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The Foreign Exchange

Market
Functions of Forex Market
 Transfer of funds from one nation & currency to
another.
 Why exchange?
# Import & Export of goods
# Import & Export of services
# Tourism
# Investment
Eg. A US commercial bank has oversupply of
pounds, then sell excess pounds, then finally a
nation pays for its tourist exp. imports, investments
etc.
Participants in Forex Market:
 Level 1:
Tourists, importers, exporters, investors-
immediate users & suppliers of foreign
currencies.
 Level 2:

Commercial banks- they act as clearing


houses between users and earners, do not
actually buy & sell- Retail market
Participants in Forex Market:
 Level 3:
Forex brokers- They deal with commercial
banks.
 Level 4:

Nation’s central bank:


Act as Lender/ Buyer of last resort- Interbank
market/ wholesale market
Entities in Forex market
 Authorised dealers-are commercial banks
 Money changers- Buy/ sell form customers-
deal in notes, coins and travelers’ cheque.

 FEDAI- Forex Dealers’ Association of India


The Foreign Exchange Rates
 Definition- An exchange rate quotation is the
price of a currency stated in terms of another.
For eg. Rs 50/ $

 This means that price of one dollar is Rs 50.

 It is like quoting the price of a commodity.


The Foreign Exchange Rates
 Suppose there are two nations: US and UK
and the exchange rate is R.

 R=2, i.e. R= 2 $/ £ or
R= $/ £ = 2
i.e. 2 dollars are required to buy one pound.
The Foreign Exchange Rates

X axis- Quantity of
pounds
Y axis- exchange
rate i.e. R
R= $/£
Analysis:
 Lower exchange rate:
a) fewer dollars will be required to purchase
one pound.
b) It will be cheaper for US to import funds from
UK.
c) Better for us to invest in UK.

 Therefore, Demand for pound increases.


Analysis:
 Higher exchange rate:
a) Uk gets more dollars for pound.
b) They find UK goods to be cheaper.
c) They find investing in US attractive.

 Therefore, Supply of pound in US increases.


Analysis:
 If exchange rate becomes 3, i.e. R= 3 $/ £,
means that now three dollars are required to
buy a pound thus, depicting Depreciation of
US dollar.
 If exchange rate becomes 1, i.e. R= 1 $/ £,
means that now one dollar is required to buy
a pound thus, depicting Appreciation of US
dollar.
Factors that affect the
Equilibrium Exchange Rate
1. Relative inflation rates- Eg. R= 2$ / £, If
inflation in US in higher than in UK, then US
goods will be costlier than that of UK goods
and therefore, UK will export more goods to
US and US will export less goods to UK.
 This means that value of Dollar has
Depreciated w.r.t. Pounds, or
 Value of Pounds has Appreciated w.r.t. US
dollars.
Factors that affect the
Equilibrium Exchange Rate
2. Relative interest rates
 If real interest rates of US are higher than that of
UK, then the dollar is said to have appreciated as
compared to pound.
 Real interest rate = Nominal interest rate -
Inflation
 If interest rate of US > int. rate of UK (because of
inflation, then wrong picture).
 Therefore, real interest rate should be considered.
Factors that affect the
Equilibrium Exchange Rate
3. Relative economic growth rates:
 Strong economic growth- attract investment

4. Political & Economic risk:


 High risk currency- more valuable
Exchange Rate Quotations:
1. American Quote/ Direct quote:
No. of units of home currency for one unit of
foreign currency.

eg. Rs 50/ $, means that 50 rupees are


required to buy one unit of foreign currency/
dollar.
Exchange Rate Quotations:
2. European Quote/ Indirect quote:
No. of units of foreign currency required to buy one
unit of home currency. i.e. for one unit of home
currency, how many units of foreign currency is
required?

eg. $0.02/ Rs 1, means that 0.02 dollars are


required to buy one unit of home currency/ rupees.
FF 0.1462/ Rs 1, 0.1462 French Franc per rupee.
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currency Symbol Direct Indirect


quote quote
UK Pound £/ GBP 66.92
Sterling

US US Dollar $ 43.30

Canada Canadian Can$ 29.10


Dollar
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currency Symbol Direct Indirect


quote quote
UK Pound £/ GBP 66.92 0.0149
Sterling

US US Dollar $ 43.30 0.0231

Canada Canadian Can$ 29.10 0.0344


Dollar
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currency Symbol Direct Indirect


