CU-MCOM-SEM-III-International Financial Management

Table 6.2 Balance Sheet Using Monetary/non-monetary Method The current rate method is the easiest method, wherein the value of every item in the balance sheet, except capital, is converted using the current rate of exchange. The stock of capital is evaluated at the prevailing rate when the capital was issued. The balance sheet prepared using the current rate method will be as follows: Table 6.3 Balance Sheet Using the Current Rate Method Temporal Method The temporal method is similar to the monetary/non-monetary method, except in its treatment of inventory. The value of inventory is generally converted using the historical rate, but if the balance sheet records inventory at market value, it is converted using the current rate of exchange. 101 CU IDOL SELF LEARNING MATERIAL (SLM)

In the example above, if there is an inventory of goods recorded in the balance sheet at its historical value of, say €1,000, its value in dollars after conversion will be $(1,000 x 1.2), or $1,200. However, if the inventory of goods is recorded at the current market value of, say €1,050, then its value will be $(1,050 x 1.15), or $1,207.50. In each of the methods used above, there is a mismatch between the total values of assets and liabilities after conversion. While calculating income and net profit, variations in exchange rates can distort the amounts to a great extent, which is why accountants often use hedging to do away with this risk. 6.2.1 Hedging Translation Exposure There are two major methods for controlling this remaining exposure. These methods are balance sheet hedge and derivatives hedge. Balance Sheet Hedge Translation exposure is not purely entity specific; rather, it is only currency specific. A mismatch of net assets and net liabilities creates it. A balance sheet hedge will eliminate this mismatch. Using the currency Euro as an example, the above exhibit presents the fact that there are €1,826,000 more net exposed assets than liabilities. Now, if the Spanish affiliate, or more probably, the parent firm or the Mexican affiliate, pays €1,826,000 as more liabilities, or reduced assets, in Euros, there would be no translation exposure with respect to the Euro. A perfect balance sheet hedge will occur in such a case. After this, a change in the Euro / Dollar (€/$) exchange rate would not have any effect on the consolidated balance sheet, as the change in value of the assets would completely offset the change in value of the liabilities. Derivatives Hedge According to the corrected translation exposure report shown above, depreciation from €1.1000/$1.00 to €1.1786/$1.00 in the Euro will result in an equity loss of $110,704, which was more when the transaction exposure was not considered. A derivative product, such as a forward contract, can now be used to attempt to hedge this loss. The word “attempt” is used because using a derivatives hedge, in fact, involves speculation about the forex rate changes. 6.3 MANAGEMENT OF POLITICAL EXPOSURE Political scientists, economists and entrepreneurs have a definite opinion about the existence of political risk. But none is sure what constitutes it and how to measure it? Since firm is 102 CU IDOL SELF LEARNING MATERIAL (SLM)

going to invest in a foreign country, therefore, firm perceives opportunity with a perspective of political risk in its own way. Finance consultants and analysts analyses the country risk from country's perspective which is specific to a country. Thus, political risk perception from the firm's perspective is likely to differ from the country's point of view. There are rating agencies such as Moody and other agencies in U.S. and other countries which prepare country risk indices that attempt to quantify the level of political risk in each country. These indices are based on political stability and policies of the government towards foreign investment. The measurement of these two aspects of the government is subjective. Political stability means frequency of changes in government, the level of violence in the country, number of armed insurgencies, wars, etc. The basic purpose of political stability indicator is to determine how long this government will survive and whether the government is capable to enforce its foreign investment guarantees. It is usually implied that greater the political stability, the safer is the country for investment. In some countries, the government can expropriate either legal tittle to property or the stream of income it generates then the political risk is said to exist. Political risk also exists if property owners may be constrained in the way they use their property. If the private companies are constrained to compete with the state-owned companies, again the political risk exists. Political risk also exists if the state itself requires particular percentage of equity participation in the corporation being started. There are risk assessment agencies which provide political risk indices (rating) in respect of a country for the investment purpose. These political risk indices try to assess the political stability of the country in making these indices, those factors are analysed from which the threat to the nation state emerges. 6.3.1 Political Risk and its Measurement The political risk index tries to incorporate all these economic, geographical and social aspects, so that political risk may be indicated in a concise manner. These indices measure over all business climate of a country. On the basis of the above type of analysis, BERI (Business Environment Risk Information) categorizes nations in four categories as per four level of risk perceptions:  Low Risk Countries  Medium Risk Countries  High Risk Countries  Prohibitive Risk Countries Capital Flight and Political Risk: Some of the finance consultants believe that Capital flight is one good indicator of the degree of political risk. By capital flight we mean the export of 103 CU IDOL SELF LEARNING MATERIAL (SLM)

