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International Finance

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Title: International Finance


1
International Finance
  • FIN45 Michael Dimond

2
The Balance of Payments
  • The measurement of all international economic
    transactions between the residents of a country
    and foreign residents is called the Balance of
    Payments (BOP)
  • The IMF is the primary source of similar
    statistics worldwide
  • Multinational businesses use various BOP measures
    to gauge the growth and health of specific types
    of trade or financial transactions by country and
    regions of the world against the home country

3
The Balance of Payments
  • Monetary and fiscal policy must take the BOP into
    account at the national level
  • Businesses need BOP data to anticipate changes in
    host countrys economic policies driven by BOP
    events
  • BOP data may be important for the following
    reasons
  • BOP is important indicator of pressure on a
    countrys exchange rate, thus potential to either
    gain or lose if firm is trading with that country
    or currency
  • Changes in a countrys BOP may signal imposition
    (or removal) of controls over payments,
    dividends, interest, etc
  • BOP helps to forecast a countrys market
    potential, especially in the short run
  • Rule of thumb to understand the BOP follow the
    cash flow

4
Fundamentals of BOP Accounting
  • The BOP must balance
  • Elements in measuring international economic
    activity
  • Identifying what is/is not an international
    economic transaction
  • Understanding how the flow of goods, services,
    assets, money create debits and credits
  • Understanding the bookkeeping procedures for BOP
    accounting

5
Typical BOP Transactions
  • Examples of BOP transactions from US perspective
  • Honda US is the distributor of cars manufactured
    in Japan by its parent, Honda of Japan
  • US based firm, Fluor Corp., manages the
    construction of a major water treatment facility
    in Bangkok, Thailand
  • US subsidiary of French firm, Saint Gobain, pays
    profits (dividends) back to parent firm in Paris
  • An American tourist purchases a small Lapponia
    necklace in Finland
  • A Mexican lawyer purchases a US corporate bond
    through an investment broker in Cleveland

6
Defining International Economic Transactions
  • Current Account Transactions
  • The export of merchandise, goods such as trucks,
    machinery, computers is an international
    transaction
  • Imports such as French wine, Japanese cameras and
    German automobiles are international transactions
  • The purchase of a glass figure in Venice by an
    American tourist is a US merchandise import
  • Financial Account Transactions
  • The purchase of a US Treasury bill by a foreign
    resident

7
BOP as a Flow Statement
  • Exchange of Real Assets exchange of goods and
    services for other goods and services or for
    monetary payment
  • Exchange of Financial Assets Exchange of
    financial claims for other financial claims

8
The Current Account
  • Goods Trade export/import of goods.
  • Services Trade export/import of services
    common services are financial services provided
    by banks to foreign investors, construction
    services and tourism services
  • Income predominately current income associated
    with investments which were made in previous
    periods. Additionally the wages salaries paid
    to non-resident workers
  • Current Transfers financial settlements
    associated with change in ownership of real
    resources or financial items. Any transfer
    between countries which is one-way, a gift or a
    grant,is termed a current transfer
  • Typically dominated by the export/import of
    goods, for this reason the Balance of Trade (BOT)
    is widely quoted

9
U.S. Current Account, 2002-2009 ( Bn)
10
U.S. Balances, 1985-2009 (Bn)
  • U.S. Trade Balance and Balance on Services and
    Income

11
The Capital and Financial Accounts
  • Capital account measures transfers of fixed
    assets such as real estate and acquisitions/dispos
    al of non-produced/non-financial assets
  • Financial account components
  • Direct Investment Net balance of capital which
    is dispersed from and into a country for the
    purpose of exerting control over assets. This
    category includes foreign direct investment
  • Portfolio Investment Net balance of capital
    which flows in and out of the country but does
    not reach the 10 ownership threshold of direct
    investment. The purchase and sale of debt or
    equity securities is included in this category
  • Other Investment Assets/Liabilities Consists of
    various short and long-term trade credits,
    cross-border loans, currency and bank deposits
    and other accounts receivable and payable related
    to cross-border trade

12
U.S. Financial Account, 2002-2009 (Bn)
13
The Other Accounts
  • Net Errors and Omissions Account is used to
    account for statistical errors and/or untraceable
    monies within a country
  • Official Reserves total reserves held by
    official monetary authorities within a country.
  • These reserves are typically comprised of major
    currencies that are used in international trade
    and financial transactions and reserve accounts
    (SDRs) held at the IMF
  • Under a fixed rate regime official reserves are
    more important as the government assumes the
    responsibility to maintain parity among
    currencies by buying or selling its currency on
    the open market
  • Under a floating rate regime the government does
    not assume such a responsibility and the
    importance of official reserves is reduced

14
Global Finance in Practice Chinas Twin Surpluses
  • Chinas twin surpluses aka double surplus in
    the current and financial accounts is highly
    unusual
  • Typically, these relationships are inverses of
    one another
  • The reason for the twin surpluses is due to the
    exceptional growth of the Chinese economy

15
Account Balances for the U.S., 1992-2009 (Bn)
16
Chinas Twin Surplus, 1998-2009
17
Official Foreign Exchange Reserves
  • Between 2001 2010 China increased foreign
    exchange reserves from 200 billion to 2,500
    billion, more than a 10-fold increase
  • China is now able to manage its currency to
    maintain competitiveness worldwide
  • China can also maintain a relatively stable fixed
    exchange rate against other major currencies

