MF0006 INTERNATIONAL FINANCIAL MANAGEMENT
1. Explain the three types of foreign exchange exposures.
(10 Marks)
Answer:
Foreign Exchange Exposures: According to Alan C. Shapiro the concept of exposures is referring to a“the degree to which a
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r business with companies in foreign countries they are exposed for different types of ha S
exposures. There are different ways to measure the exposure as well as there are different by
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e il. iv l 200 @g pa exposure exposures, transaction exposure and operating i 5/ 4 together form economic exposure. an e/0 lva8 M n m <Ju atha i r kk ha Si s 1. Transaction exposure to il: a d e m itt Em When a company have made a transaction where an uncertainty concerning the real value b u S appears it is called currency exposure. This appears when a company makes payments in one
> a are; the transaction exposure, operation exposure Un 9and meconomic exposure. The first two
currency today and receives payments in another currency in the future. The insecurity of which the true value of the received payments in the future and whether they will cover the payments the company already made represents the transaction exposure. In order to deal with and try to reduce the risks of transaction externally when a company has a cash flow of foreign currency, the company can use certain derivative instruments. Transaction exposure is a result from transactions generating either cash inflows or outflows and that have a future that is bound in a contract. As the exchange rates continuously change the value of the transactions when they settle will be different from the value of the transactions now, leading to either losses or gains. Page 1 of 8
MF0006 INTERNATIONAL FINANCIAL MANAGEMENT
2. Operation exposure Operating costs measures to which extent fluctuations in currencies can alter future operation cash flows of a company, meaning the revenues and costs in the future. All companies whose revenues are affected by changes in currencies have operation exposure, even if their operations are denominated to its home currency. Transaction exposure and operation exposure together is called economic exposure. Economic exposure means how the value of a company, measured by the value of expected cash flows today, changes when the exchange rates changes. 3. Translation or Economic or Accounting exposure
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financial statements of a foreign operation from the currency by local to the foreign operation to
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a exchange rate of the foreign currency change 9> one m reporting period to another the Un from
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MF0006 INTERNATIONAL FINANCIAL MANAGEMENT
2. Write short notes on: a. SWIFT b. CURRENCY SWAPS c. NETTING d. PIP e. INTERNATIONAL FISHER EFFECT
Answer:
a. SWIFT: The Society
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iv l 20 @g / 4 codes". The majority of international paas 5"SWIFT identifier codes (BICs) are popularly known i an e/0 lva8 M n As of November 2008, SWIFT linked 8,740 interbank messages use the SWIFT network. m <Ju atha i r financial institutions in 209 countries. SWIFT transports financial messages in a highly kk ha Si s : to accounts secure way, but does not hold ail for its members and does not perform any form of d e m t Eclearing or settlement. mit b SWIFT Su is a cooperative society under Belgian law and it is owned by its > n SWIFTNet financial institutions, much of it for use on Uthe 09 m Network, and ISO 9362 bank
member financial institutions. SWIFT has offices around the world. SWIFT headquarters are located in La Hulpe, Belgium, near Brussels. Averages of 2.4 million messages, with aggregate value of $2 trillion, were processed by SWIFT per day in 1995. It was founded in Brussels in 1973, supported by 239 banks in 15 countries. It started to establish common for financial transactions and a shared data processing system and worldwide communications network.
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MF0006 INTERNATIONAL FINANCIAL MANAGEMENT
b. CURRENCY SWAPS A swap is an agreement between two companies to exchange a specific amount of foreign currency. In which the currencies are returned at a specified date in the future. An interest rate swap is regularly used in combination with a currency swap. The second tool that a company can apply to decrease the risks of transaction exposure with foreign currencies is swaps. This tool is applied when two companies exchange interest and installments on foreign loans to insure that the principal amounts are exchanged back.