quote quote
Germany Deutsch DM/DEM 22.94
mark

Euro € 44.87

Netherlan Dutch DG/$f/ 20.36


ds Guilder NLG
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currency Symbol Direct Indirect


quote quote
Germany Deutsch DM/DEM 22.94 0.0436
mark

Euro € 44.87 0.0223

Netherlan Dutch DG/$f/ 20.36 0.0491


ds Guilder NLG
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currency Symbol Direct Indirect


quote quote
Switzerla Swiss sFr 0.0358
nd franc

France French FF/ FRF 0.1462


franc

Italy Swedish SKr 0.1931


krona
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currency Symbol Direct Indirect


quote quote
Switzerla Swiss sFr 27.97 0.0358
nd franc

France French FF/ FRF 6.84 0.1462


franc

Italy Swedish SKr 5.18 0.1931


krona
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currency Symbol Direct Indirect


quote quote
Italy Italian lira Lira/ Lit/ 43.2901
ITL

Japan Japanese ¥ 2.4994


Yen

Australia Australia AU$ 0.0360


n dollar
Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)

Country Currency Symbol Direct Indirect


quote quote
Italy Italian lira Lira/ Lit 0.0231 43.2901
/ITL

Japan Japanese ¥ 0.4001 2.4994


Yen

Australia Australia AU$ 27.76 0.0360


n dollar
Numerator and Denominator
 The higher fraction is supposed to be the
numerator and the Denominator corresponds
to its lower part.

Eg. EUR / USD,

 EUR is the basic currency (Numerator) &


USD is the counter currency (Denominator).
Buying and selling a currency
 Buy/ Long EUR/ USD, means that you want
to buy EUR and sell USD.

 Sell / Short EUR/ USD, means that you want


to sell the basic currency and buy the counter
currency i.e. sell EUR and buy USD.

 Short sell
Bid and Ask Rates
 A bank is ready to buy and sell a currency at
different prices.
Buy price- Bid rate
Sell price- Ask rate
 Spread- Difference between Bid and Ask rate is
called Bid- ask Spread.
 It is more in retail market and less in interbank
market as there is more volume, greater liquidity
and lower counterparty risk in interbank
transactions.
Causes of spread are:
 Transaction cost
 Return on capital employed

 Reward / Compensation for taking risk

 Mid rate- Arithmetic mean of bid and ask


rates i.e. when one rate is mentioned.
Important conventions
regarding quotes:
a) The bid rate always precedes the ask rate.
E.g Rs/$ 45.45 / 45.50
b) The bid and ask rates are always separated either
by slash(/) or (-).
c) The quote is always from the banker’s point of view.
Rs/$ 45.45 / 45.50
E.g The banker is ready to buy dollar at 45.45
and sell at 45.50. i.e. Banker’s buy rate= Customer’s
sell rate.
d) The Bid is always lower than the ask. (ask rate- Bid
rate = profit)
Interbank quote vs Merchant
quote
 Merchant quote is by bank to its retail
customers.
 Interbank quote is given by one bank to
another bank.
Since, both the parties are banks, then whose
quote will be considered. The bank
requesting the quote will is the customer and
the other bank’s quote will be considered.
Basis Point (BPS)
A unit that is equal to 1/100th of 1%, and
is used to denote the change in a financial
instrument. The basis point is commonly
used for calculating changes in interest rates,
equity indexes and the yield of a fixed-income
security.
 The relationship between percentage
changes and basis points can be
summarized as follows: 1% change = 100
basis points, and 0.01% = 1 basis point.
Basis Point (BPS)
 So,a bond whose yield increases from 5% to
5.5% is said to increase by 50 basis points;
or interest rates that have risen 1% are said
to have increased by 100 basis points.
Cross Rates / Synthetic rates
 When we calculate the exchange rates
between other currencies with the dollar (or
any other currency) as the intermediate
currency.

 The € / £ rate will be calculated through the


€ / $ quote and the $/ £ quote.
Cross Rates
 Eg. We need to calculate the Switzerland
franc / Canadian Dollar (sFr/ Can$) rate from
given sFr / $ and $/ Can$ quotes.
sFr / $ : 5.5971 / 5.5978
$/ Can$ : 0.7555 / 0.7562
 Synthetic (sFr/ Can$)bid rate

= 5.5971 * 0.7555
= (sFr / $)bid * ($/ Can$)bid
= 4.2286
Cross Rates
 Eg. We need to calculate the Switzerland
franc / Canadian Dollar (sFr/ Can$) rate from
given sFr / $ and $/ Can$ quotes.
sFr / $ : 5.5971 / 5.5978
$/ Can$ : 0.7555 / 0.7562
 Synthetic (sFr/ Can$)ask rate

