International Financial Management

Submitted to: Dr. anil dangwal Submitted by:

m. s. ansari mba-2nd sem. (11)

What is a company’s motivation to invest capital

abroad?

Fill product gaps in foreign markets where excess returns can be earned.

To produce products in foreign markets more efficiently than domestically.

To secure the necessary raw materials required for product production.

How does a firm make an international capital budgeting decision?

1. Estimate expected cash flows in the foreign currency.

2. Compute their U.S.-dollar equivalents at the expected exchange rate.

3. Determine the NPV of the project using the U.S. required rate of return, with the rate adjusted upward or downward for any risk premium effect associated with the foreign investment.

Types of Exchange-Rate Risk Exposure

Translation Exposure -- Relates to the change in accounting income and balance sheet statements caused by changes in exchange rates. Transactions Exposure -- Relates to settling a particular transaction at one exchange rate when the obligation was originally recorded at another. Economic Exposure -- Involves changes in expected future cash flows, and hence economic value, caused by a change in exchange rates.

Management of exchange rate risk exposure

Cash Management

What should a firm do if it knew that a local foreign currency was going to fall in value (e.g., drop from $.70 per peso to $.60 per

peso)?

Exchange cash for real assets (inventories) whose value is in their use rather than tied to a currency.Reduce or avoid the amount of trade credit that will be extended as the dollar value that the firm will receive is reduced and reduce any cash that does arrive as quickly as possible.Obtain trade credit or borrow in the local currency so that the money is repaid with fewer dollars.

Generally, one cannot predict the future exchange rates, and the best policy would be to balance monetary assets against monetary liabilities to neutralize the effect of exchange-rate fluctuations.A reinvoicing center is a company-owned financial subsidiary that purchases exported goods from company affiliates and resells (reinvoices) them to other affiliates or independent customers.

Cash Management

International Financing Hedges Commercial Bank Loans and Trade Bills

Foreign commercial banks perform essentially the same financing functions as domestic banks except:• They allow longer term loans.• Loans are generally made on an overdraft basis.• Nearly all major commercial cities have U.S. bank

branches or offices available for customers.•The use of “discounting” trade bills is widely utilized in Europe versus minimal usage in the United States.

International Financing Hedges Currency-Option and Multiple-Currency bonds

1. Currency-option bonds provide the holder with the option to choose the currency in which payment is received. For example, a bond might allow you to choose between yen and U.S. dollars.

2. Currency cocktail bonds provide a degree of exchange-rate stability by having principal and interest payments being a weighted average of a “basket” of currencies.

3. Dual-currency bonds have their purchase price and coupon payments denominated in one currency, while a different currency is used to make principal payments.

Currencies and the Euro

Each country has a representative currency like the $ (dollar) in the United States or the ₤ (pound) in Britain.On January 1, 1999, the “euro” started trading.The euro is the common currency of the European Monetary Union (EMU), which currently includes the following 12 European Union (EU) countries:

Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, and Spain.

Currency Market Hedges

A currency option is a contract that gives the holder the right to buy (call) or sell (put) a specific amount of a foreign currency at some specified price until a certain (expiration) date.Currency options hedge only adverse currency movements (“one-sided” risk). For example, a put option can hedge only downside movements in the currency exchange rate.Options exist in both the spot and futures markets.The value depends on exchange rate volatility.

Macro Factors Governing Exchange-Rate BehaviorPurchasing-Power Parity (PPP)1. The idea that a basket of goods should sell for

the same price in two countries, after exchange rates are taken into account.

2. For example, the price of wheat in Canadian and U.S. markets should trade at the same price (after adjusting for the exchange rate). If the price of wheat is lower in Canada, then purchasers will buy wheat in Canada as long as the price is cheaper (after accounting for transportation costs).

International Trade DraftThe international trade draft (bill of exchange) is a written statement by the exporter ordering the importer to pay a specific amount of money at a specified time.

Sight draft is payable on presentation to the party (drawee) to whom the draft is addressed.

Time draft is payable at a specified future date after sight to the party (drawee) to whom the draft is addressed.