18
Chinas Foreign Exchange Reserves
19
2009 Foreign Exchange Reserves (Bn)
20
Balance of Payments Interactions
  • A nations balance of payments interacts with
    nearly all of its key macroeconomic variables
  • Gross domestic product (GDP)
  • The exchange rate
  • Interest rates
  • Inflation rates

21
U.S. BOP, 1995-2005 (Bn)
22
U.S. BOP, 1995-2005 (Bn)
23
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24
Balance of Payments Interactions
  • In a static (accounting) sense, a nations GDP
    can be represented by the following equation
  • GDP C I G X M
  • C consumption spending
  • I capital investment spending
  • G government spending
  • X exports of goods and services
  • M imports of goods and services

X M Current account balance
25
The Balance of Payments and Exchange Rates
  • A countrys BOP can have a significant impact on
    the level of its exchange rate and vice versa
    depending on that countrys exchange rate regime
  • The effect of an imbalance in the BOP of a
    country works somewhat differently depending on
    whether that country has fixed exchange rates,
    floating exchange rates, or a managed exchange
    rate system
  • Under a fixed exchange rate system the government
    bears the responsibility to assure a BOP near
    zero
  • Under a floating exchange rate system, the
    government of a country has no responsibility to
    peg its foreign exchange rate

26
The Balance of Payments and Exchange Rates
  • The relationship between BOP and exchange rates
    can be illustrated by use of a simplified
    equation
  • CI capital inflows
  • CO capital outflows
  • FI financial inflows
  • FO financial outflows
  • FXB official monetary reserves

27
The Balance of Payments and Interest Rates
  • Apart from the use of interest rates to intervene
    in the foreign exchange market, the overall level
    of a countrys interest rates compared to other
    countries does have an impact on the financial
    account of the balance of payments
  • Relatively low interest rates should normally
    stimulate an outflow of capital seeking higher
    interest rates in other country-currencies
  • In the U.S. however, the opposite has occurred as
    a result of attractive growth rate prospects,
    high levels of productive innovation, and
    perceived political stability

28
The Balance of Payments and Inflation Rates
  • Imports have the potential to lower a countrys
    inflation rate
  • In particular, imports of lower priced goods and
    services places a limit on what domestic
    competitors charge for comparable goods and
    services

29
Trade Balances and Exchange Rates
  • A simple concept in principle Changes in
    exchange rates changes the relative prices of
    imports and exports which in turn result in
    changes in quantities demanded
  • In reality the process is less straight-forward

30
The J-Curve Adjustment Path
  • Trade balance adjustment occurs in three stages
    over a varying and often lengthy period of time
  • The currency contract period
  • Adjustment is uncertain due to existing contracts
    that must be fulfilled
  • The pass-through period
  • Importers and exporters must eventually pass
    along the cost changes
  • Quantity adjustment period
  • The expected balance of trade is eventually
    realized
  • U.S. trade balance (PxQx) (S/fc PfcM QM)

31
The J-Curve
Trade Balance Adjustment to Exchange Rate Changes
32
MNCs are exposed to risk from exchange rates
Resulting from Market Forces
Resulting from Accounting
Economic Exposure
Purely Accounting Based
33
Foreign Exchange Exposure
  • Foreign exchange exposure is a measure of the
    potential for a firms profitability, net cash
    flow, and market value to change because of a
    change in exchange rates
  • These three components (profits, cash flow and
    market value) are the key financial elements of
    how we view the relative success or failure of a
    firm
  • While finance theories tell us that cash flows
    matter and accounting does not, we know that
    currency-related gains and losses can have
    destructive impacts on reported earnings which
    are fundamental to the markets opinion of that
    company

34
Types of Foreign Exchange Exposure
  • Transaction Exposure measures changes in the
    value of outstanding financial obligations
    incurred prior to a change in exchange rates but
    not due to be settled until after the exchange
    rate changes
  • Translation Exposure the potential for
    accounting derived changes in owners equity to
    occur because of the need to translate
    financial statements of foreign subsidiaries into
    a single reporting currency for consolidated
    financial statements
  • Operating Exposure measures the change in the
    present value of the firm resulting from any
    change in expected future operating cash flows
    caused by an unexpected change in exchange rates

35
Why Hedge?
  • Hedging protects the owner of an asset (future
    stream of cash flows) from loss
  • However, it also eliminates any gain from an
    increase in the value of the asset hedged against
  • Since the value of a firm is the net present
    value of all expected future cash flows, it is
    important to realize that variances in these
    future cash flows will affect the value of the
    firm and that at least some components of risk
    (currency risk) can be hedged against
  • Companies must first decide what they are trying
    to accomplish through their hedging program.

36
Why Hedge - the Pros Cons
  • Proponents of hedging give the following reasons
  • Reduction in risk in future cash flows improves
    the planning capability of the firm
  • Reduction of risk in future cash flows reduces
    the likelihood that the firms cash flows will
    fall below a necessary minimum
  • Management has a comparative advantage over the
    individual investor in knowing the actual
    currency risk of the firm
  • Markets are usually in disequilibirum because of
    structural and institutional imperfections

