INTERNATIONAL FINANCE FORE IGN EXCHANGE (CURRENCY) R ISK

MANAGEMENT amp STRATEGIES FOR MANAGING REL ATED

EXPOSURES

Hisham Ahmed Rizvi

hishamrzvgmailcom

+91-9999171299

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

2

INTRODUCTIONbull Risks faced by a firmbull What is financial riskbull What is currency risk

bull Exposure amp risk Are they samebull Measuring exposurebull Measuring risk

bull Why should risk be managed

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

3

RISKS FACED BY A FIRM

Core

B

usi

ness

R

isks

Unsuccessful product launch

Labour problems

Cyclical demand fluctuations

Material supply problems

And so forthEnvir

onm

en

tal R

isks

Exchange rate fluctuationsInterest rate fluctuations

Sudden price rise of goods

Shifts in government policies

And so forth

bull Peculiar to a firm

bull All pervasive and affect all firms in an

industry

bull Financial risks are a subset of

environmental risks

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

4

WHAT IS FINANCIAL RISK

Financial Risk

Credit risk Concentration risk

Market risk

Interest rate risk

Currency risk

Equity risk

Commodity risk

Liquidity risk

Refinancing risk

Operational risk

Legal risk

Model risk

Political risk

Valuation risk

FINANCIAL RISK

Financial risk refers to the chance that an investments actual return will be different than expected It basically is exposure to the danger of financial loss on investments made by investors

RISKA situation involving exposure to danger

SOURCE Oxford Dictionary

SOURCE Investopedia

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

5

WHAT IS CURRENCY RISK

For example if you are a US investor and you have stocks in Canada the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the US dollar So if you realize a 15 return in your Canadian stocks but the Canadian dollar depreciates 15 against the US dollar this will amount to no gain at all

CURRENCY RISK

It is a form of financial risk that arises from the change in price of one currency against another Whenever investors or companies have assets or business operations across national borders they face currency risk (or foreign exchange risk)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

6

EXPOSURE amp RISK ARE THEY SAMEIN FINANCIAL CONTEXT

For example between April 1992 and July 1995 the exchange rate between rupee and US dollar was rock steady For an Indian firm involved in exports and imports from US this meant that it had significant exposure to this exchange rate (because the exchange rate could have affected its performance) but it did not perceive significant risk because the exchange rate was stable

EXPOSURE

It is the measure of the sensitivity of a firmrsquos performance to fluctuations in the relevant risk factor ie whether or not a certain risk factor affects a firms performance

Each firm is ldquoexposedrdquo to unforeseen changes in a number of variables in its environment These variables are called Risk Factors Eg Exchange rate fluctuation is a risk factor

RISK

It is the measure of the extent of variability of the performance attributable to the risk factor ie how much does a risk factor affect a firms performance

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

7

MEASURING EXPOSURE

IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION

bull Functional currency It is the primary currency of the firm in which its financial statements are published It is often the domestic currency of their country

bull Real value Values adjusted for inflation (In practice though it becomes difficult to adjust all values with an uncertain inflation rate hence nominal values are only used)

bull Unanticipated changes Only unanticipated changes in the relevant risk factor are to be considered because the market already makes allowances for anticipated changes For eg an exported invoicing a foreign buyer in the buyerrsquos currency will build an allowance for the expected depreciation of that currency This is anticipated change However if the depreciation is more than expected that becomes unanticipated change

Exposure of a firm to a risk factor is the sensitivity of the real value of the firmrsquos assets liabilities or operating income expressed in its functional currency to unanticipated changes in the risk factor

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

8

MEASURING EXPOSURE

For example suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 6800 while the one month forward rate is Rs 6820 However one month later the spot rate turns out to be Rs 6830

In this case the anticipated depreciation is 20 paise per pound in one month while the unanticipated depreciation has been 10 paise per pound

Q How do we separate a given change in the risk factor into anticipated and unanticipated components

Ans One possible way is by using forward rate

FORWARD RATE

A rate applicable to a financial transaction that will take place in the future

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

2

INTRODUCTIONbull Risks faced by a firmbull What is financial riskbull What is currency risk

bull Exposure amp risk Are they samebull Measuring exposurebull Measuring risk

bull Why should risk be managed

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

3

RISKS FACED BY A FIRM

Core

B

usi

ness

R

isks

Unsuccessful product launch

Labour problems

Cyclical demand fluctuations

Material supply problems

And so forthEnvir

onm

en

tal R

isks

Exchange rate fluctuationsInterest rate fluctuations

Sudden price rise of goods

Shifts in government policies

And so forth

bull Peculiar to a firm

bull All pervasive and affect all firms in an

industry

bull Financial risks are a subset of

environmental risks

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

4

WHAT IS FINANCIAL RISK

Financial Risk

Credit risk Concentration risk

Market risk

Interest rate risk

Currency risk

Equity risk

Commodity risk

Liquidity risk

Refinancing risk

Operational risk

Legal risk

Model risk

Political risk

Valuation risk

FINANCIAL RISK

Financial risk refers to the chance that an investments actual return will be different than expected It basically is exposure to the danger of financial loss on investments made by investors

RISKA situation involving exposure to danger

SOURCE Oxford Dictionary

SOURCE Investopedia

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

5

WHAT IS CURRENCY RISK

For example if you are a US investor and you have stocks in Canada the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the US dollar So if you realize a 15 return in your Canadian stocks but the Canadian dollar depreciates 15 against the US dollar this will amount to no gain at all

CURRENCY RISK

It is a form of financial risk that arises from the change in price of one currency against another Whenever investors or companies have assets or business operations across national borders they face currency risk (or foreign exchange risk)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

6

EXPOSURE amp RISK ARE THEY SAMEIN FINANCIAL CONTEXT

For example between April 1992 and July 1995 the exchange rate between rupee and US dollar was rock steady For an Indian firm involved in exports and imports from US this meant that it had significant exposure to this exchange rate (because the exchange rate could have affected its performance) but it did not perceive significant risk because the exchange rate was stable

EXPOSURE

It is the measure of the sensitivity of a firmrsquos performance to fluctuations in the relevant risk factor ie whether or not a certain risk factor affects a firms performance

Each firm is ldquoexposedrdquo to unforeseen changes in a number of variables in its environment These variables are called Risk Factors Eg Exchange rate fluctuation is a risk factor