a lv A Internal currency risk management strategies are an instrument used when companies ath r a group itself. The internal aspiration to minimize the currency risk within the corporate Sh hedging techniques use characteristics of the companyâ&#x20AC;&#x2122;s by trading relationships without y t omare usually simple in theory recourse to the external currency or money marketseand rsi therefore c . l v > ai ni 9the and operation. The strategy of netting applies U when and its foreign subsidiaries m 0 gcompany l 0 a /the 2 @ of every period, leaving only the net off intra-organizational currency flows ip at 5 84end n 0 a e/ lva balance exposed to risk and hence in M needunof hedging. Netting is a tool for diminishing the m <J atha i r number of transactions taking place kk internally ha in a group. An example is the one of A owing Si s toA. While il: there should be two transactions taking place, Bs 10 to B and B owing 3 to a d m te E- as the only transaction, A should pay B 7. Within a obligation towards A misit netted and b corporate group, internal Su cash flows are often processed locally by each unit leading to high c. NETTING:
costs for payments and currency management. Netting provides an instrument to make your payments more cost effective by reducing the number of payments and thus leading to greater efficiency. In general netting indicates to allow a positive value and a negative value to setoff and partially or entirely cancel each other out. Netting provides a common platform for all receivables between the various units of a group to regularly settle via a netting centre. All units participating in the netting process report their intra-group transactions to the netting centre. At the end of the netting cycle, each unit either pays or receives an amount in its domestic currency.
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MF0006 INTERNATIONAL FINANCIAL MANAGEMENT
d. PIP: In the foreign exchange market, prices are always quoted using five numbers (for example, JPY 134.85 / USD), the final digit of which is referred to as a point or a pip. A pip is the smallest price change that a given exchange rate can make. Since most major currency pairs are priced to four decimal places, the smallest change is that of the last decimal point- for most pairs this is the equivalent of 1/100th of one percent, or one basis point. For example, the smallest move the USD/CAD currency pair can make is $0.0001, or one basis point. The smallest move in a currency does not always need to be equal to one basis point, but this is generally the case with most currency pairs.
e. International Fisher Effect:
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iv g al 0 the equation for PPP can be written as:nip 5/2 84@ a e/0 va et / eo = (1 + rh) / (1 + rf) M un al m <J ath ki This r This is the equation for ikIFE. haequation can be approximated by the following S s to il: equation: a d te -m et â&#x20AC;&#x201C; eo / m eoit= rh - rf E ub the spot rate adjusts to the interest rate differential between two IFE states Sthat > Fisher Effect (FE). If the inflation differential Un is09equalmto the interest rate differential then
countries. In equilibrium, the expected change in the spot exchange rate should be equal in magnitude but opposite in sign to the interest rate differential. Thus for investors to put money into a lower yielding security, they have to be convinced that they will be equally well off after adjusting for exchange rates. The implication of IFE is that the currency with the lower interest rate is expected to appreciate relative to one with a higher rate.
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MF0006 INTERNATIONAL FINANCIAL MANAGEMENT
CASE STUDY (10MARKS) 3. Foreign Direct Investment and Foreign Portfolio Investments are essential for economic development of any country. Discuss the flow of FDI into India from 2002-07 Also discuss the impact of U.S. economy recession on FDI flow into India.
Answer: The inflow of Foreign Direct Investment (FDI) has registered robust growth in the current financial year. As per the latest report of UNCTAD, India surpassed South Korea to become the fourth largest recipient of FDI in the region. During April-September 2006, total FDI inflows (excluding ‘reinvested earnings’ and ‘other capital components’) were Rs.20,155 a
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A Crore (US$4.38 billion). Cumulative FDI inflows since August 1991 h up to September 2006 at
ar were Rs.1,81,566 Crore (US$43.29 billion). Among sectors hattracting high cumulative FDIs S
(Table 7.15), electrical equipments retained the firstby spot, followed by services and
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iv l 20 @gm a An interesting observation is the ngradual, 4 growth in inward direct investment ip 5/ steady a e/0 lva8 n to India. At USD 5.3 billion in 2004 M the numbers are dwarfed by the inflows to China and m <Ju atha i k r and, more recently, Russia, but there may below FDI in Singapore, HongikKong (China) ha S s to il: and foremost, Indian FDI data are systematically nevertheless be cause for celebration. First a d e m itt Etoo low because the statistical definitions hitherto in force fail to include several transactions m b u commonly considered S as direct investment (e.g. non-cash acquisitions, reinvested earnings of > n year. the fourth spot from the second spot held by it U last 09
