8.

INTERNATIONAL ASPECT OF FINANCIAL MANAGEMENT

1. Background
The motivation to invest capital in a foreign country is to provide a return in excess of that
required. There may be gaps in foreign market where excess returns can be earned.
Domestically, competitive pressures may be such that only a normal rate of return can be
earned. Although expansion into foreign market is the reason for most investment abroad, there
are other reasons. Some firm invest in order to produce more efficiently. Another country may
offer lower labor and other lower costs, thus a company will chose to locate production
facilities there in the quest for lower operating costs. Some companies invest abroad to secure
necessary raw materials. All these pursuit – markets, production facilities, and raw materials –
are in keeping with the objective of securing a higher rate of return than is possible through
domestic operations alone.

1.1. International Capital Budgeting

The relevant cash inflows for a foreign investment are those that can be repatriated to the
home country parent. If the expected return on the investment is based on non-remittable
cash flows that build up in the foreign subsidiary, the investment is unlikely to be
attractive. If cash flows can be freely repatriated, capital budgeting is straight forward. The
foreign firm would:

i. Estimate expected cash flows in the foreign currency

ii. Compute home currency equivalent at expected exchange rate (exchange rate is
the number of unit of one currency that may be purchased with one unit of
another currency)

iii. Determine the Net Present Value of the project using home required rate of
return, with the rate adjusted for any risk premium effect associated with the
foreign investment.

1.2. Risk Factors

With respect to required rate of return, international diversification is a consideration.
Recall the discussion on portfolio risk, the key element is the correlation among projects in
the asset portfolio. By combining projects with low degrees of correlation with each other,
a firm is able to reduce risk in relation to expected return. Because domestic investment
projects tend to correlated with each other, most being highly dependent on the state of the
domestic economy, foreign investments have an advantage. The economic cycles of
different countries do not tend to be completely synchronized, so it is possible to reduce
risk relative to expected return by investing across countries. The idea is simply that returns
on investment projects tend to be less correlated among countries than they are in any one
particular country. By diversifying across countries, overall risk may be reduced.

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1.3. Taxation by Foreign Government

Every country taxes income of foreign companies doing business in that country. The type
of tax imposed varies. Some of these countries differentiate between income distributed to
shareholders and undistributed income, with a lower tax on distributed income. Less
developed countries frequently have lower taxes and provide certain other tax incentive to
encourage foreign investment.

1.4 Political Risk

Multinational Company (MNC) faces political risks that can range from mild interference
to complete confiscation of all assets. Interference include laws that specify a minimum
percentage of nationals who must be employed in various positions, required investment in
environmental and social projects, and restriction on convertibility of currencies. The
ultimate political risk is expropriation. Between mild interference and outright
expropriation, there may be discriminatory practices such as higher taxes, higher utility
charges, and the requirement to pay higher wages than national company. In essence these
practices place the foreign operations at a competitive disadvantage. However, the situation
is not one discretional. Certain developing countries give foreign companies concessions to
invest such that they may have more favorable costs than domestic company.

Because political risk has a serious influence on the overall risk of an investment project, it
must be realistically assessed. Essentially, the job is one of forecasting political instability
by answering below questions:

- How stable is the host government?

- What are the prevailing political winds?
- What is likely to be the new government’s view of foreign investment?
- How efficient is the government to process request?
- How much inflation and economic stability are there?
- How strong and equitable are the courts?

Answers to these questions should give considerable insight into the political risk involved
in an investment. Some companies have categorized countries according to their political
risk. If a country is classified in the undesirable category, probably no investment will be
permitted, no matter how high its expected return.

Once a company decides to invest in a foreign country, it should take steps to protect itself.
By cooperating with the host country in hiring local nationals, making the right type of
investment, and acting responsibly in other ways political risk can be reduced. A joint
venture with a company in host country can improve the public image of the operations.
Indeed, in some countries a joint venture may be the only way to do business, because
direct ownership, particularly of manufacturing is prohibited. The risk of expropriation also

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can be reduced by making the subsidiary dependent on the parent for technology, market
and/or supplies. A foreign government is reluctant to expropriate if the enterprise is not self
–sustaining. In addition, political risk insurance may be warranted. Insurance or guarantee
against various political risk can be purchased from number of private insurance
companies, like Llyoids of London, and various international and governmental agencies
such as Multinational Insurance Guarantee Agency (MIGA), Agency for International
Development (AID), The Export-Import Bank of United State (Eximbank), and Overseas
Private Investment Corporation (OPIC). The political risk covered may include
expropriation, currency inconvertibility, war and revolution. In any e vent, the time to look
hardest at political risk is before the investment is made.

2. Exchange Rate Risk Exposure

The company with foreign operations is at risk in various ways. Apart from political danger,
risk fundamentally emanates from changes in exchange rates.

In this regard, the spot exchange rate represents the number of units of one currency that can be
exchanged for another for immediately delivery. The currencies of major countries are traded
in active market, where rates are determined by forces of supply and demand. Quotation can be
in terms of domestic currency or in terms of foreign currency.

Currency risk can be brought of as the volatility of the exchange rate of one currency for
another.