= 5.5978 * 0.7562
= (sFr / $)ask * ($/ Can$)ask
= 4.2330
Appreciation & Depreciation
Q1. During 2002, the yen went from
$0.0074074 to $0.0084746.

c) By how much did the yen appreciate against


the dollar?
d) By how much has the dollar depreciated
against the yen?
Appreciation & Depreciation
Solution:
b) The yen has appreciated against the dollar by an
amount equal to (0.0084746 – 0.0074074)/
0.0074074 = 14.41%.
c) An exchange rate of ¥ 1= 0.0074074 translates
into an exchange rate of $ 1 = ¥135 (1/ 0.0074074
=135). Similarly, the exchange rate of ¥ 1=
$0.0084746 is equivalent to an exchange rate of $
1 = ¥118. Therefore, the dollar has depreciated
(against the yen) by an amount equal to (118-135)/
135 = -12.59%.
The Foreign Exchange Market
Types of Transactions

 Spot- Spot quotes- Prices in spot market

 Forward- Forward quote- Prices in Forward


market
Premium / Discount
 Forward Premium- when,
Forward rate > Spot Rate
 Forward Discount- when,
Forward rate < Spot Rate
The forward discount / premium is expressed in
annualised percentage terms as follows:

Forward premium/ = Forward- Spot


Discount rate rate * 360
Spot rate Forward
contract no. of days
Arbitrage
 Simultaneous purchase and sale of the same
assets / commodities on different markets to
profit from price discrepancies.
 Eg. If the dollar price of pounds were $1.98 in
New York and $ 2.01 in London, an
arbitrageur would purchase pounds at $1.98
in New York and immediately resell them in
London for $2.01, thus realising a profit of
$0.03 per pound.
Arbitrage
As arbitrage continues, the exchange rate
between the 2 currencies tends to get
equalised in the two monetary centres.

a) Two point arbitrage- Two currencies, Two


countries
b) Three point arbitrage- Three currencies,
Three countries
Interest Arbitrage
 It refers to the International flow of short term liquid
capital to earn a higher return abroad. It can be
covered or uncovered.
1) Uncovered Interest Arbitrage
The transfer of funds abroad from to take advantage
of higher interest rates in foreign monetary centres
usually involves the conversion of the domestic
currency to the foreign currency, to make the
investment. At the time if maturity, the funds
(principal + interest) are reconverted from the
foreign currency to the domestic currency.
Uncovered Interest Arbitrage
Low interest rate High interest rate
country country

investment
Eg. In Germany, the annualised interest rate
is 11% whereas in London it is 15%.
Suppose, a company has excess funds for 3
months. In which country one should invest?
Covered Interest Arbitrage
 Spot purchase of foreign currency to make
the investment and offsetting the
simultaneous the simultaneous forward sale
to cover the foreign risk.
 Net return= Positive interest differential (-)

Forward discount on the foreign


currency
Illustration 1
 Spot rate: Rs 42.0010 = $ 1
 6 month forward rate: Rs 42.8020 = $ 1

 Annualised interest rate on:

6 month rupee: 12 %
6 month dollar: 8%
Calculate the arbitrage possibilities.
Solution to Illustration1
 The rule is that if the interest rate differential is
greater than the premium or discount, place the
money in the currency that has a higher rate if
interest or vice –versa.
Given the above data:
 Negative interest rate differential= (12-8)= 4%
 Forward premia (annualised) =
Forward rate-Spot rate * 100 * 12
Spot rate 6
= 42.8020 – 42.0010 * 100 * 12 = 3.8141 %
42.0010 6
Solution to Illustration1
 Negative interest rate differential> forward
premia, therefore, there is a possibility of
arbitrage inflow in India.
 Suppose, investment = $1000 by taking a
loan @ 8% in US. Invest in India at spot rate
of Rs 42.0010 @ 12 % for six months and
cover the principal + interest in the six month
forward rate.
 Principal= $ 1000 = Rs 42001
Solution to Illustration1
 Intereston investment for six months
= Rs 42,001 * 12/ 100* 6/12
= Rs 2520.06
 Amount at the end of six months = Interest +
Principal
= Rs 42001+ 2520.06
= Rs 44,521.06
Solution to Illustration1
 Converting the above in dollars at the
forward rate = $ 44,521.06 / 42.8020
= $ 1,040.16
 The arbitrageur will have to pay at the end of
six months = $1,000+ ($1000* 8/100 *6 /12)
 Hence, the arbitrageur gains ($1040.16 -
$1040) = $ 0.16 on borrowing $1000 for six
months.
Illustration 2
 Spot rate: Rs 44.0030 = $ 1
 6 month forward rate: Rs 45.0010 = $ 1