37
Why Hedge - the Pros Cons
  • Opponents of hedging give the following reasons
  • Shareholders are more capable of diversifying
    risk than the management of a firm if
    stockholders do not wish to accept the currency
    risk of any specific firm, they can diversify
    their portfolios to manage that risk, investors
    have already factored the foreign exchange effect
    into a firms market valuation
  • Currency risk management does not increase the
    expected cash flows of a firm currency risk
    management normally consumes resources thus
    reducing cash flow
  • The expected NPV of hedging is zero (Managers
    cannot outguess the market markets are in
    equilibrium with respect to parity conditions)
  • Managements motivation to reduce variability is
    sometimes driven by accounting reasons
    management may believe that it will be criticized
    more severely for incurring foreign exchange
    losses in its statements than for incurring
    similar or even higher cash cost in avoiding the
    foreign exchange loss
  • Management often conducts hedging activities that
    benefit management at the expense of shareholders

38
Hedgings Impact on Expected Cash Flows of the
Firm
39
Measurement of Transaction Exposure
  • Transaction exposure measures gains or losses
    that arise from the settlement of existing
    financial obligations, namely
  • Purchasing or selling on credit goods or services
    when prices are stated in foreign currencies
  • Borrowing or lending funds when repayment is to
    be made in a foreign currency
  • Being a party to an unperformed forward contract
    and
  • Otherwise acquiring assets or incurring
    liabilities denominated in foreign currencies

40
Purchasing or Selling on Open Account
  • Suppose Caterpillar sells merchandise on open
    account to a Belgian buyer for 1,800,000 payable
    in 60 days
  • Further assume that the spot rate is 1.2000/
    and Caterpillar expects to exchange the euros for
    1,800,000 x 1.2000/ 2,160,000 when payment
    is received
  • Transaction exposure arises because of the risk
    that Caterpillar will something other than
    2,160,000 expected
  • If the euro weakens to 1.1000/, then
    Caterpillar will receive 1,980,000
  • If the euro strengthens to 1.3000/, then
    Caterpillar will receive 2,340,000

41
Purchasing or Selling on Open Account
  • Caterpillar might have avoided transaction
    exposure by invoicing the Belgian buyer in US
    dollars (risk shifting), but this might have lead
    to Caterpillar not being able to book the sale
  • If the Belgian buyer agrees to pay in dollars,
    Caterpillar has transferred the transaction
    exposure to the Belgian buyer whose dollar
    account payable has an unknown euro value in 60
    days

42
The Life Span of a Transaction Exposure
43
Borrowing and Lending
  • A second example of transaction exposure arises
    when funds are loaned or borrowed
  • Example PepsiCos largest bottler outside the US
    is located in Mexico, Grupo Embotellador de
    Mexico (Gemex)
  • On 12/94, Gemex had US dollar denominated debt of
    264 million
  • The Mexican peso (Ps) was pegged at Ps3.45/US
  • On 12/22/94, the government allowed the peso to
    float due to internal pressures and it sank to
    Ps4.65/US. In January it reached Ps5.50

44
Borrowing and Lending
  • Gemexs peso obligation now looked like this
  • Dollar debt mid-December, 1994
  • US264,000,000 ? Ps3.45/US Ps910,800,000
  • Dollar debt in mid-January, 1995
  • US264,000,000 ? Ps5.50/US Ps1,452,000,000
  • Dollar debt increase measured in Ps
  • Ps541,200,000
  • Gemexs dollar obligation increased by 59 due to
    transaction exposure

45
Other Causes of Transaction Exposure
  • When a firm buys a forward exchange contract, it
    deliberately creates transaction exposure this
    risk is incurred to hedge an existing exposure
  • Example US firm wants to offset transaction
    exposure of 100 million to pay for an import
    from Japan in 90 days
  • Firm can purchase 100 million in forward market
    to cover payment in 90 days

46
Contractual Hedges
  • Transaction exposure can be managed by
    contractual, operating, or financial hedges
  • The main contractual hedges employ forward,
    money, futures and options markets
  • Operating and financial hedges use risk-sharing
    agreements, leads and lags in payment terms,
    swaps, and other strategies
  • A natural hedge refers to an offsetting operating
    cash flow, a payable arising from the conduct of
    business
  • A financial hedge refers to either an offsetting
    debt obligation or some type of financial
    derivative such as a swap

47
Risk Management in Practice
  • Which Goals?
  • The treasury function of most firms is usual
    considered a cost center it is not expected to
    add to the bottom line
  • However, in practice some firms treasuries have
    become aggressive in currency management and act
    as though they were profit centers
  • Which Exposures?
  • Transaction exposures exist before they are
    actually booked yet some firms do not hedge this
    backlog exposure
  • However, some firms are selectively hedging these
    backlog exposures and anticipated exposures

48
Risk Management in Practice
  • Which Contractual Hedges?
  • Transaction exposure management programs are
    generally divided along an option-line those
    which use options and those that do not
  • Also, these programs vary in the amount of risk
    covered these proportional hedges are policies
    that state which proportion and type of exposure
    is to be hedged by the treasury

49
Translation Exposure
  • Translation exposure arises because the financial
    statements of foreign subsidiaries must be
    restated in the parents reporting currency for
    the firm to prepare its consolidated financial
    statements
  • Translation exposure is the potential for an
    increase or decrease in the parents net worth
    and reported income caused by a change in
    exchange rates since the last transaction
  • Translation methods differ by country along two
    dimensions
  • One is a difference in the way a foreign
    subsidiary is characterized depending on its
    independence
  • The other is the definition of which currency is
    most important for the subsidiary