Spot exchange rate is distinguished from the forward exchange rate. Forward transactions
involve an agreement today for settlement in future. It might be the delivery of 1000 USD 120
days hence, where the settlement rate is 1,400 TZS per US Dollar. The forward exchange rate
usually differs from the spot exchange rate.

There are three types of exchange rate risk exposure with which we are concerned:
- Translation exposure
- Transactions exposure
- Economic exposure

Translation Exposure
Relate to change in accounting income and financial position caused by changes in
exchange rates on converting financial statements from one currency to another.

Transactions Exposure
Involve the gain or loss that occurs when settling a specific foreign transaction. The
transaction might be the purchase or sale of a product, the lending or borrowing of funds,

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8. INTERNATIONAL ASPECT OF FINANCIAL MANAGEMENT

or some other transaction involving the acquisition of asset or assumption of liabilities

denominated in a foreign currency. While any transaction will do, the term “transaction
exposure” is usually employed in connection with foreign trade that is, specific imports or
export on open account credit.

Economic Exposure
Is the change in value of a company that accompanies an unanticipated change in exchange
rates. We distinguish anticipated from unanticipated. Anticipated changes in exchange rates
are already reflected in the market value of the firm.

3. Management of Exchange Rate Risk Exposure

There are a number of ways in which exchange rate risk exposure can be managed. Natural
hedges; cash management; adjusting of intercompany account; as well as currency hedges
through forward contracts, future contracts, currency options, and currency swaps.

3.1 Natural Hedges

The relationship between pricing and costing of foreign subsidiary sometimes provide a
natural hedge, giving the firm ongoing protection from exchange-rate fluctuations. The key
is the extent to which cash flow adjust naturally to currency changes. It is not the country in
which a subsidiary is located that matters, but whether the subsidiary’s revenue and cost
functions are sensitive to global or domestic market conditions. At the extremes there are
four possible scenarios.

Globally Domestically
Determined Determined
Scenario 1*
Pricing X
Cost X
Scenario 2*
Pricing X
Cost X
Scenario 3
Pricing X
Cost X
Scenario 4
Pricing X
Cost X

*There is natural offsetting relationship provided by pricing and cost both

occurring in similar market environment.

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A key concern for the financial manager is the degree of exchange rate risk exposure
that remains after any natural hedging. This remaining exposure then can be hedged
using operating or currency market hedges.

3.2 Cash Management and Adjusting Intercompany Accounts

If a company knew that a country’s currency, where a subsidiary was based, was going
to fall in value, it would want to do a number of things:
 Reduce cash holdings in this currency to a minimum by purchasing
inventories or other real asset.
 Avoid extended trade credit (account receivable). Thus achieving as quick a
turnover as possible of receivable into cash.
 Try to obtain extended terms on accounts payable.
 Borrow in local currency to replace any advances made in foreign currency
(depending on relative interest rates).

If the currency were going to appreciate in value, opposite steps should be undertaken.
However, without knowledge of the future direction of currency value movements,
aggressive policies in either direction are inappropriate. Under most circumstances we
are unable to predict the future, so the best policy may be one of balancing monetary
assets against liabilities to neutralize the effect of exchange rate fluctuations,

A company with multiple foreign operations can protect itself against exchange rate
risk by adjusting its commitment to transfer funds among companies. Accelerating the
timing of payment made or received in foreign currencies is called leading, and
decelerating the timing is called lagging.

Some multinational companies establish a re-invoicing center to manage intra-company

and third-party foreign trade. The multinational’s exporting subsidiaries sell goods to
the re-invoicing centre, which resells (re-invoice) them to importing subsidiaries or
third part buyers. Title to the goods initially passes to the re-invoicing center, but the
goods move directly from the selling unit to the buying unit or independent customer.
Locations of re-invoicing centers are positioned in tax friendly areas such as Hong
Kong and British Virgin Islands as tax implication form a large part of the incentive for
re-invoicing.

Generally the re-invoicing center is billed in the selling unit’s home currency and, in
turn bills the purchasing unit in that unit’s home currency. In this way the re-invoicing
center can then centralize and manage all intercompany transactions exposure. The
centralized positions also facilitate inter-unit netting of obligations so as to reduce the

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necessary volume of actual foreign exchange transactions. Also this system allows for
more control over any leading or lagging arrangements between affiliates.

3.3 Currency Market Hedges

Another means to hedge currency exposure is through devices of several currency
markets- forward contracts, futures contracts, currency options, and currency swaps.

Forward Exchange Market

In this market, one buys a forward contract for exchange of one currency for another at
a specific future date and at a specific exchange ratio. A forward contract provides
assurance of being able to convert into desired currency at a price set in advance.

Example:
A TZ company sold coffee to a US customer for USD 1000 with credit terms of ‘net
90”. Upon payment, TZ Company intends to convert the USD into TZS. The spot and
forward rates for TZS were the following.

Spot rate TZS 1,300

90-day forward rate TZS 1,250

If a TZ company wishes to avoid exchange rate risk, it should sell USD 1000 forward
90 days. When it delivers the USD 90 days hence, it will receive 1,250,000 TZS. If spot
rate stays at TZS 1,300, of course, TZ Company would have been better off not having
sold the USD forward.