 Annualised interest rate on:

6 month rupee: 12 %
6 month dollar: 8%
Calculate the arbitrage possibilities.
Solution to Illustration 2
 The rule is that if the interest rate differential is
greater than the premium or discount, place the
money in the currency that has a higher rate if
interest or vice –versa.
Given the above data:
 Negative interest rate differential= (12-8)= 4%
 Forward premia (annualised) =
Forward rate-Spot rate * 100 * 12
Spot rate 6
= 45.0010 – 44.0030 * 100 * 12 = 4.5361%
42.0030 6
Solution to Illustration 2
 Negative interest rate differential< forward
premia, therefore, there is a possibility of
arbitrage inflow in US.
 Suppose, investment = Rs 10,000 by taking a
loan @ 12% in India.
 Invest in US at spot rate of Rs 44.0030 @ 8
% for six months (US $ 227.257) and cover
the principal + interest in the six month
forward rate.
Solution to Illustration 2
 Amount at the end of six months = Interest +
Principal
= $227.257* 8/ 100* 6/12
= $ 236.3473
 Sell US $ at 6 month forward to receive
236.3473* 45.0010= Rs 10635.865
 Return the rupee debt borrowed at 12%. The
amount to be refunded is Rs 10,600
 Profit= Rs 10635.865 - 10600= 35.865
Illustration 3
 Spotrate FFr 6.00 =$1
 6 month forward rate FFr 6.0020 = $1

 Annualised interest rate on :

6 month US $ = 5%
6 month FFr = 8%
Illustration 4
 An American firm purchases $4,000 worth of
perfume (FF 20,000) from a French firm. The
American distributor must make the payment
in 90 days in French francs. Given that:
 Spot rate $ 0.2000 = 1 FF

 90 day forward rate 0.2200 = 1 FF

 US interest rate 15%

 French interest rate 10%


Purchasing Power Parity (PPP)
It focuses on inflation and exchange rate
relationships.
There are 2 forms of PPP theory:
3. Absolute Purchasing Power Parity
It states that price levels should be equal
worldwide when expressed in a common
currency. i.e. A unit of home currency
should have the same purchasing power all
around the world.
Absolute Purchasing Power
Parity
 Also, the exchange rate between currencies
of two currencies is equal to the ratio of the
price levels in the two nations.
 i.e. Rab = Pa /Pb

Where,
Pa – General price level in Nation A
Pb- General price level in nation B
Rab – Exchange rate between currencies of
Nation A & B
Absolute Purchasing Power
Parity
 Itdoes not consider:
a) Transportation cost, tariffs, quotas. Product
differentiation.
b) Existence of non- traded goods and services
eg Cement, bricks, doctors etc.
Relative Purchasing Power
Parity
 The change in the exchange rate over a
period of time should be proportional to the
relative change in the price levels in the 2
nations over the same time period.
 Rab1 = Pa1/ Pa0 * Rab0

Pb1/ Pb0
If the absolute PPP were to hold true, the
relative PPP would also hold. However, the
vice- versa will not hold true.
Problems in Relative PPP
 Ratio of prices of non- traded goods to the
prices of traded goods & services is
consistently higher in developed nations than
in developing nations.
 Various factors other than relative price levels
can influence exchange rates in the short run.
International Fisher Effect (IFE)
 IFE uses interest rates rather than inflation
rates
 The relationship between the percentage
change in the spot exchange rate over time
and the differential between comparable
interest rates in different national capital
markets is known as “international Fisher
Effect”.
International Fisher Effect (IFE)
 The IFE suggests that given two countries,
the currency in the country with the higher
interest rate will depreciate by the amount of
interest rate differential. That is, within a
country, the nominal interest rate tends to
approximately equal the real interest rate plus
the expected inflation rate.
 Nominal= Real + Expected inflation rate
International Fisher Effect (IFE)
 The proportion that the nominal interest rate
varies directly with the expected inflation rate,
known as Fisher effect.
 Inc. in interest rate- Inc. in exchange rate