50
Subsidiary Characterization
  • Most countries specify the translation method to
    be used by a foreign subsidiary based upon its
    operations
  • A foreign subsidiary can be classified as
  • Integrated Foreign Entity one which operates as
    an extension of the parent company, with cash
    flows and line items that are highly integrated
    with the parent
  • Self-sustaining Foreign Entity one which
    operates in the local economy independent of its
    parent
  • The foreign subsidiary should be valued in terms
    of the currency that is the basis of its economic
    viability

51
Functional Currency
  • A foreign affiliates functional currency is the
    currency of the primary economic environment in
    which the subsidiary operates
  • The geographic location of a subsidiary and its
    functional currency can be different
  • Example US subsidiary located in Singapore may
    find that its functional currency could be
  • US dollars (integrated subsidiary)
  • Singapore dollars (self-sustaining subsidiary)
  • British pounds (self-sustaining subsidiary)

52
Translation Methods
  • There are four principal translation methods
    available the current/noncurrent method, the
    monetary/nonmonetary method, the temporal method,
    and the current-rate method.
  • The two most used the translation of foreign
    subsidiary financial statements are
  • The current rate method
  • The temporal method
  • Regardless of which is used, either method must
    designate
  • The exchange rate at which individual balance
    sheet and income statement items are remeasured
  • Where any imbalances are to be recorded
  • This can affect either the balance sheet or the
    income statement

53
Summary of Translation Methods
  • Current Rate Method
  • Everything uses the current rate
  • Current/ NonCurrent Method
  • CA CL at current rate
  • All others at Historic Rate
  • Monetary/ NonMonetary Method
  • Monetary assets at current rate
  • NonMonetary assets at historic rate
  • Temporal Method
  • Like Mon/NonMon, but Inventory is translated at
    Current rate (only if inventory is at Market
    Cost)

54
Summary of Translation Methods
  • A few pointers
  • Cash A/R Current rate for all methods
  • Inventory (_at_ mkt) Current rate for all except
    Mon/NonMon
  • Fixed Assets Historic rate for all except
    current rate method
  • Curr Liabilities Current rate for all methods
  • LT Debt Current rate for all except
    Curr/NonCurr
  • Equity plug
  • Translation Gain (Loss) Difference in Equity
    (Historic vs Method)

55
Current Rate Method
  • Under this method all financial statement items
    are translated at the current exchange rate
  • Assets liabilities are translated at the rate
    of exchange in effect on the balance sheet date
  • Income statement items all items are translated
    at either the actual exchange rate on the dates
    the various revenues, expenses, gains and losses
    were incurred or at a weighted average exchange
    rate for the period
  • Distributions dividends paid are translated at
    the rate in effect on the date of payment
  • Equity items common stock and paid-in capital
    are translated at historical rates year end
    retained earnings consist of year-beginning plus
    or minus any income or loss on the year

56
Current Rate Method
  • Any gain or loss from re-measurement is closed to
    an equity reserve account entitled the cumulative
    translation adjustment, rather than through the
    companys consolidated income statement
  • These cumulative gains and losses from
    remeasurement are only recognized in current
    income under the current rate method when the
    foreign subsidiary giving rise to that gain or
    loss is liquidated

57
Temporal Method
  • Under this method, specific assets and
    liabilities are translated at exchange rates
    consistent with the timing of the items creation
  • The temporal method assumes that a number of line
    items such as inventories and net plant and
    equipment are restated to reflect market value
  • If these items were not restated and carried at
    historical costs, then the temporal method
    becomes the monetary/non-monetary method

58
Temporal Method
  • Line items included in this method are
  • Monetary assets (primarily cash, accounts
    receivable, and long-term receivables) and all
    monetary liabilities are translated at current
    exchange rates
  • Non-monetary assets (primarily inventory and
    plant and equipment) are translated at historical
    exchange rates
  • Income statement items are translated at the
    average exchange rate for the period except for
    depreciation and cost of goods sold which are
    associated with non-monetary items, these items
    are translated at their historical rate

59
Temporal Method
  • Line items included in this method are
  • Distributions dividends paid are translated at
    the exchange rate in effect the date of payment
  • Equity items common stock and paid-in capital
    are translated at historical rates year end
    retained earnings consist of year-beginning plus
    or minus any income or loss on the year plus or
    minus any imbalance from translation
  • Under the temporal method, any gains or losses
    from remeasurement are carried directly to
    current consolidated income and not to equity
    reserves

60
US Translation Procedures
  • The US differentiates foreign subsidiaries on the
    basis of functional currency, not subsidiary
    characterization. Translation methods are
    mandated in FASB-8 and FASB-52.
  • Regardless of the translation method selected,
    measuring accounting exposure is conceptually the
    same. It involves determining which foreign
    currency-denominated assets and liabilities will
    be translated at the current (postchange)
    exchange rate and which will be translated at the
    historical (prechange) exchange rate. The former
    items are considered to be exposed, while the
    latter items are regarded as not exposed.
    Translation exposure is just the difference
    between exposed assets and exposed liabilities.
  • By far the most important feature of the
    accounting definition of exposure is the
    exclusive focus on the balance sheet effects of
    currency changes. This focus is misplaced since
    it has led firms to ignore the more important
    effect that these changes may have on future cash
    flows.