RISK

It is the measure of the extent of variability of the performance attributable to the risk factor ie how much does a risk factor affect a firms performance

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

7

MEASURING EXPOSURE

IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION

bull Functional currency It is the primary currency of the firm in which its financial statements are published It is often the domestic currency of their country

bull Real value Values adjusted for inflation (In practice though it becomes difficult to adjust all values with an uncertain inflation rate hence nominal values are only used)

bull Unanticipated changes Only unanticipated changes in the relevant risk factor are to be considered because the market already makes allowances for anticipated changes For eg an exported invoicing a foreign buyer in the buyerrsquos currency will build an allowance for the expected depreciation of that currency This is anticipated change However if the depreciation is more than expected that becomes unanticipated change

Exposure of a firm to a risk factor is the sensitivity of the real value of the firmrsquos assets liabilities or operating income expressed in its functional currency to unanticipated changes in the risk factor

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

8

MEASURING EXPOSURE

For example suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 6800 while the one month forward rate is Rs 6820 However one month later the spot rate turns out to be Rs 6830

In this case the anticipated depreciation is 20 paise per pound in one month while the unanticipated depreciation has been 10 paise per pound

Q How do we separate a given change in the risk factor into anticipated and unanticipated components

Ans One possible way is by using forward rate

FORWARD RATE

A rate applicable to a financial transaction that will take place in the future

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

3

RISKS FACED BY A FIRM

Core

B

usi

ness

R

isks

Unsuccessful product launch

Labour problems

Cyclical demand fluctuations

Material supply problems

And so forthEnvir

onm

en

tal R

isks

Exchange rate fluctuationsInterest rate fluctuations

Sudden price rise of goods

Shifts in government policies

And so forth

bull Peculiar to a firm

bull All pervasive and affect all firms in an

industry

bull Financial risks are a subset of

environmental risks

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

4

WHAT IS FINANCIAL RISK

Financial Risk

Credit risk Concentration risk

Market risk

Interest rate risk

Currency risk

Equity risk

Commodity risk

Liquidity risk

Refinancing risk

Operational risk

Legal risk

Model risk

Political risk

Valuation risk

FINANCIAL RISK

Financial risk refers to the chance that an investments actual return will be different than expected It basically is exposure to the danger of financial loss on investments made by investors

RISKA situation involving exposure to danger

SOURCE Oxford Dictionary

SOURCE Investopedia

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

5

WHAT IS CURRENCY RISK

For example if you are a US investor and you have stocks in Canada the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the US dollar So if you realize a 15 return in your Canadian stocks but the Canadian dollar depreciates 15 against the US dollar this will amount to no gain at all

CURRENCY RISK

It is a form of financial risk that arises from the change in price of one currency against another Whenever investors or companies have assets or business operations across national borders they face currency risk (or foreign exchange risk)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

6

EXPOSURE amp RISK ARE THEY SAMEIN FINANCIAL CONTEXT

For example between April 1992 and July 1995 the exchange rate between rupee and US dollar was rock steady For an Indian firm involved in exports and imports from US this meant that it had significant exposure to this exchange rate (because the exchange rate could have affected its performance) but it did not perceive significant risk because the exchange rate was stable

EXPOSURE

It is the measure of the sensitivity of a firmrsquos performance to fluctuations in the relevant risk factor ie whether or not a certain risk factor affects a firms performance

Each firm is ldquoexposedrdquo to unforeseen changes in a number of variables in its environment These variables are called Risk Factors Eg Exchange rate fluctuation is a risk factor

RISK

It is the measure of the extent of variability of the performance attributable to the risk factor ie how much does a risk factor affect a firms performance

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

7

MEASURING EXPOSURE

IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION

bull Functional currency It is the primary currency of the firm in which its financial statements are published It is often the domestic currency of their country

bull Real value Values adjusted for inflation (In practice though it becomes difficult to adjust all values with an uncertain inflation rate hence nominal values are only used)

bull Unanticipated changes Only unanticipated changes in the relevant risk factor are to be considered because the market already makes allowances for anticipated changes For eg an exported invoicing a foreign buyer in the buyerrsquos currency will build an allowance for the expected depreciation of that currency This is anticipated change However if the depreciation is more than expected that becomes unanticipated change

Exposure of a firm to a risk factor is the sensitivity of the real value of the firmrsquos assets liabilities or operating income expressed in its functional currency to unanticipated changes in the risk factor

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

8

MEASURING EXPOSURE

For example suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 6800 while the one month forward rate is Rs 6820 However one month later the spot rate turns out to be Rs 6830

In this case the anticipated depreciation is 20 paise per pound in one month while the unanticipated depreciation has been 10 paise per pound

Q How do we separate a given change in the risk factor into anticipated and unanticipated components

Ans One possible way is by using forward rate

FORWARD RATE

A rate applicable to a financial transaction that will take place in the future

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

4

WHAT IS FINANCIAL RISK

Financial Risk

Credit risk Concentration risk

Market risk

Interest rate risk

Currency risk

Equity risk

Commodity risk

Liquidity risk

Refinancing risk

Operational risk

Legal risk

Model risk

Political risk

Valuation risk

FINANCIAL RISK

Financial risk refers to the chance that an investments actual return will be different than expected It basically is exposure to the danger of financial loss on investments made by investors

RISKA situation involving exposure to danger

SOURCE Oxford Dictionary

SOURCE Investopedia

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

5

WHAT IS CURRENCY RISK

For example if you are a US investor and you have stocks in Canada the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the US dollar So if you realize a 15 return in your Canadian stocks but the Canadian dollar depreciates 15 against the US dollar this will amount to no gain at all

CURRENCY RISK

It is a form of financial risk that arises from the change in price of one currency against another Whenever investors or companies have assets or business operations across national borders they face currency risk (or foreign exchange risk)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

6

EXPOSURE amp RISK ARE THEY SAMEIN FINANCIAL CONTEXT

For example between April 1992 and July 1995 the exchange rate between rupee and US dollar was rock steady For an Indian firm involved in exports and imports from US this meant that it had significant exposure to this exchange rate (because the exchange rate could have affected its performance) but it did not perceive significant risk because the exchange rate was stable

EXPOSURE

It is the measure of the sensitivity of a firmrsquos performance to fluctuations in the relevant risk factor ie whether or not a certain risk factor affects a firms performance

