Intro Chap I

8/6/2019 Intro Chap I

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International FinancialInternational Financial

ManagementManagement Module 1 - International Financial

Environment


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n erna onan erna onaFinancialFinancial

EnvironmentEnvironmentImportance, Rewards and Risk of Importance, Rewards and Risk of

International financeInternational financeGoals of MNCsGoals of MNCsInternational business methodsInternational business methods- -

Exposure to International riskExposure to International riskInternational Monetary SystemInternational Monetary SystemGovernment influence onGovernment influence on

exchange rateexchange rate


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Importance o InternationaImportance o InternationaFinanceFinance

Rapid Economic growth Flow of goods New and more remunerativemarkets Changes in the allocation of

resources within and acrosscountries.


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Developing countries like Indiafollowed an inward looking

development strategy concentratingon import substitution , eventuallyrealised that participation inInternational trade in terms of goods, capital and technology wasvital.


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G lobal linksG lobal links Integrated and interdependent

financial environment,

close links between capital andmoney markets, trade growing faster than NI in

developing countries Revolution in ICT.


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International FinanceInternational Finance - -FeaturesFeatures

Foreign exchange risk Political risk Expanded opportunity sets Market imperfections


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G oals of MNCsG oals of MNCs Maximise the shareholders wealth. For this, the managers must

understand:a) International Financial Systemb) Foreign Exchange market

c) Host countrys Environment


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International BusinessInternational BusinessMethodsMethods

Licensing Franchising Joint Ventures Establishing New Foreign

Subsidiaries

Management Contracts


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LicensingLicensing A firm in one country licenses the

use of some or all Intellectual

property to a firm of some othercountry in exchange for fees orroyalty payment.

Licensing enables a firm to usetechnology in foreign marketswithout a substantial investment inforeign countries.


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Franchising and Joint VenturesFranchising and Joint Ventures

Franchising : A firm in one countryauthorising a firm in another country

to utilise its brand names, logos inreturn for royalty payment. Joint Ventures: JVs allow two or

more firms to apply their respectivecomparative advantage in a givenproject.


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u s ar es anu s ar es anManagement ContractsManagement Contracts

A firm can penetrate foreign marketsby establishing new operations inforeign countries with hugeinvestment.

Management Contracts: A firm in onecountry agrees to operate or providefacilities to firms in another countryfor an agreed fees.


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Basic QuestionsBasic Questions Benefit to cost in the above methods

and which would be the best?

Can some common measure beapplied to measure cost-benefitdecision in the above methods?


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xposure o n erna onaxposure o n erna onaRiskRisk

Macro-Economic environmentalrisk: affect all firms in theeconomy.

Core Business Risk: are specific tofirm.

Exposure: It is the measure of sensitivity of the measure of thevariability of the value of the itemattributable to the risk factor.


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ExampleExample

Consider a firm whose business involved bothexports to and imports from US during 1993-95when the Rupee-Dollar exchange rate was rocksteady.

The firm would agree that the operating cashflows were sensitive to rupee-dollar exchangerate,i.e., it had significant exposure to thisexchange rate; at the same time, it would havesaid that it does not perceive any risk onaccount of the stability of the exchange rate, asthe probability of fluctuations is minimal.

Thus the magnitude of risk is determined by themagnitude of exposure and the degree of variability in the relevant risk factor.


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ExposureExposure

Definition : Exposure of a firm to arisk factor is the sensitivity of thereal value of a firms assets,

liabilities or operating income,expressed in its functionalcurrency, to unanticipated changesin risk factor.

Note:a) Value of the assets, liabilities, or

operating income to be expressed

in the functional currency of thefirm.


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ExposureExposure

b) Exposure is defined with respect tothe real values, i.e. adjusted toinflation.

c) Only unanticipated changes in therelevant risk factor are to be

considered. For expected changes,relevant forward rates are considered.


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Types of ExposureTypes of Exposure

Currency Exposure

Accounting Exposure Operating Exposure

Translation Transaction ContingentCompetition/

Strategic Exposure


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Strategic ExposureStrategic Exposure

It has significant implications for some strategicbusiness decisions.

Examples:a) In the late 70s Laker Airways started offering

cut-price, trans-Atlantic air travel to Britishtourists taking vacations in the U.S. The dollarwas weak and tourist traffic was strong. Lakerthen expanded its fleet by buying airdraftfinanced with dollar borrowing. In late 1981,the dollar started rising and climb for nearlyfour years. On the other hand, the transactionexposure on servicing the dollar liabilities andoperating exposure due to falling trafficcreated a severe cash crunch for Laker. Thestrong dollar meant that US vacations wereexpensive proposition for British tourists.Laker Airways went bankrupt eventually.