61
Managing Translation Exposure
  • Balance Sheet Hedge this requires an equal
    amount of exposed foreign currency assets and
    liabilities on a firms consolidated balance
    sheet
  • A change in exchange rates will change the value
    of exposed assets but offset that with an
    opposite change in liabilities
  • This is termed monetary balance
  • The cost of this method depends on relative
    borrowing costs in the varying currencies

62
Managing Translation Exposure
  • When is a balance sheet hedge justified?
  • The foreign subsidiary is about to be liquidated
    so that the value of its CTA would be realized
  • The firm has debt covenants or bank agreements
    that state the firms debt/equity ratios will be
    maintained within specific limits
  • Management is evaluated on the basis of certain
    income statement and balance sheet measures that
    are affected by translation losses or gains
  • The foreign subsidiary is operating in a
    hyperinflationary environment

63
Choosing Which Exposure to Minimize
  • As a general matter, firms seeking to reduce both
    types of exposures typically reduce transaction
    exposure first
  • They then recalculate translation exposure and
    then decide if any residual translation exposure
    can be reduced without creating more transaction
    exposure

64
Operating Exposure
  • The change in company value resulting from
    changes in future operating cash flows caused by
    an unexpected change in exchange rates.
  • Because the value of a firm is equal to the
    present value of future cash flows, accounting
    measures of exposure that are based on changes in
    the book values of foreign currency assets and
    liabilities need bear no relationship to reality.
  • Because currency changes are usually preceded by
    or accompanied by changes in relative price
    levels between two countries, it is impossible to
    determine exposure to a given currency change
    without considering simultaneously the offsetting
    effects of these price changes.

65
Operating Exposure
  • The primary exposure management objective of
    financial executives should be to arrange their
    firm's finances in such a way as to minimize the
    real effects of exchange rate changes.
  • The major burden of coping with exchange risk
    must be borne by the marketing and production
    people
  • They deal in imperfect product and factor markets
    where their specialized knowledge provides a real
    advantage.
  • Their role is to design marketing and production
    strategies to deal with exchange risks.
  • The appropriate marketing and production
    strategies are similar to those that would be
    suitable for any firm confronted with shifting
    relative output or input prices caused by any
    economic, political, or social factors.
  • Measuring the operating of a firm requires
    forecasting and analyzing all the firms future
    individual transaction exposures together with
    the future exposure of all the firms competitors
    and potential competitors
  • This long term view is the objective of operating
    exposure analysis

66
Operating Exposure
  • Exchange rate changes do not always increase the
    riskiness of multinational corporations.
  • Purchasing Power Parity tells us devaluations
    (or revaluations) are usually preceded by higher
    (or lower) rates of inflation, therefore we
    should not evaluate only the devaluation phase of
    an inflation-devaluation cycle.
  • Nominal currency changes smooth out the profit
    peaks and valleys caused by differing rates of
    inflation. Devaluations or revaluations should
    actually reduce earnings variability for MNCs.
    Only if currency changes involve real exchange
    rate changes does risk increase.
  • Domestic firms are also subject to exchange rate
    risk, not just MNCs
  • Domestic facilities that supply foreign markets
    normally entail much greater exchange risk than
    foreign facilities supplying local markets
    (because material and labor used in a domestic
    plant are paid for in the home currency while the
    products are sold in a foreign currency).
  • A purely domestic company selling locally but
    facing import competition may be seriously hurt
    (helped) by the devaluation (revaluation) of a
    competitor's home currency.

67
Managing Exchange Risk
  • Since currency risk affects all facets of a
    firm's operations, it should not be the concern
    of financial managers alone.
  • Operating managers should develop marketing
    production initiatives that help to ensure
    profitability over the long run. They should also
    devise anticipatory strategic alternatives in
    order to gain competitive leverage
    internationally.
  • The key to effective exposure management is to
    integrate currency considerations into the
    general management process.
  • Managers trying to cope with actual or
    anticipated exchange rate changes must first
    determine whether the exchange rate change is
    real or nominal. Nominal changes can be ignored.
    Real changes must be responded to.
  • If real, the manager must first assess the
    permanence of the change. In general, real
    exchange rate movements that narrow the gap
    between the current rate and the equilibrium rate
    are likely to be longer lasting than are those
    that widen the gap. Neither, however, will be
    permanent. Rather, there will be a sequence of
    equilibrium rates, each of which has its own
    implications for the firm's marketing and
    production strategies.

68
Integrated Exchange Risk Program
  • The role of the financial executive in an
    integrated exchange risk program is fourfold
  • to provide local operating management with
    forecasts of inflation and exchange rates
  • to identify and highlight the risks of
    competitive exposure
  • to structure evaluation criteria such that
    operating managers are not rewarded or penalized
    for the effects of unanticipated real currency
    changes
  • to estimate and hedge whatever real operating
    exposure remains after the appropriate marketing
    and production strategies have been put in place.

69
Expected Versus Unexpected Changes in Cash Flows
  • Operating exposure is far more important for the
    long-run health of a business than changes caused
    by transaction or translation exposure
  • Planning for operating exposure is total
    management responsibility since it depends on the
    interaction of strategies in finance, marketing,
    purchasing, and production
  • An expected change in exchange rates is not
    included in the definition of operating exposure
    because management and investors should have
    factored this into their analysis of anticipated
    operating results and market value