Each firm is ldquoexposedrdquo to unforeseen changes in a number of variables in its environment These variables are called Risk Factors Eg Exchange rate fluctuation is a risk factor

RISK

It is the measure of the extent of variability of the performance attributable to the risk factor ie how much does a risk factor affect a firms performance

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

7

MEASURING EXPOSURE

IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION

bull Functional currency It is the primary currency of the firm in which its financial statements are published It is often the domestic currency of their country

bull Real value Values adjusted for inflation (In practice though it becomes difficult to adjust all values with an uncertain inflation rate hence nominal values are only used)

bull Unanticipated changes Only unanticipated changes in the relevant risk factor are to be considered because the market already makes allowances for anticipated changes For eg an exported invoicing a foreign buyer in the buyerrsquos currency will build an allowance for the expected depreciation of that currency This is anticipated change However if the depreciation is more than expected that becomes unanticipated change

Exposure of a firm to a risk factor is the sensitivity of the real value of the firmrsquos assets liabilities or operating income expressed in its functional currency to unanticipated changes in the risk factor

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

8

MEASURING EXPOSURE

For example suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 6800 while the one month forward rate is Rs 6820 However one month later the spot rate turns out to be Rs 6830

In this case the anticipated depreciation is 20 paise per pound in one month while the unanticipated depreciation has been 10 paise per pound

Q How do we separate a given change in the risk factor into anticipated and unanticipated components

Ans One possible way is by using forward rate

FORWARD RATE

A rate applicable to a financial transaction that will take place in the future

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

5

WHAT IS CURRENCY RISK

For example if you are a US investor and you have stocks in Canada the return that you will realize is affected by both the change in the price of the stocks and the change in the value of the Canadian dollar against the US dollar So if you realize a 15 return in your Canadian stocks but the Canadian dollar depreciates 15 against the US dollar this will amount to no gain at all

CURRENCY RISK

It is a form of financial risk that arises from the change in price of one currency against another Whenever investors or companies have assets or business operations across national borders they face currency risk (or foreign exchange risk)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

6

EXPOSURE amp RISK ARE THEY SAMEIN FINANCIAL CONTEXT

For example between April 1992 and July 1995 the exchange rate between rupee and US dollar was rock steady For an Indian firm involved in exports and imports from US this meant that it had significant exposure to this exchange rate (because the exchange rate could have affected its performance) but it did not perceive significant risk because the exchange rate was stable

EXPOSURE

It is the measure of the sensitivity of a firmrsquos performance to fluctuations in the relevant risk factor ie whether or not a certain risk factor affects a firms performance

Each firm is ldquoexposedrdquo to unforeseen changes in a number of variables in its environment These variables are called Risk Factors Eg Exchange rate fluctuation is a risk factor

RISK

It is the measure of the extent of variability of the performance attributable to the risk factor ie how much does a risk factor affect a firms performance

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

7

MEASURING EXPOSURE

IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION

bull Functional currency It is the primary currency of the firm in which its financial statements are published It is often the domestic currency of their country

bull Real value Values adjusted for inflation (In practice though it becomes difficult to adjust all values with an uncertain inflation rate hence nominal values are only used)

bull Unanticipated changes Only unanticipated changes in the relevant risk factor are to be considered because the market already makes allowances for anticipated changes For eg an exported invoicing a foreign buyer in the buyerrsquos currency will build an allowance for the expected depreciation of that currency This is anticipated change However if the depreciation is more than expected that becomes unanticipated change

Exposure of a firm to a risk factor is the sensitivity of the real value of the firmrsquos assets liabilities or operating income expressed in its functional currency to unanticipated changes in the risk factor

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

8

MEASURING EXPOSURE

For example suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 6800 while the one month forward rate is Rs 6820 However one month later the spot rate turns out to be Rs 6830

In this case the anticipated depreciation is 20 paise per pound in one month while the unanticipated depreciation has been 10 paise per pound

Q How do we separate a given change in the risk factor into anticipated and unanticipated components

Ans One possible way is by using forward rate

FORWARD RATE

A rate applicable to a financial transaction that will take place in the future

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

6

EXPOSURE amp RISK ARE THEY SAMEIN FINANCIAL CONTEXT

For example between April 1992 and July 1995 the exchange rate between rupee and US dollar was rock steady For an Indian firm involved in exports and imports from US this meant that it had significant exposure to this exchange rate (because the exchange rate could have affected its performance) but it did not perceive significant risk because the exchange rate was stable

EXPOSURE

It is the measure of the sensitivity of a firmrsquos performance to fluctuations in the relevant risk factor ie whether or not a certain risk factor affects a firms performance

Each firm is ldquoexposedrdquo to unforeseen changes in a number of variables in its environment These variables are called Risk Factors Eg Exchange rate fluctuation is a risk factor

RISK

It is the measure of the extent of variability of the performance attributable to the risk factor ie how much does a risk factor affect a firms performance

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

7

MEASURING EXPOSURE

IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION

bull Functional currency It is the primary currency of the firm in which its financial statements are published It is often the domestic currency of their country

bull Real value Values adjusted for inflation (In practice though it becomes difficult to adjust all values with an uncertain inflation rate hence nominal values are only used)

bull Unanticipated changes Only unanticipated changes in the relevant risk factor are to be considered because the market already makes allowances for anticipated changes For eg an exported invoicing a foreign buyer in the buyerrsquos currency will build an allowance for the expected depreciation of that currency This is anticipated change However if the depreciation is more than expected that becomes unanticipated change

Exposure of a firm to a risk factor is the sensitivity of the real value of the firmrsquos assets liabilities or operating income expressed in its functional currency to unanticipated changes in the risk factor

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

8

MEASURING EXPOSURE

For example suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 6800 while the one month forward rate is Rs 6820 However one month later the spot rate turns out to be Rs 6830

In this case the anticipated depreciation is 20 paise per pound in one month while the unanticipated depreciation has been 10 paise per pound

Q How do we separate a given change in the risk factor into anticipated and unanticipated components

