EUR 120 million
USMed’s economic exposure is therefore negative EUR 120 million, which means that the value of its stake in
EuroMed goes down as the euro gets stronger, and goes up as the euro weakens.

In this example, we have used a 50-50 possibility (of a stronger or weaker euro) for the sake of simplicity.
However, different probabilities can also be used, in which case the calculations would be a weighted average of
these probabilities.
Managing operating exposure
The risks of operating or economic exposure can be alleviated either through operational strategies or currency
risk mitigation strategies.
Operational strategies

Diversifying production facilities and markets for products: Diversification would mitigate the risk
inherent in having production facilities or sales concentrated in one or two markets. However, the
drawback here is that the company may have to forgo economies of scale.

Sourcing flexibility: Having alternative sources for key inputs makes strategic sense, in case exchange
rate moves make inputs too expensive from one region.

Diversifying financing: Having access to capital markets in several major nations gives a company the
flexibility to raise capital in the market with the cheapest cost of funds.

Currency risk mitigation strategies
The most common strategies in this regard are listed below.

Matching currency flows: This is a simple concept that requires foreign currency inflows and outflows to
be matched. For example, if a U.S. company has significant inflows in euros and is looking to raise debt,
it should consider borrowing in euros.

Currency risk-sharing agreements: This is a contractual arrangement in which the two parties involved in
a sales or purchase contract agree to share the risk arising from exchange rate fluctuations. It involves a
price adjustment clause, such that the base price of the transaction is adjusted if the rate fluctuates
beyond a specified neutral band.

Back-to-back loans: Also known as a credit swap, in this arrangement two companies located in different
countries arrange to borrow each other’s currency for a defined period, after which the borrowed
amounts are repaid. As each company makes a loan in its home currency and receives equivalent
collateral in a foreign currency, a back-to-back loan appears as both an asset and a liability on their
balance sheets.

Currency swaps: This is a popular strategy that is similar to a back-to-back loan but does not appear on
the balance sheet. In a currency swap, two firms borrow in the markets and currencies where each can
get the best rates, and then swap the proceeds.

The Bottom Line
An awareness of the potential impact of economic exposure can help business owners take steps to mitigate this
risk. While economic exposure is a risk that is not readily apparent to investors, identifying companies and stocks
that have the biggest such exposure can help them make better investment choices during times of heightened
exchange rate volatility.

5 Elaborate on the tools of foreign exchange risk management and techniques of
exposure management.
Many firms are exposed to foreign exchange risk - i.e. their wealth is affected by movements in exchange rates - and will seek
to manage their risk exposure. This page looks at the different types of foreign exchange risk and introduces methods for
hedging that risk.

Types of foreign exchange risk
Transaction risk
This us the risk of an exchange rate changing between the transaction date and the subsequent settlement date, i.e. it is the
gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company exports goods on credit then it has a figure for
debtors in its accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date
to the settlement date.
As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such
exposure. Measuring and monitoring transaction risk is normally an important component oftreasury risk management.

The degree of exposure is dependent on:
(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.
The anticipated volatility of the exchange rates during the hedge period.
The corporate risk management policy should state what degree of exposure is acceptable. This will probably be dependent on
whether the Treasury Department is been established as a cost or profit centre.
Economic risk
Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses these plus the
longer-term affects of changes in exchange rates on the market value of a company. Basically this means a change in
the present value of the future after tax cash flows due to changes in exchange rates.
There are two ways in which a company is exposed to economic risk.
Directly: If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because
your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at
If your firm's home currency strengthens then foreign competitors are able to gain sales at your expense because your products
have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home.
Indirectly: Even if your home currency does not move vis-a -vis your customer's currency you may lose competitive position.
For example suppose a South African firm is selling into Hong Kong and its main competitor is a New Zealand firm. If the New
Zealand dollar weakens against the Hong Kong dollar the South African firm has lost some competitive position.
Even if your home currency does not move vis-a -vis your customer's currency you may lose competitive position. For example
suppose a South African firm is selling into Hong Kong and its main competitor is a New Zealand firm. If the New Zealand dollar
weakens against the Hong Kong dollar the South African firm has lost some competitive position.
Economic risk is difficult to quantify but a favoured strategy to manage it is to diversify internationally, in terms of sales, location
of production facilities, raw materials and financing. Such diversification is likely to significantly reduce the impact of economic
exposure relative to a purely domestic company, and provide much greater flexibility to react to real exchange rate changes.
Translation risk
The financial statements of overseas subsidiaries are usually translated into the home currency in order that they can be
consolidated into the group's financial statements. Note that this is purely a paper-based exercise - it is the translation not the
conversion of real money from one currency to another.
The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if there has been
a significant foreign exchange movement.