savings by a nation's citizens because of the fears about the safety of their capital. It is very difficult to measure capital flight accurately because it is not completely observable. Apparently one can use the item errors and omissions on the balance of payment to assess the extent of capital flight. Capital flights occur for several reasons. These reasons are: Government Regulations and Controls: Sometimes governments try to control and regulate the use of savings to channelize the resources to a particular sector. In this case, government enacts the rules for using capital. The return on investment is fixed by the government. Taxes: If the government imposes heavy taxes on returns from investment the net return, becomes low. The capital flight occurs in search of better returns. Low Returns: If the economy itself is providing low returns, the capital flight would occur. High Inflation: The countries having high inflation also face capital flight, because domestic hedging against inflation becomes difficult therefore the citizens try to hedge through a foreign currency which is less likely to depreciate. Political Instability: Perhaps the most powerful motivation to capital flight comes from political instability because no one is sure about the return on investment. Econometric Modelling: Econometric modelling can also be used to assess the- sovereign [political) risk. This type of risk is being assessed by banks to assess the capacity of the Government to repay the loans without default. Basically, econometric modelling requires quantification of the variables discussed above. If the subjective variables are quantified on different scales, then econometric modelling is done as follows: Suppose yt refers to a particular level of risk measured as an index given economic, geographical and social variables then we can write: yt = a + bX1 + cX2 + dX3 + et Where Xl is the variable capturing economic factors, X2 is a variable capturing geographical factors and X3 is the variable that captures sociological factors. In this equation, 'e' is error term following normal distribution with zero mean and constant variance, 'a' is the intercept of the regression line indicating the minimum level of political risk that will exist in the absence to other factors, and 'b', 'c' and 'd' are slope parameters which provide the sensitivity of political risk index to the economic, geographical and sociological factors.' With the help of above equation, we can identify a critical level above which if the index climbs, the country may be referred as having political risk. Delphi Method: The Delphi Method involves the collection of independent opinions on country risk from various experts without group discussion. The MNC can average these 104 CU IDOL SELF LEARNING MATERIAL (SLM)

country risk scores and assess the degree of disagreement by measuring dispersion of opinions. Risk Rating Matrix: An MNC may evaluate country risk for several countries to determine location of investment. One approach to compare political and financial ratings among countries, advocated by some foreign risk managers is called foreign investment risk matrix, which shows the financial risk intervals ranging across the matrix from acceptable to unacceptable. It also shows political risk by interval ranging from stable to unstable. The matrix is based on ratings provided by rating agencies. 6.4 FACTORS AFFECTING POLITICAL RISK To analyse the extent of political risk, the factors that contribute to the general level of risk can be classified in to two categories:  Country Related Factors  Company Related Factors. The factors in these categories have been explained below: Country Related Factors Economic Factors Fiscal Discipline: One of the important indicators of fiscal discipline is the fiscal deficit as a percentage of gross national product. The higher is this ratio, the more the government is promising to its population relative to the resources it is obtaining from them. The fiscal gap can force governments to resort to the expropriation or create a politically risky situation. Controlled Exchange Rate System: The controlled exchange rate system compounds the balance of payment problem and thereby makes fiscal discipline difficult. The' control' should not be confused with 'regulations'. By controlled system we mean the government using currency controls to fix exchange rate, i.e. the pegging of the currency. In controlled exchange rate systems, usually the domestic currency is overvalued, which implied subsidizing the imports. The risk of tighter exchange control leads to capital flight because there is a greater risk of devaluation. The controlled exchange rate system provides the economy little flexibility to respond to the changing relative prices. Wasteful Government Expenditure: Wasteful public spending is potential indicator of financial problems. This spending refers to the unproductive spending in the economy. In this case, even the borrowings from abroad are used to subsidize consumption in the economy. In this case, the government has less savings to draw on to pay foreign debt and therefore resorts to exchange controls and higher taxes. This would inject inflation and capital flight into the economy. 105 CU IDOL SELF LEARNING MATERIAL (SLM)