Ans One possible way is by using forward rate

FORWARD RATE

A rate applicable to a financial transaction that will take place in the future

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

7

MEASURING EXPOSURE

IMPORTANT TERMS TO UNDERSTAND IN THIS DEFINITION

bull Functional currency It is the primary currency of the firm in which its financial statements are published It is often the domestic currency of their country

bull Real value Values adjusted for inflation (In practice though it becomes difficult to adjust all values with an uncertain inflation rate hence nominal values are only used)

bull Unanticipated changes Only unanticipated changes in the relevant risk factor are to be considered because the market already makes allowances for anticipated changes For eg an exported invoicing a foreign buyer in the buyerrsquos currency will build an allowance for the expected depreciation of that currency This is anticipated change However if the depreciation is more than expected that becomes unanticipated change

Exposure of a firm to a risk factor is the sensitivity of the real value of the firmrsquos assets liabilities or operating income expressed in its functional currency to unanticipated changes in the risk factor

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

8

MEASURING EXPOSURE

For example suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 6800 while the one month forward rate is Rs 6820 However one month later the spot rate turns out to be Rs 6830

In this case the anticipated depreciation is 20 paise per pound in one month while the unanticipated depreciation has been 10 paise per pound

Q How do we separate a given change in the risk factor into anticipated and unanticipated components

Ans One possible way is by using forward rate

FORWARD RATE

A rate applicable to a financial transaction that will take place in the future

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

8

MEASURING EXPOSURE

For example suppose the price of a pound sterling in terms of rupees right now (also called spot rate) is Rs 6800 while the one month forward rate is Rs 6820 However one month later the spot rate turns out to be Rs 6830

In this case the anticipated depreciation is 20 paise per pound in one month while the unanticipated depreciation has been 10 paise per pound

Q How do we separate a given change in the risk factor into anticipated and unanticipated components

Ans One possible way is by using forward rate

FORWARD RATE

A rate applicable to a financial transaction that will take place in the future

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

9

MEASURING EXPOSUREAN EXAMPLEA firm has a 90-day payable amounting to US $500000 arising out of raw material import transaction Current spot rate is Rs 4060 per dollar 3-month forward rate is Rs 4080 per dollar Actual rate 3 months later turns out to be Rs 4100 per dollar

bull Therefore the unanticipated depreciation of rupee is Rs 020 per dollar

bull The loss on account of increase in rupee value of the payable is (500000020) = Rs 100000

According to the 3-month forward rate the firm would have paid (4080500000) = Rs 20400000

But actually it will pay (41500000) = Rs 20500000

Rs 100000 extra on account of unanticipated depreciation of rupee

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

10

MEASURING EXPOSUREAN EXAMPLEOne straightforward way to define exposure is ldquoBy how much will the value of the payable change if the rupee-dollar rate changes by 1 rupee per dollarrdquo

In this case the value of the payable changes by 100000 on a 20 paise change of rupee-dollar rate therefore it will change by 500000 for a rupee change

Note here that the exposure is here is same as the value of the foreign currency (500000)

A general rule is that if the foreign currency value of the exposed item is fixed exposure identically equals that value

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

11

MEASURING RISK

For example we have the following forecast by a financial consulting outfitldquoIn our view the most likely value of the spot rate three months from now is Rs 4100 per dollar but it could be as high as Rs 4150 There is a small probability that the dollar could fall to Rs 3940rdquo

Risk is the measure of the extent of variability of the performance attributable to the risk factor (eg exchange rate) It depends on the size of the exposure and the extent of fluctuations expected in the risk factor (eg exchange rate) In simple words risk gives us a range within which the variation due to the risk factor can take place It can be arrived by analyzing the best-case and worst-case scenarios for a firm

Scenario Best-case Worst-case

3-month spot rate Rs 3940 Rs 4150

Rupee outlay to settle the payable

Rs 19700000

Rs 20750000

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

12

WHY SHOULD RISK BE MANAGEDLeads to lower demand for returns by investorsbull Investors can manage unsystematic risks (peculiar to a

company) by diversifying their portfolio (eg by buying stocks in oil as well as aviation industry) but they have no control over systematic risks (related to the industry and economy at large) Hence greater the systematic risk greater is the return demanded by investorsEnsures better cash flows

bull If the various risks associated with a firm are managed properly it will ensure a steady and healthy cash flow for the firm thereby ensuring that it takes full advantage of good investment opportunities

External financing can be avoidedbull If risk is managed effectively it will lead to ready

availability of internal funds for investments and lower the reliance on external funds like debt and new equity which are always less preferred and more risky

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

13

WHY SHOULD RISK BE MANAGED

Financial distress can be avoidedbull If not managed properly the risks associated with a firm

can lead to a liquidity crunch This will lead to the bankers customers employees and suppliers to believe there is financial distress and they may react in way which will affect future cash flows of the firm

Creation of ldquocorporate valuerdquobull Firms enhance shareholder wealth ndash create ldquocorporate

valuerdquo ndash by making good investments in areas of product development RampD advertising promotion etc This is possible only with a steady stream of cash flows

Increased investor confidencebull A firm that manages its risk effectively and consistently

over a period of time is well reputed by investors and bankers and considered creditworthy This ensures availability of credit when and if required

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

14

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

15

WHAT IS HEDGING

>

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

16

HEDGINGbull What is hedging

bull To hedge or not to hedge

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

17

TO HEDGE OR NOT TO HEDGEbull Hedging is the taking of a position either acquiring a cash flow or an asset or a contract (including a forward contract) that will rise (or fall) in value to offset a fall (or rise) in value of an existing position

bull Hedging therefore protects the owner of the existing asset from loss (but it also eliminates any gain resulting from changes in exchange rates on the value of the exposure)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

18

TO HEDGE OR NOT TO HEDGE

Opponents of Hedging

Stockholders are much more capable of diversifying currency risk than the management of the firm

Currency risk management does not add value to the firm and it incurs costs

Hedging might benefit corporate management more than shareholders

Proponents of Hedging

Reduction in risk in future cash flows improves the planning capability of the firm

Management has a comparative advantage over the individual shareholder in knowing the actual currency risk of the firm

Reduction of risk in future cash flows reduces the likelihood that the firmrsquos cash flows will fall below a necessary minimum

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

19

CURRENCY EXPOSUREbull Transactions exposurebull Translation exposurebull Operating exposurebull Economic exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

20

TYPES OF CURRENCY EXPOSURES

Currency Exposure

Short-TermAccounting

(Translation

Exposure)

Cash Flow

Unanticipated

Changes

(Transactions

Exposure)

Anticipated

Changes

Long-Term

Operating Exposure

Strategic Exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

21

TYPES OF CURRENCY EXPOSURES Changes in exchange rate can affect firm value through