 It is often argued that an increase in a


country’s interest rate tends to increase the
exchange value of its currency by inducing
capital inflows.
International Fisher Effect (IFE)
 However, the IFE argues that a rise in a
country’s nominal interest rate relative to the
nominal interest rate of other countries
indicates that the exchange value of the
country’s currency is expected to fall. This is
due to the increase in the country’s expected
inflation and due to the increase in the
nominal interest rate.
Foreign Exchange Risk
 Foreign exchange risk is the possibility of a
gain or loss to a firm that occurs due to
unanticipated changes in the exchange rate.
 The primary goal is to protect corporate
profits from the negative impact of exchange
rate fluctuations.
Types of Exposure
 Translation exposure

 Transaction exposure

 Economic exposure
1. Translation exposure
 All financial statements of a foreign
subsidiary have to be translated into the
home currency for the purpose of finalising
the accounts for any given period.
 Translation exposure is the degree to which a
firm’s foreign currency denominated financial
statements are affected by the exchange rate
changes.
1. Translation exposure
 The changes in the asset valuation due to
fluctuations in the exchange rate will affect
the group’s assets, capital structure ratios,
profitability ratios, solvency ratios etc.
1. Translation exposure
The following procedure has been followed:
 Assets & Liabilities are to be translated at the
current rate, i.e. the rate prevailing at the time of
preparation of consolidated statements.
 All revenues & expenses are to be translated at the
actual exchange rates prevailing on the date of
transactions.
 Translation adjustments (gains or losses) are not be
charged to the net income of the reporting company.
(They are accumulated & reported in a separate
account).
Measurement of Translation
exposure
 Translationexposure = (Exposed assets –
Exposed liabilities) * (Change in exchange in
exchange rates)
Example
 Current exchange rate: $ 1 = Rs 47.10

Assets Liabilities
 Rs. 15,300,000 Rs 15,300,000
 $ 3,24,841 $ 3,24,841
Example
 In the next period, exchange rate fluctuates
to $ 1 = Rs. 47.50

Assets Liabilities
Rs. 15,300,000 Rs 15,300,000
$ 3,22,105 $ 3,22,105
 Decrease in the Book Value of the assets is $
2736.
Transaction exposure
 This exposure refers to the extent to which
the future value of firm’s domestic cash flow
is affected by exchange rate fluctuations. It
arises from thepossibility of incurring
exchange rate gains or losses on transaction
already entered into and denominated in a
foreign currency.
 More the transactions, more the risk.
Transaction exposure
 All transactions gains and losses should be
accounted for and included in the equity’s net
income for the reporting period.

 The exposure could be interpreted either


from the standpoint of the affiliate or the
parent company.
Economic Exposure
 It refers to the degree to which a firm’s
present value of future cash flows can be
influenced by exchange rate fluctuations.
 It is a more managerial concept than an
accounting concept.
 The risk is that a variation in the rate will
affect the company’s competitive position in
the market and hence its profits.
 It cannot be hedged.
Tools & Techniques of Foreign
Exchange Risk Management
 Forward contracts
 Futures contracts

 Option contract

 Currency swap- It is an agreement where two


parties exchange a series of cash flows in
one currency for a series of cash flows in
another currency, at agreed intervals over an
agreed period.
Management of Translation
exposure
 Accounting exposure/ translation exposure,
arises because MNCs may wish to translate
financial statements of foreign affiliates into
their home currency in order to prepare
consolidated financial statements. Or to
compare financial results.
 Translation exposure = Exposed assets –
Exposed liabilities
Management of Translation
exposure- Example
A US parent company has a single wholly
owned subsidiary in France. This subsidiary
has monetary assets of 200 million francs &
monetary liabilities of 100 million francs. The
exchange rate declines from FFr 4 per dollar
to FFr 5 per dollar.
Management of Translation
exposure- solution
 The potential foreign exchange loss on the
company’s exposed net monetary assets of 100
million francs would be $5 million.
Monetary assets FFr 200 million
Monetary liabilities FFr 100 million
Net exposure FFr 100 million
 Pre-devaluation rate

(FFr 4= $1) FFr 100 million $ 25.0 million


 Post-devaluation rate
(FFr 5= $1) FFr 100 million $ 20.0 million
 Potential Exchange Loss $ 5.0 million
Translation Methods
1. The current rate method

3. The monetary/ non- monetary method

5. The temporal method

4. The current / non- current method


1. The Current Rate Method
 All balance sheet and income items are
translated at the current rate of exchange,
except for stockholders’ equity.
 Income statement items, including
depreciation and cost of goods sold, are
translated at either the actual exchange rate
(date of translation) or the weighted average
exchange rate for the period.
1. The Current Rate Method
 Dividends paid are translated at the
exchange rate prevailing on the date the
payment was made.
 The common stock account and paid in
capital accounts are translated at historical
rates.
 Gains & losses by translation adjustments-
separate account – known as Cumulative
Translation Adjustment (CTA).
2. The Monetary/ Non-
Monetary Method
 Monetary items- are those that represent a
claim to receive or an obligation to pay fixed
amount of foreign currency unit, e.g. cash,
accounts receivable, current liabilities etc.