Resource Base: Countries rich in natural resources have less economic instability. The nations are different in their natural, technological and financial resources; therefore, political risk assessment also requires analysis of the resource base. This is because shortage or abundance of resources can cause economic, political or social instability. For example, excess of population relative to other resources would cause unemployment leading to social and political tensions. Country’s Capacity to Adjust to External Shocks: If a country has vast resource base, the country will process greater capacity to respond to external shocks. The national spirit of population is also important factor to adjust to external shocks. Cuba and Iraq are two countries where the national identity was responsible for bearing external shocks. Another important characteristic of a nation that makes it resilient against external shocks, is the sustained growth model being adopted for growth in the economy. If the development is internalized, i.e., it does not depend on foreign aid or foreign flow of funds, then the economy becomes insulated to external shocks. Geographical Factors As we have already discussed that-the nations are living in a particular geographical configuration and that if the environment around the nation is hostile, greater level of political risk exists. More number of border disputes imply greater degree of political risk. Similarly, if a nation is more prone to calamities, (historical data), greater is the political risk. Sociological Factors Sociological factors are related to religious diversity, lingual diversity, ethnic diversity and political dogmatism. Greater is religious diversity, the greater will be chances of social discontent because every religious group tries to assert its supremacy over others. Similarly, the diversity in language and ethnic groups create social tensions. India is an example of religious, language and ethnic diversity. Most of the social tensions in the country are due to these diversities. Afghan problem is also due to ethnic and tribal diversity. Political dogmatism among various political groups also creates political instability in the country resulting in higher political risk. Company Related Factors Nature of Industry: The nature of the industry also determines the political risk. We observe in the world that some industries are subject to more government regulations as compared to others. This is because these industries are seen as being important to development and therefore the government wishes to control it. The pricing of the product of these industries affect population in general, therefore it is necessary to control these for political hold on 106 CU IDOL SELF LEARNING MATERIAL (SLM)

population. Some industries are crucial and strategic to some countries; therefore, these industries attract more regulation. Level of Operation: The companies with complex, globally integrated operations appear to be relatively safe from government intervention. These operations are difficult to take over and regulate. Suppose the parent company control the source of supply of a technology or raw material. It is not possible for the government to regulate this operation. Level of Technology and Research and Development: High and sophisticated technology companies and those companies having high degree of research and development content International Financial Management are difficult to be regulated. This is because these qualities are quite individual and have been developed over a long period of time after sub stand efforts. Level of Competition: The companies having little competition are also not regulated because the host government is unable to replace them. Form of Ownership: The company's ownership is also an important component of its vulnerability to risk. Local ownership is usually viewed favorably by governments, thus wholly owned subsidiaries are at greater risk while joint ventures with the locals are less risky. Nationality of Management: If the management is entirely foreign, the company is more vulnerable to political risk than a company having mixed nationals in the management or locals in the management. The fact that the degree of risk in any situation is a function of both the country and company specific risks, the company while assessing the risk needs to consider both types of risks. Political Risk Management Political risk process can be thought of as comprising both assessment and management of risk. The process evaluates a company to estimate the degree of risk that exists in any situation and then decide how to deal with the risk. If the risk element is high at a particular location, then a commensurate return (risk adjusted) is expected. If higher returns are not available to offset high risks, the company is likely to forego the opportunity of investment. Only in the situation when risk is compensated with commensurate return, the project is undertaken. Process of management of political risk can be thought of consisting of following six steps: Step 1. Identify the risk: The purpose of identifying the risk is to identify the policies and activities of the government which are most likely to affect company's operations. 107 CU IDOL SELF LEARNING MATERIAL (SLM)

Step 2. Evaluate risk: This step evaluates the likelihood of government policies and activities and the extent to which these are going to affect the company's operations. There are consultants and political risk assessment services which provide information on different countries the estimates of political risk. Step 3. Select Management Techniques: Management techniques are to be selected to counter the effect of government's policies and activities. In this step, the decision is made on as to how to deal with the risk that have been identified. The selection of the technique requires a complete understanding of functional area of management. One should bear in mind that if the selection is not proper it is usually non-reversible after implementation. There are different approaches to meet the challenge. The company should choose that approach which seeks to protect the best interest of the company. There are many countries which provide insurance against political risk to their own companies. Overseas Private Insurance Corporation (OPIC) is a US government agency which provides insurance against expropriation, war or currency's non-convertibility. Step 4. Implement decided technique: The purpose of this step is to start encountering the political risk through management policies so that damage is limited. Step 5. Evaluation of the degree of success: The purpose of this step is to evaluate the effectiveness of company's political risk management. This step provides opportunity to reassess the likelihood of various kinds of risk and appraise the effectiveness of the risk management technique. Political risk management should be an ongoing process because political situation embodies change and therefore the companies have to be vigilant against the political changes that affect operations of the companies. Step 6. Re-evaluation and correction after evaluation of the degree of success, corrective measures are to be thought and implemented. Again, the risk assessment is required to be done. The process of protecting against political risk is a continuous (Figure 6.1). The figure shows the six steps to manage and evaluate and re-adjustment of policies to meet the challenge of political risk: 108 CU IDOL SELF LEARNING MATERIAL (SLM)