Currency Futures
Currency future market exists for major currencies of the world (USD, GBP, EUR
AUS$ etc). A future contract is a standardized agreement that calls for delivery of
currency at some specified future date, either the third Wednesday of March, June,
September or December. Contracts are traded on an exchange, and the clearinghouse of
the exchange interposes itself between the buyer and the seller. This means that all
transactions are with the clearinghouse, not made directly between two parties. Very
few contracts involve actual delivery at expiration. Rather, a buyer and a seller of
contract independently take offsetting positions to close out a contract. The seller
cancels contract by buying another contract, while the buyer can cancel a contract by
selling another contract.

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8. INTERNATIONAL ASPECT OF FINANCIAL MANAGEMENT

Future contracts are different from forward contracts in this regard;

- forward contract need to be settled only at expiration
- only a set number of maturities are available for future contracts
- future contracts come only in multiples of standard-size contract

Currency Options
Is a contract that a gives the holder a right to buy (call) or sell (put) a specific amount of
a foreign currency at some specified price until a certain expiration date. Currency
option enables the hedging of one sided risk contrast to forward and future contracts.
Only adverse currency movements are hedged, either with a call option to buy the
foreign currency or with a put option to sell it. The holder has a right, but not
obligation, to buy or sell the currency over the life of the contract. If not exercised, of
course the option expires. For this protection, one pays a premium.

Currency Swaps
In currency swap two parties exchange debt obligations denominated in different
currencies. Each part agrees to pay the other’s interest obligation. At maturity, principal
amounts are exchanged, usually at a rate of exchange agreed to in advance. The
exchange is notional in that only the cash flow difference is paid. If one part should
default, there is no loss of principal per se. There is however, the opportunity cost
associated with currency movements after the swap’s initiation.

4. Cross Exchange Rate

Is an exchange rate between two currencies calculated through their relationship with a single
common currency.

Special Example on Cross Exchange Rate:

A Tanzanian importer can buy one US$ for TZS. 1,350 and with that dollar, can buy
0.6205£. The cross rate between TZS and GBP would be calculated as follows:

TZS/US$ = 1350 TZS/US$ = 2176TZS/£

GBP/US$ 0.6205£/US$

However, calculating cross-rates is usually not as straight as this!

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Example:
Given the following Bid-Ask rates:
US$ 1.4419 - 1.4436 /£
US$ 0.6250 - 0.6267 /CHF

Calculate the CHF/£ rate! (2.3008 – 98)

Steps to follow:
a. Write the required rate in terms of the given rates,
b. Bid price: Going from bottom to top, use bottom currency to buy common
currency, then use obtained common currency to buy top currency,
c. Ask price: Go from top to bottom, use top currency to buy common
currency, then use obtained common currency to buy bottom currency.
d. Present results in terms of bid-ask quotation.

Cross rates mechanism:

As you practice more on cross rate questions you will see patterns emerging i.e

+ For example if rates are per unit common currency or common currency per unit
other two currencies, then you will have to divide the rates somehow and you
will be matching bids with asks.

+ Or if the rates are in different forms (common currency in different places) then
you will be multiplying and you will match bid with bid and ask with ask.

Importance of Cross Rates

Cross rates can be used to check on opportunities for inter-market arbitrage which is
commonly known as Triangular Arbitrage. This occurs when the cross rate obtained
from calculation differs from the actual quotation i.e there exist opportunities for
making profits from inter-market arbitrage.

Arbitrage process involves buying and selling currencies to benefit from inefficiencies
existing in the foreign exchange market. Here, arbitrager knows from the beginning
what is going to earn from the process.

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Example on Triangular Arbitrage:

Suppose the following exchange rates are available

Bank of Tanzania TZS/US$ 1,350

Bank of America GBP/US$ 0.6205
Bank of England TZS/GBP 2,235

The synthetic cross rate between TZS and GBP is obtained from calculation as:

TZS/US$ = 1350 = 2,176 TZS/GBP

GBP/US$ 0.6205

This means, more TZS are obtained from Bank of England.

Triangular Arbitrage:

The above diagram demonstrates how Tanzanian investors having one million TZS benefit
from exchange market inefficiencies.

Steps:
a. Convert 1Million TZS into common currency, i.e buy US$ in spot
market at spot exchange market. The transaction will lead to 747.74US$.
i.e 1

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1,000,000 = 747.74 US$

1350

b. Buy GPB in spot market using proceeds (in common currency) from (a),
investor will get 459.63 GBP (747.74 US$ x 0.6205GBP/US$)

c. Buy TZS in spot market using GBP proceeds from (b), investor will get
TZS 1,027,272 (459.63GBP x 2,235 TZS/GBP)

The profit made is TZS 27,272. This is possible only when the market of for
foreign exchange is inefficient.

Arbitrage process may not continue for long time. It will carry on until when market
equilibrium is re-established i.e. when calculated cross rate is equal to actual quotation.
The larger the difference between the actual rate and calculated cross rate the larger the
profit.

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