International Financial Markets By- Rahul Jain. Foreign Exchange Rate Determination Determined by Demand and Supply Determined by Demand and Supply This

International Financial International Financial MarketsMarkets

By- Rahul JainBy- Rahul Jain

Foreign Exchange Rate Foreign Exchange Rate DeterminationDetermination

Determined by Demand and SupplyDetermined by Demand and Supply

This also depends on the relative economic This also depends on the relative economic performance of the two countriesperformance of the two countries

Three Types of ExchangeThree Types of ExchangeRate ExposureRate Exposure

Transaction ExposureTransaction Exposure Economic ExposureEconomic Exposure Translation (accounting) ExposureTranslation (accounting) Exposure

Transaction ExposureTransaction Exposure

Transaction exposure arises whenever a Transaction exposure arises whenever a company is committed to a foreign-currency-company is committed to a foreign-currency-denominated transaction. Since the transaction denominated transaction. Since the transaction will result in a future foreign currency cash will result in a future foreign currency cash inflow or outflow, any change in the exchange inflow or outflow, any change in the exchange rate between the time the transaction is entered rate between the time the transaction is entered into and the time it is settled in cash will lead into and the time it is settled in cash will lead to a change in the dollar (HC) amount of the to a change in the dollar (HC) amount of the cash inflow or outflow. cash inflow or outflow.


Affects exposure to net cash flowAffects exposure to net cash flow consolidates subsidiaries’ cash in/outflowsconsolidates subsidiaries’ cash in/outflows e.ge.g., minimal exposure in Mexican peso if., minimal exposure in Mexican peso if

Subsidiary A has net inflow of PS9,000,000Subsidiary A has net inflow of PS9,000,000 Subsidiary B has net outflow of PS8,700,000Subsidiary B has net outflow of PS8,700,000

MNC net flow = PS300,000

Measures how greatly exchange rate fluctuations may affect cash transactions

Transaction ExposureTransaction Exposure Transaction exposure measures gains or losses that arise from Transaction exposure measures gains or losses that arise from

the settlement of existing financial obligations, namelythe settlement of existing financial obligations, namely o Purchasing or selling on credit goods or services when o Purchasing or selling on credit goods or services when

prices are stated in foreign currenciesprices are stated in foreign currencies o Borrowing or lending funds when repayment is to be o Borrowing or lending funds when repayment is to be

made in a foreign currencymade in a foreign currency o Being a party to an unperformed forward contract ando Being a party to an unperformed forward contract and o Otherwise acquiring assets or incurring liabilities o Otherwise acquiring assets or incurring liabilities

denominated in foreign currenciesdenominated in foreign currencieshttp://www.businessfaculty.utoledo.edu/pkozlowski/FINA3500/http://www.businessfaculty.utoledo.edu/pkozlowski/FINA3500/

ch08.ppt.ch08.ppt.


Steps to assess transaction exposureSteps to assess transaction exposure assess MNC’s position in each currencyassess MNC’s position in each currency estimate how an exposure in a currency affects the estimate how an exposure in a currency affects the

MNCMNC use standard deviations and correlationsuse standard deviations and correlations

assess the “net” effect of currency exposuresassess the “net” effect of currency exposures

Economic ExposureEconomic Exposure

Transaction is a subset of economic exposureTransaction is a subset of economic exposure Currency fluctuations affect more than currency Currency fluctuations affect more than currency

transactionstransactions-- e.g-- e.g., an increase in inflation in France may:., an increase in inflation in France may:

1. lower value of outflow from France (transaction exposure)1. lower value of outflow from France (transaction exposure) 2. increase subsidiary’s French sales2. increase subsidiary’s French sales 3. raise financing cost in France3. raise financing cost in France

Measures how greatly an MNC’s present value of future cash flows is affected by unexpected exchange rate fluctuations

Economic exposureEconomic exposure

It measures how greatly a firm’s present value of It measures how greatly a firm’s present value of future cash flows is affected by unexpected future cash flows is affected by unexpected exchange rate fluctuations.exchange rate fluctuations.