70
Measuring Operating Exposure
  • Short Run - The first-level impact is on expected
    cash flows in the 1-year operating budget. The
    gain or loss depends on the currency of
    denomination of expected cash flows. These are
    both existing transaction exposures and
    anticipated exposures. The currency of
    denomination cannot be changed for existing
    obligations
  • Medium Run Equilibrium - The second-level impact
    is on expected medium-run cash flows, such as
    those expressed in 2- to 5-year budgets
  • Medium Run Disequilibrium. The third-level
    impact is on expected medium-run cash flows
    assuming disequilibrium conditions. In this case,
    the firm may not be able to adjust prices and
    costs to reflect the new competitive realities
    caused by a change in exchange rates
  • Long Run. The fourth-level impact is on expected
    long-run cash flows, meaning those beyond five
    years. At this strategic level, a firms cash
    flows will be influenced by the reactions of both
    existing and potential competitors, possible new
    entrants, to exchange rate changes under
    disequilibrium conditions

71
Strategic Management of Operating Exposure
  • The objective of both operating and transaction
    exposure management is to anticipate and
    influence the effect of unexpected changes in
    exchange rates on a firms future cash flows
  • To meet this objective, management can diversify
    the firms operating and financing base
  • Management can also change the firms operating
    and financing policies

72
Diversifying Operations
  • Diversifying operations means diversifying the
    firms sales, location of production facilities,
    and raw material sources
  • If a firm is diversified, management is
    prepositioned to both recognize disequilibrium
    when it occurs and react competitively
  • Recognizing a temporary change in worldwide
    competitive conditions permits management to make
    changes in operating strategies

73
Diversifying Financing
  • Diversifying the financing base means raising
    funds in more than one capital market and in more
    than one currency
  • If a firm is diversified, management is
    prepositioned to take advantage of temporary
    deviations from the International Fisher effect

74
Proactive Management of Operating Exposure
  • Operating and transaction exposures can be
    partially managed by adopting operating or
    financing policies that offset anticipated
    currency exposures
  • Six of the most commonly employed proactive
    policies are
  • Matching currency cash flows
  • Risk-sharing agreements
  • Back-to-back or parallel loans
  • Currency swaps
  • Leads and lags
  • Reinvoicing centers

75
Matching Currency Cash Flows
  • One way to offset an anticipated continuous long
    exposure to a particular currency is to acquire
    debt denominated in that currency
  • This policy results in a continuous receipt of
    payment and a continuous outflow in the same
    currency
  • This can sometimes occur through the conduct of
    regular operations and is referred to as a
    natural hedge

76
Debt Financing as a Financial Hedge
77
Currency Clauses Risk-sharing
  • Risk-sharing is a contractual arrangement in
    which the buyer and seller agree to share or
    split currency movement impacts on payments
  • Example Ford purchases from Mazda in Japanese
    yen at the current spot rate as long as the spot
    rate is between 115/ and 125/.
  • If the spot rate falls outside of this range,
    Ford and Mazda will share the difference equally
  • If on the date of invoice, the spot rate is
    110/, then Mazda would agree to accept a total
    payment which would result from the difference of
    115/- 110/ (i.e. 5)

78
Currency Clauses Risk-sharing
  • Fords payment to Mazda would therefore be
  • Note that this movement is in Fords favor,
    however if the yen depreciated to 130/ Mazda
    would be the beneficiary of the risk-sharing
    agreement

79
Back-to-Back Loans
  • A back-to-back loan, also referred to as a
    parallel loan or credit swap, occurs when two
    firms in different countries arrange to borrow
    each others currency for a specific period of
    time
  • The operation is conducted outside the FOREX
    markets, although spot quotes may be used
  • This swap creates a covered hedge against
    exchange loss, since each company, on its own
    books, borrows the same currency it repays

80
Cross-Currency Swaps
  • Cross-Currency swaps resemble back-to-back loans
    except that it does not appear on a firms
    balance sheet
  • In a currency swap, a dealer and a firm agree to
    exchange an equivalent amount of two different
    currencies for a specified period of time
  • Currency swaps can be negotiated for a wide range
    of maturities
  • A typical currency swap requires two firms to
    borrow funds in the markets and currencies in
    which they are best known or get the best rates

81
Cross-Currency Swaps
  • For example, a Japanese firm exporting to the US
    wanted to construct a matching cash flow swap, it
    would need US dollar denominated debt
  • But if the costs were too great, then it could
    seek out a US firm who exports to Japan and
    wanted to construct the same swap
  • The US firm would borrow in dollars and the
    Japanese firm would borrow in yen
  • The swap-dealer would then construct the swap so
    that the US firm would end up paying yen and
    receiving dollars be paying dollars and
    receiving yen
  • This is also called a cross-currency swap

82
Using Cross Currency Swaps
83
Contractual Approaches
  • Some MNEs now attempt to hedge their operating
    exposure with contractual strategies
  • These firms have undertaken long-term currency
    option positions hedges designed to offset lost
    earnings from adverse changes in exchange rates
  • The ability to hedge the unhedgeable is
    dependent upon predictability
  • Predictability of the firms future cash flows
  • Predictability of the firms competitor responses
    to exchange rate changes
  • Few in practice feel capable of accurately
    predicting competitor response, yet some firms
    employ this strategy

84
Capital Mobility
  • The degree to which capital moves freely
    cross-border is critically important to a
    countrys balance of payments
  • Historical patterns of capital mobility
  • 1860-1914 period characterized by continuously
    increasing capital openness as more countries
    adopted the gold standard and expanded
    international trade relations
  • 1914-1945 period of global economic destruction
    due to two world wars and a global depression
  • 1945-1971 Bretton Woods era, saw great
    expansion of international trade in goods and
    services
  • 1971-2002 period characterized by floating
    exchange rates, economic volatility, but rapidly
    expanding cross-border capital flows