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

22

TYPES OF CURRENCY EXPOSURESILLUSTRATIVE EXAMPLES

A Taiwanese company has the following USD exposures1 Owns a factory in Texas worth US$5 million2 Agreement to buy goods worth US$2 million3 Biggest competitor is a US company

What happens if the NT dollar appreciates4 NT$ value of US factory goes down (translation)5 NT$ cost of buying goods goes down (transaction)6 Global competitiveness of Taiwanese company

decreases (operating)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

23

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

24

TRANSLATION EXPOSURE

bull Translation exposure is the potential for an increase or decrease in the parentrsquos net worth and reported net income caused by a change in exchange rates since the last translation

bull The accounting process of translation involves converting these foreign subsidiaries financial statements into home currency-denominated statements

bull It is the exposure on assets and liabilities appearing in the balance sheet but which are not going to be liquidated in the foreseeable future

bull It has no direct impact on cash flows of a firm

TRANSLATION EXPOSURE

Translation exposure also called Accounting Exposure or Balance Sheet exposure arises because financial statements of foreign subsidiaries ndash which are stated in foreign currency ndash must be restated in the parentrsquos reporting currency for the firm to prepare consolidated financial statements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

25

TRANSLATION EXPOSUREbull No cash gains or losses are involved but translation exposure affects the published financial statements and hence may affect market valuation of the parent companys stock

Indian company law does not require translation and consolidation of foreign subsidiaries financial statements with those of the parent company unless the foreign operations are an integral part of the parent business for eg a branchbull However major stock exchanges require it as one of their listing requirements

bull As more and more Indian firms are going multinational they are increasingly considering translation and consolidation of foreign subsidiaries and hence are becoming vulnerable to translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

26

TRANSLATION EXPOSURE AN EXAMPLEAN INDIAN COMPANY WITH A UK SUBSIDIARY

Particular

March 31 2012 (pound1=Rs85)

March 31 2013(pound1=Rs70)

Value in pound Translated value

Value in pound

Translated value

Real Estate

pound1000000 Rs 85000000 pound950000 Rs

66500000

Inventories pound200000 Rs 17000000 pound250000 Rs

17500000

Cash pound150000 Rs 12750000 pound160000 Rs 11200000

Total pound1350000

Rs 102000000

pound1360000

Rs 95200000

Financial details of UK Subsidiary

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

27

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational

exposure

Regardless of which method is employed a translation method must not only designate at what exchange rate individual balance sheet and income statement items are remeasured but also designate where any imbalance is to be recorded (current income or an equity reserve account)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

28

CURRENTNONCURRENT METHODbull The underlying principle is that assets and liabilities should be translated based on their maturity

Current assets (like Cash) translated at the spot rate eg DM2=$1

Noncurrent assets (like Net Fixed Assets) translated at the historical rate in effect when the item was first recorded on the books eg DM3=$1

Balance Sheet Local Currency

Current Noncurrent

Cash 2100 DM $1050 Inventory 1500 DM $750 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2800 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $600 Common stock 2700 DM $900 Retained earnings 900 DM $700CTA -------- --------Total Liabilities and

Equity6600 DM $2800

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

29

MONETARYNONMONETARY METHODbull The underlying principle is that monetary accounts have a similarity because their value represents a sum of money whose value changes as the exchange rate changes

bull All monetary balance sheet accounts (cash marketable securities accounts receivable etc) of a foreign subsidiary are translated at the current exchange rate eg DM2=$1

All other (nonmonetary) balance sheet accounts (common stock) are translated at the historical exchange rate in effect when the account was first recorded egDM3=$1

Balance Sheet Local Currency

Monetary Nonmonetary

Cash 2100 DM $1050 Inventory 1500 DM $500 Net fixed assets 3000 DM $1000

Total Assets 6600 DM $2550 Current liabilities 1200 DM $600 Long-Term debt 1800 DM $900 Common stock 2700 DM $900 Retained earnings 900 DM $0CTA -------- --------Total Liabilities and

Equity6600 DM $2400

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

30

TEMPORAL METHODbull The underlying principle is that assets and liabilities should be translated based on how they are carried on the firmrsquos books

bull Balance sheet accounts are translated at the current spot exchange rate if they are carried on the books at their current value

bull Items that are carried on the books at historical costs are translated at the historical exchange rates in effect at the time the firm placed the item on the books

bull Gains or losses resulting from remeasurement are carried directly to current consolidated income and not to equity reserves (increased variability of consolidated earnings)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

31

CURRENT RATE METHODbull All balance sheet items (except for stockholderrsquos equity) are translated at the current exchange rate

DM2=$1

bull Very simple method in application

bull The biggest advantage of the current rate method is that the gain or loss on translation does not pass through the income statement but goes directly to a reserve account (reducing variability of reported earnings)

Balance Sheet Local Currency

Current Rate

Cash DM2100 $1050 Inventory DM1500 $750 Net fixed assets DM3000 $1500

Total Assets DM6600 $3300 Current liabilities DM1200 $600 Long-Term debt DM1800 $900 Common stock DM2700 $900 Retained earnings DM900 $360 CTA -------- $540

Total Liabilities and Equity

DM6600 $3300

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

32

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

Spot exchange rate

earnings

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

33

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Book value of inventory

at spot exchange rate

Book value of

inventory historic

rate

Current value of inventory at spot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

34

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 historic

ratespot exchange rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

35

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 spot rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

36

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

spot ratehistorical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

37

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

historical rate

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

38

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300

From income statement

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

39

Balance Sheet Local Currency

Current Noncurrent

Monetary Nonmonetary

Temporal Current Rate

Cash 2100 DM $1050 $1050 $1050 $1050 Inventory 1500 DM $750 $500 $900 $750 Net fixed assets 3000 DM $1000 $1000 $1000 $1500

Total Assets 6600 DM $2800 $2550 $2950 $3300 Current liabilities

1200 DM $600 $600 $600 $600

Long-Term debt

1800 DM $600 $900 $900 $900

Common stock 2700 DM $900 $900 $900 $900 Retained earnings

900 DM $700 $150 $550 $360CTA -------- -------- -------- -------- $540

Total Liabilities and

Equity

6600 DM $2800 $2550 $2950 $3300 Under the current rate method a ldquoplugrdquo equity account named

cumulative translation adjustment makes the balance sheet balance

earnings

HOW VARIOUS TRANSLATION METHODS DEAL WITH A CHANGE FROM DM3 TO DM2 = $1

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

40

TRANSLATION EXPOSUREbull Introduction amp example

bull Methodsbull Strategies to manage translational exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