Figure 6.1: Six steps to political risk management Approaches to Political Risk Management There are two approaches to political risk management: defensive approach and integrative approach. Defensive Approach In this approach, the company tries to protect its interests by locating crucial aspects of the company beyond the reach of the host governments. This is intended to minimize the firm's dependence on host or make the host government's intervention costlier. The protection is also embedded in policies of all functional areas of management. Some important strategies in these functional areas are discussed below: Financial Strategies: To protect against the hostility of the host government following steps should be taken:  Maximise debt investments  Raise capital from variety of sources including host government, local banks and third parties  Enter into joint venture with host government or with the local third party  Obtain host country's guarantees for investment  Minimise local retained earnings  If possible, transfer pricing should be resorted 109 CU IDOL SELF LEARNING MATERIAL (SLM)

Management Policies: To insulate the information about the company functioning following steps should be considered:  Minimise the role of host nationals at strategic points and limit locals to low and junior levels  Train and educate the host country nationals at the head quarter to inculcate loyalty  If host country's nationals are at key positions, try to replace them with third country nationals first so that the hostility of the company is not evidenced Logistics: If the political risk is assessed, then  Locate the crucial segment of the company's process outside the country but near the country  Concentrate on research and development in the home country making the subsidiary dependent on the parent  Balance the production of goods among several locations, thus reducing dependence on single location Marketing Management: In the case of marketing policies following steps are suggested:  Control markets wherever and whenever possible  Maintain control over distribution network including transportation of goods  Maintain a strong single global trademark Government Relations: In this approach the company must know its own strengths and weaknesses and try to negotiate with the government to defend its interests. The competitive strength of the company should not be compromised. Integrative Approach This approach aims at integrating the company with host economy to make it appear local. In this background the strategies in the functional areas of management would aim at integrating the Company with the host economy. The important strategies to be adopted are: Financial Strategies: Following strategies are required to be adopted for financing the projects in the host country:  Raise equity from the host country and involve local creditors  Establish joint ventures with locals and government  Ensure that internal pricing among subsidiaries and between headquarters and subsidiaries is fair. 110 CU IDOL SELF LEARNING MATERIAL (SLM)

Management: Following strategy may be adopted for integrating the company with the host country:  Employ high percentage of locals in the organisation  Ensure that the expatriate understood the host environment  Establish commitment among local employees Operations Management: In operations management, following steps are required to be taken:  Maximise localisation in terms of sourcing, employment and research and development  Use local sub-contractors, distributors, professionals and transport system Marketing Management: In the case of marketing policies following steps are suggested:  Share markets with domestic players as collaborators or market products through local marketing companies  Appoint local distributors and use local network including transportation of goods  Maintain a strong single global trademark Government Relations: The company, for developing good and cordial relationship may adopt following strategy:  Deve1op and maintain channels of communication with member of political elite  Be willing to negotiate agreements that seem fair to host governments keeping in view the company's interest  Provide expert opinion when ever asked for  Provide public services 6.5 MANAGEMENT OF INTEREST RATE EXPOSURE Interest rate risk is the probability of a decline in the value of an asset resulting from unexpected fluctuations in interest rates. Interest rate risk is mostly associated with fixed- income assets (e.g., bonds) rather than with equity investments. The interest rate is one of the primary drivers of a bond’s price. 111 CU IDOL SELF LEARNING MATERIAL (SLM)

The current interest rate and the price of a bond demonstrates an inverse relationship. In other words, when the interest rate increases, the price of a bond decreases. Understanding Opportunity Risk The inverse relationship between the interest rate and bond prices can be explained by opportunity risk. By purchasing bonds, an investor assumes that if the interest rate increases, he or she will give up the opportunity of purchasing the bonds with more attractive returns. Whenever the interest rate increases, the demand for existing bonds with lower returns declines as new investment opportunities arise (e.g., new bonds with higher return rates are issued). Although the prices of all bonds are affected by interest rate fluctuations, the magnitude of the change varies among bonds. Different bonds show different price sensitivities to interest rate fluctuations. Thus, it is imperative to evaluate a bond’s duration while assessing the interest rate risk. Generally, bonds with a shorter time to maturity carry a smaller interest rate risk compared to bonds with longer maturities. Long-term bonds imply a higher probability of interest rate changes. Therefore, they carry a higher interest rate risk. Similar to other types of risks, the interest rate risk can be mitigated. The most common tools for interest rate mitigation include: Diversification If a bondholder is afraid of interest rate risk that can negatively affect the value of his portfolio, he can diversify his existing portfolio by adding securities whose value is less prone to the interest rate fluctuations (e.g., equity). If the investor has a “bonds only” portfolio, he can diversify the portfolio by including a mix of short-term and long-term bonds. Hedging The interest rate risk can also be mitigated through various hedging strategies. These strategies generally include the purchase of different types of derivatives. The most common examples include interest rate swaps, options, futures, and forward rate agreements (FRAs). 6.5.1 Interest Rate Risk and Sources of Interest Rate Risk Repricing Risk: As financial intermediaries, banks encounter interest rate risk in several ways. The primary and most often discussed form of interest rate risk arises from timing differences in the maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off-balance-sheet (OBS) positions. While such repricing mismatches are fundamental to the business of banking, they can expose a bank's income and underlying 112 CU IDOL SELF LEARNING MATERIAL (SLM)