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ExamplesExamples

b) The relentless rise of the dollar duringthe first half of eighties eroded thecompetitive position of many Americanfirms. Kodak found most of its costswere dollar denominated while theirsales were in all parts of the worlddenominated in different currencies.

They faced stiff competition from Fuji of Japan. Kodak could not raise priceswithout significant loss of sales.


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ExamplesExamples

Closer home, many IndianManufacturers of cars and two-wheelers with significant importcontent denominated in Yen havefound that persistent strength of theYen has meant cost raise which theycould not pass on to the consumerbecause of depressed demandconditions and competitive

considerations.


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Summing Up..Summing Up..

Exposures on anticipated cash flowsdenominated in foreign currency andbalance sheet exposures of foreignoperations. translation exposure.

Operating exposure is defined as thesensitivity of future operating profits tounanticipated changes in the exchange

rates. Strategic exposure refers to still horizonand contemplates longer termoperational flexibility such as changingproduct-mix, shifting location of


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ConclusionConclusion Value based exposure is difficult to

operationalise, which focuses on theimpact of currency fluctuations onthe market value of the firm.

It must take into account both shortterm accounting exposures as well asoperating and strategic flexibility inresponding to currency movements.


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International Monetary SystemInternational Monetary System

For the efficient operation of International trade, an efficientmultilateral financial system is a

prerequisite. Objectives:a) Exchange rate regimesb) International liquidityc) IMFd) Adjustment process in balancing

imports and exports.


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Exchange rate regimesExchange rate regimes

It refers to the mechanism,procedures and institutionalframework for determining exchangerates at a point in time and changes inthem over time, including factorswhich induce changes.

Three Main Regimes:a) G old regime lasted for first four

decades of 20 th century.b) Adjustable exchange rates lasted till

1973.c) Managed floats - Countries chose the

exchange rate depending on its


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G old regimeG old regime

T he gold standard : Theauthorities stand ready to convert,at a fixed rate, the paper currencyof another currency issued bythem into paper currency of another country which is operating

a gold bullion standard. Thus, if rupees are freelyconvertible into dollars and dollarsin turn into gold, rupee can be saidt e n l -exch n e


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G old regimeG old regime

The exchange rate between any pairof currencies will be determined bytheir respective exchange ratesagainst gold. This is also called as

mint parity rate of exchange.T hree rules of the game:

a) Must fix once for all rate of conversionof paper money issued into gold

b) There must be free flow of gold

between countries on gold standard.c) The money supply in the country mustbe tied to the amount of gold themonetary authorities have in reserve.If this decreases, money supply mustcontract and vice-versa.


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Bretton Woods SystemBretton Woods System After the II World War, US and UKrevamped the world monetary system,

where World Bank, IMF and BrettonWoods System took birth.

Features of Bretton Woods System:a) US G ovt. undertook to convert the USdollar freely into gold at a fixed parityof $35 per ounce.

b) Other member countries of the IMFagreed to fix parities of theircurrencies vis--vis the dollar with avariation within 1% on either side of

the central parity being permissible.


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Exchange rate regimesExchange rate regimes IMFsIMFsclassification Systemclassification System

Exchange rateregimes

Description

Dollarisation, Euroisation No separate legal tender(EU members)

Currency board Currency fully backed by foreignexchange reserves .(countrieswhich adopted other currency astheir currency, E.g.Panama-$,Monaco- Euro,)

Conventional fixed pegs Peg to another currency or currencybasket within a band of +/- 1%.

Independent Float Market determined exchange ratewith monetary policy independent

of the exchange rate policy.


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Some thoughts ..Some thoughts .. In the years to come, there willbe only two types of exchange

rate regimes :a) Truly fixed rate arrangements

like, Currency Union

b) Truly market determined ,independently floating exchangerates.


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Impossible Trinity Impossible Trinity

It asserts that a country can achieveany two of the three policy goals, butnot all the three:

a) A stable exchange rateb) A financial system integrated with

global financial systemc) Freedom to conduct an independent

monetary policy. Of these, a) & b) can be achieved with

currency Union, b) & c) within anindependently floating exchange rateand a) & c) with capital controls.


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Impossible Trinity Impossible Trinity

M onetaryIndependenceExchange ratestability

Integration with global financialmarkets

PUREFLOAT

CURRENCYUNION


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Assignment 1Assignment 1

Write a note on G overnment influenceon exchange rate in India.

Write a note on the role of IMF in thepresent international financial system.

Write a note on SDRs and EMU(Economic and Monetary Union).

Intro Chap I

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