41

MANAGING TRANSLATION EXPOSUREBALANCE SHEET HEDGE

bull To create a balance sheet hedge once transaction exposure has been controlled often means creating new transaction exposure Hence this is not always a very wise option

BALANCE SHEET HEDGE

It involves equating the amount of exposed assets in an exposure currency to exposed liabilities in that currency so that the net exposure is zero

bull Two common methods used for managing translation exposure are called balance sheet hedge and derivates hedge

HEDGEMaking an investment to reduce or control risk Investors use this strategy when they are unsure of what the market will do

bull In simple language a hedge is used to reduce any substantial lossesgains A hedge can be constructed from many types of financial instruments including stocks derivative products futures contracts etc

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

42

MANAGING TRANSLATION EXPOSUREDERIVATIVES HEDGE

bull Derivatives allow risk related to the price of the underlying asset to be transferred from one party to another

DERIVATIVES

A derivative is a financial contract which derives its value from the performance of another entity such as an asset index or interest rate called the underlying

bull For example a wheat farmer and a miller could sign a futures contract to exchange a specified amount of cash for a specified amount of wheat in the future

bull Both parties have reduced a future risk for the wheat farmer the uncertainty of the price and for the miller the availability of wheat

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

43

SHOULD FIRMS HEDGE TRANSLATION EXPOSURE

YES- Investors donrsquot have enough information to estimate cash flows and instead must rely on reported earnings- If reported earnings are distorted by translation issues investors will misvalue the firm

NO- The value of the firm is the PV of cash flows- Translation exposure doesnrsquot effect cash flows so we should ignore it

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

44

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

45

TRANSACTION EXPOSURE

bull It stems from the possibility of incurring exchange gains or losses on transactions already entered into and denominated in a foreign currency

bull Transaction exposure is short term in nature

bull It has a direct impact on cash flows of a firm

TRANSACTION EXPOSURE

The risk faced by companies involved in international trade that currency exchange rates will change after the companies have already entered into financial obligations

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

46

TRANSACTION EXPOSUREEXAMPLESbull A currency has to be converted in order to make or receive a payment for goods or services on a particular date in future

bull A currency has to be converted to repay a loan or make an interest payment on a particular date in future

bull A currency has to converted to make a dividend payment royalty payment etc whose foreign currency amount is fixed

For eg suppose a firm receives an export order It fixes a price manufactures the product makes the shipment and gives 90 days credit to the buyer who will pay in his currency

Then the company has transaction exposure from the time it accepts the order till the time the payment is received and converted to home currency

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

47

TRANSACTION EXPOSUREEXAMPLES

bull Transaction exposure arises because of the risk that the US seller will receive something other than $1620000

bull If the euro weakens to $08500euro then Trident will receive $1530000

bull If the euro strengthens to $09600euro then Trident will receive $1728000

bull Thus exposure is the chance of either a loss or a gain

Suppose a US firm Trident sells merchandise on account to a Belgian buyer for euro1800000 payment to be made in 60 days (S0 = $090euro)

The US seller expects to exchange the euro1800000 for $1620000 when payment is received

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

48

TRANSACTION EXPOSUREbull Introduction amp example

bull Strategies to manage transaction exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

49

MANAGING TRANSACTION EXPOSURE

Strategies

Contractual Hedges

Forward Market Hedge

Money Market Hedge

Options Market Hedge

Futures Market Hedge

Financial Hedges

Swaps

Operating Strategies

Risk Shifting

Price adjustment clauses

Exposure Netting

Risk Sharing

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

50

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

bull If you are going to owe a foreign currency on future agree to buy the foreign currency now by entering into long position in a forward contract

bull If you are going to receive a foreign currency on future agree to sell the foreign currency now by entering into short position in a forward contract

FORWARD MARKET

An over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery Contracts entered into in the forward market are binding on the parties involved

The buying of a security such as a stock commodity or currency with the expectation that the asset will rise in value is called long position

The sale of a borrowed security commodity or currency with the expectation that the asset will fall in value is called short position

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

51

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGEEXAMPLE You are a US importer of British woolens and you have just ordered next yearrsquos inventory Payment of pound100M is due in one year How can you fix the cash outflow in dollars

Answer One way is to put yourself in a position that delivers pound100M in one year ndash a long forward contract on the pound

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

52

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

53

MANAGING TRANSACTION EXPOSUREFORWARD MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

54

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEbull To hedge a foreign currency payable buy the foreign currency today amphold it1 Buy the present value of the foreign currency payable today2 Invest that amount at the foreign rate3 At maturity your investment will have grown enough to cover for your

foreign currency payableA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Can hedge this payable by buying euro9615385 = euro100000(104) today and investing it at 4 in Italy for one year

At maturity he will have euro100000 = euro9615385(104)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

55

MANAGING TRANSACTION EXPOSUREMONEY MARKET HEDGEA US based importer of Italian bicycles What can he do in this situationbull In one year owes euro100000 to an Italian supplierbull The spot exchange rate is $125 = euro100bull The one year interest rate in Italy is 4

Dollar cost today = $12019231 = euro9615385

With this money market hedge we have redenominated a one-year euro100000 payable into a $12019231 payable due today

If the US interest rate is 3 we could borrow$12019231 today and owe it in one year

$12379808 = $12019231 (103)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

56

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGEbull To hedge a foreign currency payable buy calls on the

currencybull If the call currency appreciates your call option lets

you buy the currency at the exercise price of the call

bull To hedge a foreign currency receivable buy puts on the currencybull If the currency depreciates your put options lets you

sell the currency for the exercise price

OPTIONS

An option is a contract that gives the buyer the right but not the obligation to buy or sell an underlying asset at a specific price on or before a certain date

Two types of options are bull A call gives the holder the right to buy an asset at a certain

price within a specific period of time bull A put gives the holder the right to sell an asset at a certain

price within a specific period of time

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

57

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

58

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

59

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

60

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

61

MANAGING TRANSACTION EXPOSUREOPTIONS MARKET HEDGE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

62

MANAGING TRANSACTION EXPOSUREFUTURES MARKET HEDGEbull Futures contracts are one of the most common derivatives used to hedge risk The main reason that companies or corporations use future contracts is to offset their risk exposures and limit themselves from any fluctuations in price

bull When a company knows that it will be making a purchase in the future for a particular item it should take a long position in a futures contract to hedge its position

bull If a company knows that it will be selling a certain item it should take a short position in a futures contract to hedge its position