85
The Evolution of Capital Mobility
86
Capital Flight
  • International flows of direct and portfolio
    investments under ordinary circumstances are
    rarely associated with the capital flight
    phenomenon. Rather, it is when capital transfers
    by residents conflict with political objectives
    that the term flight comes into general usage.
  • Ingo Walter, Capital Flight and Third World Debt

87
Capital Flight
  • Five primary mechanisms exist by which capital
    may be moved from one country to another
  • Transfers via the usual international payments
    mechanisms, regular bank transfers are easiest,
    cheapest and legal
  • Transfer of physical currency by bearer
    (smuggling) is more costly, and for many
    countries illegal
  • Transfer of cash into collectibles or precious
    metals, which are then transferred across borders
  • Money laundering, the cross-border purchase of
    assets which are then managed in a way that hide
    the movement of money and its owners
  • False invoicing on international trade
    transactions

88
Currency Market Intervention
  • Foreign currency intervention, the active
    management, manipulation, or intervention in the
    markets valuation of a countrys currency, is a
    component of currency valuation and forecast that
    cannot be overlooked.
  • Central banks driving consideration inflation
    or unemployment?
  • beggar-thy-neighbor, policy to keep currency
    values low to aid in exports, may prove
    inflationary if some goods MUST be imported
    e.g. oil

89
Currency Market Intervention
  • Direct Intervention - This is the active buying
    and selling of the domestic currency against
    foreign currencies. This traditionally required a
    central bank to act like any other trader in the
    currency market
  • Coordinated Intervention - in which several major
    countries, or a collective such as the G8 of
    industrialized countries, agree that a specific
    currencys value is out of alignment with their
    collective interests
  • Indirect Intervention - This is the alteration of
    economic or financial fundamentals which are
    thought to be drivers of capital to flow in and
    out of specific currencies

90
Currency Market Intervention
  • Capital Controls - This is the restriction of
    access to foreign currency by government. This
    involves limiting the ability to exchange
    domestic currency for foreign currency
  • The Chinese regulation of access and trading of
    the Chinese yuan is a prime example over the use
    of capital controls over currency value.

91
Disequilibria Exchange Rates in Emerging Markets
  • Although the three different schools of thought
    on exchange rate determination make understanding
    exchange rates appear to be straightforward, that
    is rarely the case
  • The problem lies not in the theories but in the
    relevance of the assumptions underlying each
    theory
  • After several years of relative global economic
    tranquility, the second half of the 1990s was
    racked by a series of currency crises which shook
    all emerging markets
  • The Asian crisis of July 1997
  • The Argentine crisis (1998 2002)

92
The Asian Crisis July 1997
  • The roots of the Asian crisis extended from a
    fundamental change in the economies of the
    region, the transition of many Asian countries
    from being net exporters to net importers
  • Starting in 1990 in Thailand, the rapidly
    expanding economies of the Far East began
    importing more than they were exporting,
    requiring major net capital inflows to support
    their currencies
  • As long as capital kept flowing in, the
    currencies were stable, but if this inflow
    stopped then the governments would not be able to
    support their fixed currencies

93
The Asian Crisis July 1997
  • The most visible roots of the crisis were in the
    excesses of capital inflows into Thailand in 1996
    and 1997
  • Thai banks, firms and finance companies had ready
    access to capital and found US dollar denominated
    debt at cheap rates
  • Banks continued to extend credits and as long as
    the capital inflows were still coming, the banks,
    firms, and government was able to support these
    credit extensions abroad

94
The Asian Crisis July 1997
  • After some time, the Thai Baht came under attack
    due to the countrys rising debt
  • The Thai government intervened in the foreign
    exchange markets directly to try to defend the
    Baht by selling foreign reserves and indirectly
    by raising interest rates
  • This caused the Thai markets to come to a halt
    along with massive currency losses and bank
    failures
  • On July 2, 1997 the Thai central bank allowed the
    Baht to float and it fell over 17 against the
    dollar and 12 against the Japanese Yen
  • By November 1997, the baht fell 38 against the
    US dollar

95
The Asian Crisis July 1997
  • Within days, other Asian countries suffered from
    the contagion effect from Thailands devaluation
  • Speculators and capital markets turned towards
    countries with similar economic traits as
    Thailand and their currencies fell under attack
  • In late October, Taiwan caught the markets
    off-guard with a 15 devaluation and this only
    added to the momentum
  • The Korean Won fell from WON900/ to WON1100/
    (18.2)
  • The Malaysian ringgit fell 28.6 and the Filipino
    peso fell 20.6 against the dollar
  • The only currencies that were not severely
    affected were the Hong Kong dollar and the
    Chinese renminbi

96
The Thai Baht and the Asian Crisis
97
The Asian Crisis July 1997
  • The Asian currency crisis was more than just a
    currency collapse
  • Although the varying countries were different
    they did have similar characteristics which allow
    comparison
  • Corporate socialism Post WWII Asian companies
    believed that their governments would not allow
    them to fail, thus they engaged in practices,
    such as lifetime employment, that were no longer
    sustainable

98
The Asian Crisis July 1997
  • Corporate governance Most companies in the Far
    East were often largely controlled by either
    families or groups related to the governing body
    or party of that country
  • This was labeled cronyism and allowed the
    management to ignore the bottom line at times
    when this was deteriorating
  • Banking liquidity and management Although bank
    regulatory structures and markets have been
    deregulated across the globe, their central role
    in the conduct of business has been ignored
  • As firms collapsed, government coffers were
    emptied and investments made by banks failed
  • The banks became illiquid and they could no
    longer support companies need for capital