Indirect exposureIndirect exposure implies even domestic firms have foreign implies even domestic firms have foreign

exchange riskexchange risk


Exposure of domestic firmsExposure of domestic firms impacted by foreign competition and financial impacted by foreign competition and financial

markets markets


Exposure of MNCsExposure of MNCs face exposure on domestic and foreign operationsface exposure on domestic and foreign operations Jan-May 1993:13% appreciation of Japanese yen Jan-May 1993:13% appreciation of Japanese yen

against $USagainst $US many US firms increase US market sharemany US firms increase US market share Japanese firms often priced out of the US marketJapanese firms often priced out of the US market

Economic Exposure:Economic Exposure:MeasurementMeasurement

Assess sensitivity of earnings to exchange Assess sensitivity of earnings to exchange rate fluctuationsrate fluctuations

A firm is relatively insulated from exchange rate movements if costs and revenues are affected by

similar magnitudes.

Translation (Accounting) exposure Translation (Accounting) exposure

The change in the value of a firm’s foreign The change in the value of a firm’s foreign currency denominated accounts due to a currency denominated accounts due to a change in exchange rates.change in exchange rates.

Translation ExposureTranslation Exposure

Affects value of assets, liabilities and earningsAffects value of assets, liabilities and earnings Argument for relevance to MNCArgument for relevance to MNC

affects financial statements (MNC performance)affects financial statements (MNC performance)

Measures impact that exchange rate fluctuations haveupon an MNC’s consolidated financial statement

LedgerLedger

Translation ExposureTranslation ExposureDeterminantsDeterminants

Level of foreign Level of foreign involvement by foreign involvement by foreign subsidiariessubsidiaries a greater exposure exists a greater exposure exists

when:when: a larger contribution is made a larger contribution is made

offshoreoffshore


Locations of foreign subsidiariesLocations of foreign subsidiaries affects currencies used in initial affects currencies used in initial

measurementsmeasurements


Accounting methodsAccounting methods affect how and what financial numbers are affect how and what financial numbers are

reportedreported

Accounting

Accounting

SummarySummary

Exchange rate exposure may affect financing Exchange rate exposure may affect financing costscosts volatile cash flow from exchange rate changes volatile cash flow from exchange rate changes

increases riskincreases risk Transaction exposureTransaction exposure

reflects the exposure of an MNC’s future cash reflects the exposure of an MNC’s future cash transactions to exchange rate movementstransactions to exchange rate movements

SummarySummary Economic exposureEconomic exposure

measures the direct and indirect risks to cash flows measures the direct and indirect risks to cash flows from exchange rate movementsfrom exchange rate movements

Translation exposureTranslation exposure focuses on consolidated financial statementsfocuses on consolidated financial statements

Characterstics of Foreign BondCharacterstics of Foreign Bond

The bond is issued by a foreign entity (such as a The bond is issued by a foreign entity (such as a government, municipality or corporation) government, municipality or corporation) The bond is traded on a foreign financial The bond is traded on a foreign financial market market The bond is denominated in a foreign currency The bond is denominated in a foreign currency “ “

Euro BondEuro Bond

““Eurobond is a bond issued and traded in a Eurobond is a bond issued and traded in a country other than the one in which its country other than the one in which its currency is denominated. A Eurobond does not currency is denominated. A Eurobond does not necessarily have to originate or end up in necessarily have to originate or end up in Europe although most debt instruments of this Europe although most debt instruments of this type are issued by non-European entities to type are issued by non-European entities to European investors.” European investors.”

Foreign Currency Convertible Foreign Currency Convertible Bond - FCCBBond - FCCB

A type of convertible bond issued in a currency A type of convertible bond issued in a currency different than the issuer's domestic currency. In different than the issuer's domestic currency. In other words, the money being raised by the other words, the money being raised by the issuing company is in the form of issuing company is in the form of a foreign currency. A convertible bond is a mix a foreign currency. A convertible bond is a mix between a debt and equity instrument. It acts between a debt and equity instrument. It acts like a bond by making regular coupon and like a bond by making regular coupon and principal payments, but these bonds also give the principal payments, but these bonds also give the bondholder the option to convert the bond into bondholder the option to convert the bond into stock.stock.

FeaturesFeatures

Sweetening DebtSweetening Debt Deferred Equity FinancingDeferred Equity Financing Cash Inflow in FutureCash Inflow in Future May keep the share prices high.May keep the share prices high. Investor enabled to have access to shares Investor enabled to have access to shares

without investing now.without investing now. RisksRisks

Documents

International Financial Markets By- Rahul Jain. Foreign Exchange Rate Determination Determined by Demand and Supply Determined by Demand and Supply This