FUTURES CONTRACT

A futures contract is as an arrangement between two parties to buy or sell an asset at a particular time in the future for a particular price

bull Futures market hedge is similar to hedging with forwards

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

63

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Shifting

bull Strategy for risk shiftingbull Denominating exports in a strong currencybull Denominating imports in a weak currency

bull Outcome depends onbull Bargaining power or parties involvedbull Competitiveness of firmrsquos particular business

Exposure Nettingbull Offsetting exposures in one currency with exposures in the same or another currency when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure

bull A firmrsquos currency exposures can be viewed as a portfoliobull Exposure netting depends on the correlation between

currencies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

64

MANAGING TRANSACTION EXPOSUREOPERATING STRATEGIESRisk Sharingbull Both parties reach agreement to share the currency risk

associated with a dealbull Risk sharing arrangements

bull Price adjustment clausebull Neutral zonebull Outside neutral zoneCurrency Collars

bull Providing protection if the currency moves outside an agreed-on range This agreement is arrived on both parties at the time of the financial deal

Leading and Lagging

bull leading (accelerate timing of depreciating currency)bull lagging (delay timing of appreciating currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

65

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

66

OPERATING EXPOSURE

bull Measuring the operating exposure of a firm requires forecasting and analyzing all the firmrsquos future individual transaction exposures together with the future exposures of all the firmrsquos competitors and potential competitors worldwide

bull Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

OPERATING EXPOSURE

Operating exposure also called economic exposure competitive exposure and even strategic exposure on occasion measures any change in the present value of a firm resulting from changes in future operating cash flows caused by an unexpected change in exchange rates

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

67

ATTRIBUTES OF OPERATING EXPOSUREbull The cash flows of a multinational firm can be divided into operating cash flows and financing cash flows

bull Operating cash flows arise from intercompany (between unrelated companies) and intracompany (between units of the same company) receivables and payables rent and lease payments royalty and license fees and assorted management fees

bull Financing cash flows are payments for loans (principal and interest) equity injections and dividends of an inter and intracompany nature

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

68

FINANCIAL amp OPERATING CASH FLOWS BETWEEN PARENT amp SUBSIDIARY

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

69

MEASURING THE IMPACT OF OPERATING EXPOSURE An unexpected change in exchange rates impacts a firmrsquos expected cash flows at four levels depending on the time horizon used Short run

Medium run Equilibrium case

Medium run Disequilibrium case

Long run

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

70

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The first level impact is on the one-year operating budget the gain or loss depends on the currency of denomination (currency of expected cash flows)

bull In the short run it is difficult to change the exposure due to implied obligations such as purchase or sales commitments because the currency of denomination cannot be changed

bull It is also difficult to change sales prices or to renegotiate factor costs

SHORT RUN IMPACT

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

71

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull The second level impact is on expected medium-term cash flows

bull If parity conditions hold the firm should be able to adjust prices and factor costs over time to maintain the expected level of cash flows if no real variables have changed

bull The country of cash flow origination and its monetary fiscal and balance of payments policies will determine whether firms can adjust prices and costs

bull Example If Volvo is selling cars to Germany and the DM depreciates because the German money supply rises Volvo will be protected if it can raise its DM prices so that the Krona price is maintained

MEDIUM RUN ndash PARITY CONDITIONS HOLD

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

72

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull If the firm is not able to adjust prices and costs because the change in exchange rates has been accompanied by real changes so that relative prices have been altered

bull Example If the DM has depreciated relative to the Krona because German investors have lost confidence in the German economy and are moving their capital to Sweden the wealth of German investors has dropped the real price of a Swedish car has risen and Volvo may not be able to raise its prices proportionately There is less than perfect pass-through

MEDIUM RUN ndash CHANGE IN REAL VARIABLES

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

73

MEASURING THE IMPACT OF OPERATING EXPOSURE

bull Long-run cash flows beyond five years could be affected Cash flows will be influenced by the reactions of existing and potential competitors to exchange rate changes when real variables are affected

bull In principle all firms subject to international competition domestic or multinational are subject to foreign exchange operating exposure in the long run whenever real variables are affected

LONG RUN

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

74

OPERATING EXPOSUREAN EXAMPLE

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

75

OPERATING EXPOSUREbull Introduction amp example

bull Strategies to manage operating exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

76

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firmrsquos future cash flows rather than merely hoping for the best

bull To meet this objective management can diversify the firmrsquos operating and financing base

bull Management can also change the firmrsquos operating and financing policies

bull If a firmrsquos operations are diversified internationally management is prepositioned both to recognize disequilibrium when it occurs and to react competitively

bull Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

77

MANAGEMENT OF OPERATING EXPOSURE STRATEGIC DIVERSIFICATIONbull If a firmrsquos financing sources are diversified it will be prepositioned to take advantage of temporary deviations from the international Fisher effect

bull However to switch financing sources a firm must already be well-known in the international investment community

bull Again this would not be an option for a domestic firm (if it has limited its financing to one capital market)INTERNATIONAL FISHER EFFECTAn economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries nominal interest rates for that time

Calculated as E represents the change in the exchange ratei1 represents country As interest ratei2 represents country Bs interest rate

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

78

MANAGEMENT OF OPERATING EXPOSURE Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated foreign exchange exposures

The four most commonly employed proactive policies areMatching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

79

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS EXAMPLE

A US firm has continuing export sales to Canada

In order to compete effectively in Canadian markets the firm invoices all export sales in Canadian dollars

This policy results in a continuing receipt of Canadian dollars month after month

This endless series of transaction exposures could be continually hedged with forwards or other contractual agreements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

80

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWS

Exposure The sale of goods to Canada creates a foreign currency exposure from the inflow of Canadian dollarsHedge The Canadian dollar debt payments act as a financial hedge by requiring debt service an outflow of Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

81

MANAGEMENT OF OPERATING EXPOSUREMATCHING CURRENCY CASH-FLOWSOne way to offset an anticipated continuous long exposure to a particular company is to acquire debt denominated in that currency (matching)