 Monetary items- Current rate


2. The Monetary/ Non-
Monetary Method
 Non- Monetary items- are those that do not
represent a claim to receive or an obligation
to pay fixed amount of foreign currency items,
e.g. inventory, fixed assets, long-term
investments etc.

 Monetary items- Historical rates


3. Temporal Method
 Modified version of monetary / non- monetary
method.
 If inventory is in balance sheet at market
values, then current rate otherwise historical
rate.
 Income statement items- average exchange
rate
 Cost of Goods Sold (COGS) & Depreciation-
historical rates.
4. The Current/ Non- Current
Method
 Current assets & liabilities- Current exchange
rate

 Non- Current assets & Liabilities – Historical


rates
Functional vs Reporting
Currency
 Functional Accounting Standard’s Board (FASB
52) differentiates between a foreign affiliate’s
“functional” and “reporting” currency.
 Functional currency is defined as the currency of
the primary economic environment in which the
affiliate operates and in which it generates cash
flows. Generally, this is the local currency of the
country in which the entity conducts most of the
business.
Functional vs Reporting
Currency
 The reporting currency is the currency in
which the parent firm prepares its own
financial statements./; This currency is
normally the home country currency, i.e., the
currency of the country in which the parent is
located and conducts most of its business.
Conclusion
 Accounting exposure is the potential for
translation losses or gains. Translation is the
measurement, in a reporting currency, of
assets, liabilities, revenues and expenses of
a foreign operation where the foreign
accounts are originally denominated and/ or
measured in functional currency.
Management of Economic
Exposure
 Economic exposure measures the impact of
an actual conversion on the expected future
cash flows as a result of an unexpected
change in exchange rates.
Measuring Economic
Exposure
 The degree of economic exposure to
exchange rate fluctuations is significantly
higher for a firm involved in international
business than for a purely domestic firm.
Measuring Economic
Exposure
 One method of measuring an MNCs
economic exposure is to classify the cash
flows into different items on the income
statement and predict movement of each
item in the income statement based on a
forecast of exchange rates.
 This will help in developing an alternate
exchange rate scenario and the forecasts for
the income statement items can be revised.
Managing Economic Exposure
 The following are some of the proactive
marketing & production strategies which a
firm can pursue in response to anticipated
or actual real exchange rate changes.
1. Marketing initiatives
c) Market selection
d) Product strategy
e) Pricing strategy
f) Promotional strategy
Managing Economic Exposure
2. Production initiatives
b) Product sourcing

c) Input mix

d) Plant location

e) Raising productivity
Market selection
 Market strategy considerations for an
exporter are the markets in which to sell, i.e.
market selection. It is also necessary to
consider the issue of market segmentation
with individual countries.
 A firm that sells differentiated products to
more affluent customers may not be harmed
as much by a foreign currency devaluation as
will a mass marketer.
Product strategy
 Companies can also respond to exchange
rate changes by altering their product
strategy, which deals in such areas as new
product introduction.
 Product line decisions

 Product innovations
Promotional strategy
A firm exporting its products after a domestic
devaluation may well find that the return per
home currency expenditure on advertising or
selling is increased because of the product’s
improved price positioning.
Pricing Strategy- Market Share
vs Profit Margin
 To begin the analysis, a firm selling overseas
should follow the standard economic
proposition of setting the price that
maximizes dollar profits (by equating
marginal revenues and marginal costs). In
making this decision, however, profits should
be translated using the forward exchange
rate that reflects the true expected dollar
value of the receipts upon collection.
Input Mix
 Outright additions to facilities overseas
accomplish a manufacturing shift. A more
flexible solution is to purchase more
components overseas. This practice is called
as outsourcing.
Shifting production among
plants
 MNCs with world wide production systems
can allocate production among their several
plants in line with the changing home
currency cost of production, increasing
production in a nation whose currency has
devalued and decreasing production in a
country where their has been a revaluation.
 Assumption- Company has a portfolio of
plants worldwide.
Plant location
Raising Productivity
 Raising productivity through closing
inefficient plants, automating heavily and
negotiating wage benefit cutbacks and work
rule concessions is another alternative to
manage economic exposure.
Corporate philosophy for
Exposure Management
High risk

