INTERNATIONAL

FINANCIAL
MANAGEMENT
BY
JOSHUA, ABIMBOLA ABOSEDE
INTERNATIONAL FINANCIAL
MANAGEMENT
No country can produce all that she need. Countries individually
produce goods in which such a country has comparative advantage and
sells those goods to other countries while also buying the goods the
other countries have comparative advantage in.
Any organisation that engages in exporting or importing activities or
receives or makes payments in foreign currency exposes itself to the
possibility of fluctuations in exchange rates (exchange rate risk).
Although exchange rate fluctuation may result in a gain (positive) or a
loss (deficit).
The Balance of trade: When a country produces visible goods such as
cars, machinery, crops, timber etc. and sell such to foreign countries, it
is refer to as the visible export. On the other hand if a country buys
such visible goods from foreign countries, it is refer to as the visible
import. The difference in the value of visible exports and visible imports
is known as the balance of trade. The BOT may be favourable or
unfavourable. When the value of visible export is higher than the visible
import, the BOT is favourable but when the reverse is the case, then
the BOT is term unfavourable.
The invisible balance: Countries also buy and sell services such as
banking, shipping services etc. These transactions are refer to as the
invisible export if country sell to foreign countries. However, if a
country buy from the foreign countries, it is refer to as the invisible
import. The difference between the invisible export and import is refer
to as the invisible balance or balance on invisible items which may be
favourable or unfavourable. It is favourable when the value of invisible
export exceed the invisible import and reverse is the case when the
value of invisible import exceed that of export.
The balance of payment on current account: The balance of payment
on current account is the record of all transactions between one
country and the rest of the world, for all visible goods and the invisible
services in the course of the year. When the total payment made for
both visible goods and invisible services in the course of one year
exceed the total receipt, the BOP is unfavourable and the country is
said to be in deficit position but if reverse is the case, the country is in a
position term surplus
Exchange rate: This is the equivalent of the foreign currency that is
obtainable from a unit of home currency.
Direct quote: This is the number of units amount of a local/domestic
currency that exchanges one unit of a foreign currency.
Indirect quote: An indirect quote is the amount of a foreign currency
that can be exchange for one unit of the local currency.
Spot rate: This is the price at which foreign exchange can be bought or
sold with payment set for the same day.
Forward rate: The rate quoted for delivery at a fixed future date of a
specified amount of one currency against another.
Factors affecting fluctuations in exchange
rates
i. Supply and demand for the foreign and local currency.
ii.Global inflation rates and its effect on the domestic rate of inflation.
iii.
The political environment in Nigeria and in the foreign country.
iv.Local economic conditions including local production of goods for
export and local interest rates.
v. Volume of trade
Methods of hedging against foreign currency
risk.
i. Forward contracts: This is a contract usually between a bank and a customer to buy
and sell a specified quantity of foreign currency at an agreed future date or within a
specified future time period.
ii. Foreign currency invoicing: This is when the exporter who is a Nigerian invoice a
foreign customer in Naira in order to avoid risk .
iii. Matching: This is when a Nigerian company for instance decide to offset his
payments against receipts in the currency.
iv. Borrowing in a foreign currency: A exporter who invoices foreign customers in a
foreign currency can hedge against the exchange risk by borrowing an amount in the
foreign currency now and convert the foreign currency into domestic currency at the
spot rate.
v. Leading and Lagging: Accelerating (Leading) and delaying (lagging) international
payment by modifying credit terms normally on credit.
INTERNATIONAL FINANCIAL MARKET
1. EURO CURRENCY MARKET: This consists of banks that accept
deposits and make loans in foreign currency especially short and
medium term finances.
2. EURO CREDIT MARKET: This market deals with medium term
financing.
3. EURO BOND MARKET: This is the market where long-term finance is
raised.
HOW TO FINANCE OVERSEAS
INVESTMENTS
1. Borrow from Nigerian financial market.
2. Borrow in a country of operation.
3. Retention from holding company or subsidiaries.
TYPES OF FOREIGN EXCHANGE RATE
1. Fixed exchange rate: The government of a country maintains its
currency at a particular exchange rate against a specified foreign
exchange.
2. Floating exchange rate: Under this, the market determines the
exchange rate of that currency with other currencies and these
rates will constantly fluctuate.
THEORIES OF FOREIGN EXCHANGE
DETERMINATION
1. Purchasing Power Parity: This theory depicts that the exchange value of
foreign exchange depends on the relative purchasing power of each
currency in its own country and spot exchange rate will vary over time
according to relative price changes.