If initially the exchange rate is given by $/£1.00 and an American subsidiary is worth $500,000, then the UK parent company
will anticipate a balance sheet value of £500,000 for the subsidiary. A depreciation of the US dollar to $/£2.00 would result in
only £250,000 being translated.
Unless managers believe that the company's share price will fall as a result of showing a translation exposure loss in the
company's accounts, translation exposure will not normally be hedged. The company's share price, in an efficient market,
should only react to exposure that is likely to have an impact on cash flows.

Hedging transaction risk - the internal techniques
Internal techniques to manage/reduce forex exposure should always be considered before external methods on cost grounds.
Internal techniques include the following:
Invoice in home currency
One easy way is to insist that all foreign customers pay in your home currency and that your company pays for all imports in
your home currency.
However the exchange-rate risk has not gone away, it has just been passed onto the customer. Your customer may not be too
happy with your strategy and simply look for an alternative supplier.
Achievable if you are in a monopoly position, however in a competitive environment this is an unrealistic approach.
Leading and lagging
If an importer (payment) expects that the currency it is due to pay will depreciate, it may attempt to delay payment. This may be
achieved by agreement or by exceeding credit terms.
If an exporter (receipt) expects that the currency it is due to receive will depreciate over the next three months it may try to
obtain payment immediately. This may be achieved by offering a discount for immediate payment.
The problem lies in guessing which way the exchange rate will move.
When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them
against each other.
It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.
An extension of the matching idea is setting up a foreign currency bank account.
Bilateral and multilateral netting and matching tools are discussed in more detail here.
Decide to do nothing?
The company would "win some, lose some".
Theory suggests that, in the long run, gains and losses net off to leave a similar result to that if hedged.
In the short run, however, losses may be significant.
One additional advantage of this policy is the savings in transaction costs.

Hedging transaction risk - the external techniques
Transaction risk can also be hedged using a range of financial products. These are introduced below with links to more detailed
Forward contracts

The forward market is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e. the forward
rate of exchange. This effectively fixes the future rate.
Forward contracts can be explored in more detail here.
Money market hedges
The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate instead. This is
achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur. This effectively
fixes the future rate.
Money market hedges can be explored in more detail here.
Futures contracts
Futures contracts are standard sized, traded hedging instruments.
The aim of a currency futures contract is to fix an exchange rate at some future date, subject to basis risk.
Currency futures can be explored in more detail here.
A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If there is a
favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The
right will only be exercised to protect against an adverse movement, i.e. the worst-case scenario.
A call option gives the holder the right to buy the underlying currency.
A put option gives the holder the right to sell the underlying currency.
Options are more expensive than the forward contracts and futures but result in an asymmetric risk exposure.
Currency options can be explored in further detail here.
Forex swaps
In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the
period at an agreed swap rate. The swap rate and amount of currency is agreed between the parties in advance. Thus it is
called a fixed rate/fixed rate swap.
The main objectives of a forex swap are:
To hedge against forex risk, possibly for a longer period than is possible on the forward market.
Access to capital markets, in which it may be impossible to borrow directly.
Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.
Forex swaps can be explored in further detail here.
Currency swaps
A currency swap allows the two counter parties to swap interest rate commitments on borrowings in different currencies.
In effect a currency swap has two elements:
An exchange of principal in different currencies, which are swapped back at the original spot rate - just like a forex swap.

An exchange of interest rates - the timing of these depends on the individual contract.
The swap of interest rates could be fixed for fixed or fixed for variable.

6 Write short note on:
a. Adjusted present value model (APV model)

The method is to calculate the NPV of the project as if it is all-equity financed (so called base
case). Then the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit
is a tax shield resulted from tax deductibility of interest payments. Another benefit can be a
subsidized borrowing at sub-market rates. The APV method is especially effective when
a leveraged buyout case is considered since the company is loaded with an extreme amount of
debt, so the tax shield is substantial.

Technically, an APV valuation model looks similar to a standard DCF model. However, instead
of WACC, cash flows would be discounted at the unlevered cost of equity, and tax shields at either
the cost of debt (Myers) or following later academics also with the unlevered cost of equity.[1] . APV
and the standard DCF approaches should give the identical result if the capital structure remains

APV formula[edit]

APV = Unlevered NPV of Free Cash Flows and assumed Terminal Value + NPV of Interest Tax
Shield and assumed Terminal Value

The discount rate used in the first part is the return on assets or return on equity if unlevered. The
discount rate used in the second part is the cost of debt financing by period.

In detail:


- Taxes on EBIT

=Net Operating Profit After Tax (NOPAT)

+ Non cash items in EBIT

- Working Capital changes

- Capital Expenditures and Other Operating Investments

=Free Cash Flows

Take Present Value (PV) of FCFs discounted by Return on Assets % (also Return on Unlevered
Equity %)

+ PV of terminal value

=Value of Unlevered Assets

+ Excess cash and other assets

=Value of Unlevered Firm (i.e., firm value without financing effects or benefit of interest tax shield)

+ Present Value of Debt's Periodic Interest Tax Shield discounted by Cost of Debt Financing %

=Value of Levered Firm

- Value of Debt

=Value of Levered Equity or APV

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