All exposures left unhedged Active trading

Low reward High reward

All exposures hedged Selective hedging

Low risk
Multinational Cash
Management
Multinational Cash
Management
 Objectives of cash management
 How to manage & control the cash resources
of the company as quickly and efficiently as
possible.
 Achieve the optimum utilization and
conservation of the funds.
Objective of an efficient
system:
 Minimise the currency exposure risk.
 Minimise the country and political risk.

 Minimise the overall cash requirements of the


company.
 Minimise the transaction costs.

 Full benefits of economies of scale as well as


the benefit of superior knowledge.
Techniques to Optimise Cash
Flows
 Accelerating cash inflows.
 Managing blocked funds.

 Leading and lagging strategy.

 Using netting to reduce overall transaction


costs by eliminating a no. of unnecessary
conversions and transfer of currencies.
 Minimising the tax on cash flow through
international transfer pricing.
Accelerating cash inflows
 Quicker recovery of inflows by
 # establishing lockboxes

 # Pre-authorising payments- It allows an


organisation to charge a customer’s bank
account up to some limit.
Managing blocked funds
 The host country may block funds that the
subsidiary attempts to send to the parent.
For eg. The host country may ask the
company to re-invest the funds for few years
and create jobs.
 Prior to making a capital investment in a
foreign subsidiary, the parent firm should
investigate the potential of future funds
blockage.
Leading and Lagging
 MNCs can accelerate (lead) or delay (lag) the
timing of foreign currency payments by
modifying the credit terms extended by one
unit to another.
Leading & Lagging-
advantages
 It is used for minimising foreign exchange
exposure and helps in shifting liquidity among
affiliates by changing credit terms.
 It helps in taking advantage of expected
revaluations and devaluations of currency
movements.
 No formal note of indebtedness is required
and credit terms can be changed by
increasing & decreasing the terms on the
account.
Example
 AnMNC faces the after tax borrowing and
lending rates in UK and the US as shown
below:
Borrowing rate Lending rate
% %
US 3.6 2.8
UK 3.4 2.6
+ -
Example- solution
UK
+ -

2.8% / 2.6% (0.2%) 2.8% / 3.4% (-0.6%)

3.6% / 2.6% (1.0%) 3.6% / 3.4% (0.2%)


Netting
 Netting is a technique of optimising cash flow
movements with the joint efforts of
subsidiaries.
 The process involves the reduction of
administration and transaction costs that
result from currency conversion.
 Netting helps in minimising the total volume
of inter company fund flow.
Advantages of Netting
 It reduces the no. of cross border transactions
between subsidiaries, thereby reducing the overall
costs of such cash transfers.
 There is a more co-ordinated effort among all the
subsidiaries to accurately report and settle various
accounts
 It reduces the need for foreign exchange conversion
and hence, reduces transaction costs
 It helps improved cash flow forecasting since, only
net cash transfers are made at the end of each
period.
Types of Netting
 Bilateral netting system

 Multinational netting system


Bilateral Netting System
Example:
Suppose, The US parent and the German
Affiliate have to receive net $ 40,000 and $
30,000 from one another. Then, under a
bilateral netting system, only one payment
will be made – the German affiliate pays the
US parent an amount equal to $ 10,000.
Bilateral Netting System

Pay $ 30,000

US Parent German Affiliate

Pay $ 40,000

After Bilateral Netting

US Parent German Affiliate

Pay $ 10,000
Multinational Netting System
 In this system, each affiliate nets all its inter
affiliate receipts against all its disbursements.
It then transfers or receives the balance,
depending upon whether it is the net receiver
or a payer.
 To be really effective, it needs centralised
and effective communication system and
discipline.
Multinational Netting System
X

$ 20 m $ 20 m

Y Z
$ 20 m
Country Risk Analysis
Political Risk Indicators
It is very difficult to measure political risk
associated with a particular country or a
borrower. Assessing political risk is a
continuous problem.
 Stability of the local political environment
 Consensus regarding priorities
 Attitude of the host government
 War
 Mechanisms for expressions of discontent
Economic Risk Indicators
 Inflation
rate
 Current and potential state of the country’s
economy
 Resource base