99
The Russian Crisis of 1998
  • 1995 1998 Russian govt and nongovt borrowing
    very high, servicing the debt becomes difficult
  • Russian exports are mostly commodity-based and
    world commodity prices drop as a result of the
    Asian crisis of 1997 thus, Russian exports
    values decline
  • The Ruble was under a managed float with a band
    of 1.5 and most days the Russian Central Bank is
    forced to enter the market to buy rubles
  • The August Collapse Currency reserves had
    fallen, Russia announces it will raise an extra
    1 billion in foreign bonds to help pay for
    rising debt

100
The Russian Crisis of 1998
  • The August Collapse Russian stocks drop by 5
    on August 10 on fears that China would cut its
    currency value Russia claims they will not
    devalue the Ruble then at RUB6.3/USD
  • August 17, the ruble is devalued by 34 by the
    26th the Ruble is down to RUB13/USD
  • Exhibit 9.3 traces the fall of the Russian Ruble

101
The Fall of the Russian ruble
102
The Argentine Crisis - 2002
  • In 1991 the Argentine peso had been fixed to the
    U.S. dollar at a one-to-one rate of exchange
  • This policy was a radical departure from
    traditional methods of fixing the rate of a
    currencys value
  • Argentina adopted a currency board, which was a
    structure rather than just a commitment, to
    limiting the growth of money in the economy
  • Under a currency board, the central bank of a
    country may increase the money supply in the
    banking system only with increases in its
    holdings of hard currency reserves

103
The Argentine Crisis - 2002
  • By removing the ability of government to expand
    the rate of growth of the money supply, Argentina
    believed it was eliminating the source of
    inflation which had devastated its standard of
    living
  • The idea was to limit the rate of growth in the
    countrys money supply to the rate at which the
    country receives net inflows of U.S. dollars as a
    result of trade growth and general surplus

104
The Collapse of the Argentine peso
105
The Argentine Crisis - 2002
  • A recession that began in 1998, as a result of a
    restrictive monetary policy, continued to worsen
    by 2001 and revealed three very important
    problems with Argentinas economy
  • The Argentine peso was overvalued
  • The currency board regime had eliminated monetary
    policy alternatives for macroeconomic policy
  • The Argentine government budget deficit and
    deficit spending was out of control

106
The Argentine Crisis - 2002
  • While the value of the peso had been stabilized,
    inflation had not been eliminated
  • The inability of the pesos value to change with
    market forces led many to believe increasingly
    that it was overvalued
  • Argentine exports became some of the most
    expensive in all of South America as other
    countries saw their currencies slide marginally
    against the dollar over the past decade while the
    peso did not

107
The Argentine Crisis - 2002
  • Because the currency board eliminated
    expansionary monetary policy as a means to
    stimulate economic growth in Argentina, the
    Argentine government was left with only fiscal
    policy as a means to this end
  • The Argentine government continued to spend as a
    means to quell increasing social and political
    tensions and unrest, but without the benefit of
    increasing (or even stable) tax receipts
  • Continued government spending and the injection
    of foreign capital into the country steadily
    increased the debt burden

108
The Argentine Crisis - 2002
  • Many began to fear an impending devaluation,
    removing their peso denominated funds (as well as
    U.S. dollar funds) from Argentine banks
  • Capital flight as well as rampant conversion of
    peso holdings into U.S. dollar deposits put
    additional pressure on the value of the peso
  • On Sunday January 6, 2002, in the first act of
    his presidency (the fifth president in two
    weeks), President Eduardo Duhalde devalued the
    peso from Ps 1.00/ to Ps 1.40/
  • On February 3, 2002, the government announced
    that the peso would be floated, beginning a slow
    but gradual depreciation

109
The Greek Crisis 201X?
  • In early 2000s, Greece was managing to a large
    budget deficit and relying on a healthy global
    economy to feed two main industries Shipping and
    Tourism. In 2001, Greece transitioned away from
    its sovereign currency to the Euro.
  • By 2010, concerns about Greeces national debt
    suggested emergency bailouts might be necessary.
    Germany refused to endorse the loan until a
    series of austerity measures were announced.
  • In May 2010, Eurozone countries and the IMF
    agreed to a three year 110 billion loan at 5.5
    interest, conditional on the implementation of
    austerity measures.
  • Changes to the ruling government of Greece and
    rioting protestors showed evidence at the
    dissatisfaction of the Greek people with the
    circumstances.

110
The Greek Crisis 201X?
  • In 2011, Eurozone leaders changed the terms of
    the Greek loan package to extend the payback
    period and reduce the interest rate to 3.5.
    Also, eurozone leaders and the IMF also came to
    an agreement with banks to accept a write-off of
    100 billion of Greek debt, reducing the
    country's debt level from 340bn to 240bn or
    120 of GDP by 2020.
  • In 2012, the second bailout package from July
    2011 was extended from 109 billion to 130
    billion
  • One current opinion is the best option for Greece
    (and the rest of the EU), would be to create an
    orderly default on Greeces public debt. In
    this case, Greece would withdraw simultaneously
    from the eurozone and reintroduce its national
    currency the drachma at a debased rate. This
    might lead to a 60 devaluation of the new
    drachma. Critics also point to political and
    financial instability leading to hyperinflation,
    civil unrest and possibly a forcible overthrow of
    the current government.
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