Another alternative would be for the US firm to seek out potential suppliers of raw materials or components in Canada as a substitute for US or other foreign firms

In addition the company could engage in currency switching in which the company would pay foreign suppliers with Canadian dollars

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

82

MANAGEMENT OF OPERATING EXPOSURERISK SHARING AGREEMENTS Currency Clauses Risk-SharingAn alternate method for managing a long-term cash flow exposure between firms is risk sharing

This is a contractual arrangement in which the buyer and seller agree to ldquosharerdquo or split currency movement impacts on payments between them

This agreement is intended to smooth the impact on both parties of volatile and unpredictable exchange rate movements

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

83

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS Back-to-Back LoansA back-to-back loan also referred to as a parallel loan or credit swap occurs when two business firms in separate countries arrange to borrow each otherrsquos currency for a specific period of time

At an agreed terminal date they return the borrowed currencies

Such a swap creates a covered hedge against exchange loss since each company on its own books borrows the same currency it repays

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

84

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS

The back-to-back loan provides a method for parent-subsidiary cross-border financing without incurring direct currency exposure

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

85

MANAGEMENT OF OPERATING EXPOSUREBACK TO BACK LOANS There are two fundamental impediments to widespread use of the back-to-back loan It is difficult for a firm to find a partner termed a counterparty for the currency amount and timing desired

A risk exists that one of the parties will fail to return the borrowed funds at the designated maturity ndash although each party has 100 collateral (denominated in a different currency)

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

86

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS Currency SwapsA currency swap resembles a back-to-back loan except that it does not appear on a firmrsquos balance sheet

In a currency swap a firm and a swap dealer or swap bank agree to exchange an equivalent amount of two different currencies for a specified amount of time

For Example

A Japanese corporation and US corporation would like to enter into a cross currency swap which would allow them to use foreign currency cash inflows to service debt

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

87

MANAGEMENT OF OPERATING EXPOSURECURRENCY SWAPS

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

88

MANAGEMENT OF OPERATING EXPOSUREOTHER STRATEGIESbull Use of Marketing Strategies

bull Market Selectionbull Pricing StrategyProduct Strategybull Promotional Strategy

bull Use of Production Managementbull Input mixbull Plant Location amp Shifting production among

plantsbull Raising Productivity (ie lowering costs)

bull Financial Hedging techniques may also be used

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89

INTERNATIONAL FINANCE PRESENTATION | HISHAM AHMED RIZVI | HISHAMRZVGMAILCOM

89

THANK YOUARUSHI SHARMA |

arushisharma888gmailcomDIVIK GIRDHAR | divikgirdhargmailcom

DIVYA GUPTA | guptadivya2310gmailcom

• International finance Foreign exchange (Currency) risk managem
• Slide 2
• Risks faced by a firm
• What is FINANCIAL risk
• What is currency risk
• Exposure amp risk are they same In Financial context
• Measuring exposure
• Measuring exposure (2)
• Measuring exposure An Example
• Measuring exposure An Example (2)
• Measuring Risk
• Why should risk be managed
• Why should risk be managed (2)
• Slide 14
• What is hedging
• Slide 16
• To hedge or not to hedge
• To hedge or not to hedge (2)
• Slide 19
• Types of currency exposures
• Types of currency exposures (2)
• Types of currency exposures (3)
• Slide 23
• Translation exposure
• Translation exposure (2)
• Translation exposure An Example An Indian Company with a Uk
• Slide 27
• CurrentNoncurrent Method
• MonetaryNonmonetary Method
• Temporal method
• Current rate method
• How Various Translation Methods Deal with a Change from DM3 to
• How Various Translation Methods Deal with a Change from DM3 to (2)
• How Various Translation Methods Deal with a Change from DM3 to (3)
• How Various Translation Methods Deal with a Change from DM3 to (4)
• How Various Translation Methods Deal with a Change from DM3 to (5)
• How Various Translation Methods Deal with a Change from DM3 to (6)
• How Various Translation Methods Deal with a Change from DM3 to (7)
• How Various Translation Methods Deal with a Change from DM3 to (8)
• Slide 40
• Managing Translation exposure Balance sheet hedge
• Managing Translation exposure derivatives hedge
• Should Firms Hedge Translation Exposure
• Slide 44
• Transaction exposure
• Transaction exposure Examples
• Transaction exposure Examples (2)
• Slide 48
• Managing Transaction Exposure
• Managing Transaction Exposure Forward market hedge
• Managing Transaction Exposure Forward market hedge (2)
• Managing Transaction Exposure Forward market hedge (3)
• Managing Transaction Exposure Forward market hedge (4)
• Managing Transaction Exposure money market hedge
• Managing Transaction Exposure money market hedge (2)
• Managing Transaction Exposure Options market hedge
• Managing Transaction Exposure Options market hedge (2)
• Managing Transaction Exposure Options market hedge (3)
• Managing Transaction Exposure Options market hedge (4)
• Managing Transaction Exposure Options market hedge (5)
• Managing Transaction Exposure Options market hedge (6)
• Managing Transaction Exposure FUTURES market hedge
• Managing Transaction Exposure Operating strategies
• Managing Transaction Exposure Operating strategies (2)
• Slide 65
• OPERATING exposure
• ATTRIBUTES OF OPERATING exposure
• Financial amp Operating Cash Flows Between Parent amp Subsidiary
• Measuring the impact of OPERATING exposure
• Measuring the impact of OPERATING exposure (2)
• Measuring the impact of OPERATING exposure (3)
• Measuring the impact of OPERATING exposure (4)
• Measuring the impact of OPERATING exposure (5)
• OPERATING exposure An example
• Slide 75
• Management of Operating Exposure strategic Diversification
• Management of Operating Exposure strategic Diversification (2)
• Management of Operating Exposure
• Management of Operating Exposure Matching currency cash-flows
• Management of Operating Exposure Matching currency cash-flows (2)
• Management of Operating Exposure Matching currency cash-flows (3)
• Management of Operating Exposure Risk sharing agreements
• Management of Operating Exposure back to back loans
• Management of Operating Exposure back to back loans (2)
• Management of Operating Exposure back to back loans (3)
• Management of Operating Exposure CURRENCY SWAPS
• Management of Operating Exposure CURRENCY SWAPS (2)
• Management of Operating Exposure OTHER STRATEGIES
• Slide 89