Purchasing power parity can be expressed as follows:
St = S0 x 1 + ifc
1 +ihc
Where:
St = the current spot exchange rate at time 0
S0 = the current spot exchange rate at time t
ifc = the expected inflation in the foreign country at time t (expressed in decimal)
ihc = the expected inflation in the home country at time t (expressed in decimal)
The Fisher effect: The term fisher effect is used sometimes to
determine the relationship between interest rates and expected rates
of inflation. It can be expressed as follows
1 + rfc
1+ rhc =
Where rfc = the nominal interest rate in the foreign country
rhc = the nominal interest rate in the home country
2. Interest rate parity: The theory that the differential between the forward
exchange rate and spot exchange rate is equal to the differential between the
foreign and domestic interest rates. The principle of interest rate parity links the
foreign exchange markets and the international money market.
1 + rfc = ifc/$
1 + r$ Sfc/$
Where:
rfc = foreign currency interest rate on a deposit for a certain time period
r$ = dollar interest rate on deposit for the same time period.
ifc/$ = forward exchange rate fc/$ for time period.
Sfc/$ = spot exchange rate
CALCULATION OF EXCHANGE RATE
Illustration 1
Given an exchange rate of N126/$ and 140Cedis/$ , what is the
exchange rate quoted for cedes/N?
Solution
N/$ = 126 or $/N = 1/126
C/$ = 140 or $/C = 1/140
Therefore, C/N
C/N = C/$ x $/N
140 x (1/126)
C/N = 1.1111
FORWARD DISCOUNT/PREMIUM
Forward exchange rates are often quoted at a discount or premium to
the spot exchange rate. Mathematically, this can be determined using
the formula below:
(FR-SR)/SR x 12/No of months forward x 100
FR = The forward rate
SR = The spot rate
Illustration 2
You are given the following quotes:
Spot rate (SFr)/$ = 1.3598
3-Months forward (SFr)/$ = 1.3471
Is the dollar trading at discount or premium?
What is the annualised forward premium or discount?
Solution
The dollar quotes at a discount while the Swiss Franc quotes at a
premium.
Annualised forward premium/discount = FR-SR/SR x 12/No of Months x
100
(1.3471 – 1.3598)/1.3598 x (12/3) x 100
= -3.7%
This implies that the dollar trades at discount of 3.7% whereas the
Swiss France trade at a premium of 3.7%
Illustration 3
A professional accountancy institute in Nigeria is evaluating an investment project overseas – in Canada. The project involves
the establishment of a training school to offer courses on international accounting and management topics. It will cost an
initial 2.5 million Canadian dollars and it is expected to earn post-tax cash flows as follows
Year 1 2 3 4
Cash flow(Canadian$’000) 750 950 1,250 1,350
The following information is available
a. The expected inflation rate in Canada is 3% a year while that of Nigeria is 5%
b. Real interest rate in the two countries are the same. They are expected to remain the same for the period of the
project.
c. The current spot rate is CAD$ 2 per N1.
d. The risk-free rate of interest in Canada is 7% and Nigeria is 9%
e. The company requires a Naira return from the project of 16%
Required:
Calculate the naira net present value of the project using both the following methods
i. By discounting annual cash flows in Naira
ii. By discounting annual cash flows in CAD$
Solution
% annual change in rate = 3% - 5%
1 + 5% = -0.01905 = -1.905%
The expected spot rate at the end of each year can now be found as follows
Year CAD$
0 2.0000
1 1.9619(2x(1-0.01905)
2 1.9245(1.9619x(1-0.01905)
3 1.8879
4 1.8519
1. Discounting annual cash flows in Naira at 16%
Year Cash fs(C$’000) $/N Cash flows (N’000) DCF PV(N’000)
0 (2,500) 2.000 (1,250) 1.000 (1,250)
1 750 1.9619 382 0.862 329
2 950 1.9245 494 0.743 367
3 1,250 1.8879 662 0.641 424
4 1,350 1.8519 729 0.552 402
272
2. Discounting annual cash flows in CAD$
The discount rate must be adjusted to take into account the lower rate of interest in CAD$. The adjusted rate will be as
follows:
1+x = 1 +0.07
1 + 0.16 1 + 0.09
X = 13.87% or 14%
Year CF(CAD$’000) DCF PV(CAD$’000)
0 (2500) 1.000 (2500)
1 750 0.877 658
2 950 0.769 731
3 1,250 0.675 844
4 1,350 0.592 799
Total NPV(CAD$’000) 532
This converts to Naira at the spot rate of 2.000 to give N266,000 which differs slightly from the answer in (1) due to
rounding errors
FOREIGN EXCHANGE MANAGEMENT
TECHNIQUES
1. Currency option: This gives the holder the right but not the obligations to sell or
buy the contract currency at a set price and at a given date.
2. Currency future: This is a contract for future delivery of a specific quantity of a
given currency with the exchange rate fixed at the time the contract is entered
into.
3. Currency forward contract: similar to the future contract except that they are
not traded on organised market.
4. Interest rate swap: This is an agreement between two parties to exchange
interest rate payment for a specific maturity on an agreed principal.
5. Currency swap: This is simultaneous borrowing and lending operation whereby
two parties exchange specific amount of two currencies at the outset at the spot
rate.