 Adjustment to external shocks

 Other factors include exports and imports as


a proportion of GDP etc.
Techniques to assess Country
Risk
 1. Debt related factors:
For eg, countries with a high export growth
rate are more likely to be able to service their
debt and are expected t enjoy better credit
worthiness rating since exporters are the
main source of foreign exchange earnings for
most of the countries.
Techniques to assess Country
Risk
1. Debt related factors:
The debt service indicators include:
 Debt / GDP (to rank countries according to
external debt)
 Debt- service ratio (relates debt service
requirements to export incomes)
 Short term debt/ Total exports
Techniques to assess Country
Risk
1. Debt related factors:
The debt service indicators include:
 Imports/ GDP (Sensitivity of domestic
economy to external development)
 Net interest payment / Export of goods and
services
Techniques to assess Country
Risk
2. Balance of Payments
The balance of payment indicators include:
 %age increase in imports / %age increase in
GDP (this ratio shows the income elasticity of
demand for exports)
 Current Account/ GNP (a measure of the
country’s net external borrowings relative to
country size)
Techniques to assess Country
Risk
2. Balance of Payments
The balance of payment indicators include:
 Imports of goods and services / GDP

 Effective exchange rate Index (measures the


relative movements in domestic and
international prices)
Techniques to assess Country
Risk
3. Economic Performance
It can be measured in terms of a country’s
rate of growth and its rate of inflation. The
inflation can be regarded as a proxy for the
quality of economic management. Thus, the
higher the inflation rate, the lower the
creditworthiness rating.
Techniques to assess Country
Risk
3. Economic Performance
Ratios that can be used are:
 GNP per capita

 Money supply (serves as an early indicator for future


inflation)
 Gross Domestic Savings / Gross National Product

 Gross Investment / GDP. This ratio is called


propensity to invest ratio and captures a country’s
prospects for future growth.
Techniques to assess Country
Risk
4. Political Instability undermines the
economic capacity of a country to service its
debt.
 Political instability generates adverse
consequences for economic growth, inflation,
domestic supply, level of import dependency
and creates foreign exchange shortage from
imbalance between exports and imports.
Techniques to assess Country
Risk
4. Political instability:
 The political instability indicators which can
be considered are:
 The political protest, for example, protest
demonstrations, political strikes, riots, political
assassination etc.
 Successful and unsuccessful irregular
transfer.
Techniques to assess Country
Risk
5. Check list approach
A number of relevant indicators that
contribute to a firm’s assessment of country
risk are chosen and a weight is attached to it.
 Factors having greater influence on country
risk are assigned greater weights.
 It employs a combination of statistical and
judgmental factors.
Techniques to assess Country
Risk
5. Check list approach
 Statistical factors try and assess the performance of
a country’s economy. (study past to judge the future)
 Judgmental factors – give some indication of a
country’s future ability and willingness to repay.
 The weighting of the judgmental and statistical
factors could then be done to arrive at thea risk
ranking for countries.
Cost of Capital &
Capital Structure
Cost of capital
 Cost of capital for a firm is the rate that must
be earned in order to satisfy the required rate
of return of the firm’s investors.

 It has a major impact on firm’s value.

 Lesser the cost of capital, the better it is.


Cost of capital for MNCs vs
Domestic firms
There is a difference between Cost of capital
for MNCs and Domestic firms because of the
following:
1. Size of the firm: Firms that operate
internationally are usually much bigger in size
than firms that operate only in the domestic
market. MNCs generally borrow substantial
amount of funds by virtue of their size and
are in a position to get it at cheaper rates.
Cost of capital for MNCs vs
Domestic firms
2. Foreign exchange risk: An exceptionally
volatile exchange rate is not much
appreciated as it leads to wide fluctuations in
in the cash flows of an MNC. It would be
difficult for the firm to meet its fixed
commitments and therefore, the shareholders
and creditors demand a higher return which,
in turn, would increase the cost of capital of
the firm.
Cost of capital for MNCs vs
Domestic firms
3. Access to international capital markets:
MNCs can access to international capital
markets helps them to attract funds at lower
cost than domestic companies.
4. International diversification effect: If a firm’s
cash flows come from sources all over the
world, there might be more stability in them.
Cost of capital for MNCs vs
Domestic firms
Cost of capital for MNCs vs
Domestic firms
Cost of capital for MNCs vs
Domestic firms
Cost of capital for MNCs vs
Domestic firms
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