indirectly held investment enterprises and short-term trade credits between related enterprises). India is now altering its measurement of FDI in accordance with internationally standard methodology and is expected soon to produce re-estimates for recent years that will be significantly higher than previously published figures. Secondly, the process of opening India to foreign direct investment started later than in China and certain other developing economies. Less than a decade ago FDI flows into India were paltry, so the levels attracted in 2003 and 2004 represent a major improvement over previous levels. If the national commitment to further economic and regulatory reform remains on track there is no reason why this growth in direct investment should not continue in the coming years. Page 6 of 8
MF0006 INTERNATIONAL FINANCIAL MANAGEMENT
A comprehensive review of the FDI policy was undertaken during the current year vide Press Note 4 dated February 10, 2006, to consolidate the liberalization already effected and further rationalize the FDI policy governing various activities. The major policy initiatives taken are: •
Change of route: FDI has been allowed up to 100 per cent under the automatic route for distillation and brewing of potable alcohol, manufacture of industrial explosives, manufacture of hazardous chemicals, manufacturing activities located within 25 kms., of the Standard Urban Area limits requiring industrial license under the IDR(Act) 1951, setting up of Greenfield airport projects, laying of natural gas/LNG pipelines, market study and formulation and investment a
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b increased to 100 per cent and Increase in equity caps: FDI caps have been ity
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iv > ai l 20 @ pa of5/diamonds 4 i sector and exploration and mining and precious stones. an e/0 lva8 M unbeena allowed up to 100 per cent on the automatic • FDI in new activities: FDI m has i <J rath k k route in power tradingi and processing and warehousing of coffee and rubber. FDI ha S s : o l t has also been allowed up to ai 51 per cent for ‘single brand’ product retailing which d e m t it requires prior m approvalE of Government. Specific guidelines have been issued for b Su FDI for ‘single brand’ product retailing. governing
9 gm in petroleum and natural gas setting up of infrastructure relating Unto 0marketing
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Removal of restrictive conditions: Mandatory divestment conditions for Business to Business e-commerce have been dispensed with.
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Procedural simplification: The transfer of shares from resident to non-resident including acquisition of shares in an existing company has been placed on the automatic route subject to sectoral policy on FDI.
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MF0006 INTERNATIONAL FINANCIAL MANAGEMENT
Deepening global recession impacts India The U.S. is likely to increase further spending on defense and on rebuilding the infrastructure that has been destroyed. This would ultimately create a positive sentiment in an already lethargic American economy. Since Indian markets are increasingly dependent on the U.S. economy and its markets, it is imperative to analyze the impact on US economy which is manifold. ``Consumer spending and confidence which was holding well thus far will receive a severe setback. The U.S. recovery is likely to be delayed,'' stated a report of Tata TD Waterhouse Securities. Other impacts are: Investor sentiment will take a beating and result in further declines in stock markets in the U.S.; money flows in the U.S. could experience a shift towards safer avenues, like, bonds, and away from equities; Therea could be redemption
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pressure from U.S. investors which may trigger withdrawal hofA monies from non-U.S.
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ar currencies following the markets; The U.S. dollar could weaken against the other hmajor setback to its safe haven image.
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s Upon closer analysis the Indian economy does er not present .co a very encouraging picture. ail
iv l 20 @g / 4 is unlikely to fare much better this pa 5economy export prospects, it is expected that the Indian i an e/0 lva8 fiscal vis-a-vis last fiscal. We believeMthatunthe Indian economy is unlikely to grow by more m <J atha i than 5.4 per cent during the current kk fiscal. har Si : smarkets around the globe, Indian authorities were l i Ever since the fall dofto the stock a m te t i E up the stock markets. Expecting a positive reaction from mostly worried about, mhow to prop b u the market participants S the Government decided to increase the investment limit of foreign 9> m investment slow down and lower With continuing demand recession, lower industrial Un 0growth,
funds to the level of foreign direct investment set in various sectors by the Ministry of Industries. Stock prices are falling not because of lack of sentiment boosting measures by the Government. The prices are falling because of several other factors which are affecting the global economy and other events. But the sad fact is that while the government has taken care to address issues concerning the capital market, scant attention has been paid to the economy and pivotal institutions. Further, there is a lack of clarity on the part of Government in formulating policies which have far reaching effects on the economy. It seems the Government is not sure about the fact that a free fall in rupee will affect the sentiments of foreign funds. Page 8 of 8