economic value to unanticipated fluctuations as interest rates vary. For instance, a bank that funded a long-term fixed rate loan with a short-term deposit could face a decline in both the future income arising from the position and its underlying value if interest rates increase. These declines arise because the cash flows on the loan are fixed over its lifetime, while the interest paid on the funding is variable, and increases after the short-term deposit matures. Yield Curve Risk: Repricing mismatches can also expose a bank to changes in the slope and shape of the yield curve. Yield curve risk arises when unanticipated shifts of the yield curve have adverse effects on a bank's income or underlying economic value. For instance, the underlying economic value of a long position in 10-year government bonds hedged by a short position in 5-year government notes could decline sharply if the yield curve steepens, even if the position is hedged against parallel movements in the yield curve. Basis Risk: Another important source of interest rate risk (commonly referred to as basis risk) arises from imperfect correlation in the adjustment of the rates earned and paid on different instruments with otherwise similar repricing characteristics. When interest rates change, these differences can give rise to unexpected changes in the cash flows and earnings spread between assets, liabilities and OBS instruments of similar maturities or repricing frequencies. For example, a strategy of funding a one-year loan that reprices monthly based on the one-month U.S. Treasury Bill rate, with a one-year deposit that reprices monthly based on one-month Libor, exposes the institution to the risk that the spread between the two index rates may change unexpectedly. Optionality: An additional and increasingly important source of interest rate risk arises from the options embedded in many bank assets, liabilities and OBS portfolios. Formally, an option provides the holder the right, but not the obligation, to buy, sell, or in some manner alter the cash flow of an instrument or financial contract. Options may be standalone instruments such as exchange-traded options and over the counter (OTC) contracts, or they may be embedded within otherwise standard instruments. While banks use exchange-traded and OTC-options in both trading and non-trading accounts, instruments with embedded options are generally most important in non-trading activities. They include various types of bonds and notes with call or put provisions, loans which give borrowers the right to prepay balances, and various types of non-maturity deposit instruments which give depositors the right to withdraw funds at any time, often without any penalties. If not adequately managed, the asymmetrical payoff characteristics of instruments with optionality features can pose significant risk particularly to those who sell them, since the options held, both explicit and embedded, are generally exercised to the advantage of the holder and the disadvantage of the seller. Moreover, an increasing array of options can involve significant leverage which can magnify the influences (both negative and positive) of option positions on the financial condition of the firm. Effects of Interest Rate Risk 113 CU IDOL SELF LEARNING MATERIAL (SLM)

 As the discussion above suggests, changes in interest rates can have adverse effects both on a bank's earnings and its economic value. This has given rise to two separates, but complementary, perspectives for assessing a bank's interest rate risk exposure.  Earnings Perspective: In the earnings perspective, the focus of analysis is the impact of changes in interest rates on accrual or reported earnings. This is the traditional approach to interest rate risk assessment taken by many banks. Variation in earnings is an important focal point for interest rate risk analysis because reduced earnings or outright losses can threaten the financial stability of an institution by undermining its capital adequacy and by reducing market confidence.  In this regard, the component of earnings that has traditionally received the most attention is net interest income (i.e., the difference between total interest income and total interest expense). This focus reflects both the importance of net interest income in banks' overall earnings and its direct and easily understood link to changes in interest rates. However, as banks have expanded increasingly into activities that generate fee-based and other non- interest income, a broader focus on overall net income - incorporating both interest and non-interest income and expenses - has become more common. The non-interest income arising from many activities, such as loan servicing and various asset securitisation programs, can be highly sensitive to market interest rates. For example, some banks provide the servicing and loan administration function for mortgage loan pools in return for a fee based on the volume of assets it administers. When interest rates fall, the servicing bank may experience a decline in its fee income as the underlying mortgages prepay. In addition, even traditional sources of non-interest income such as transaction processing fees are becoming more interest rate sensitive. This increased sensitivity has led both bank management and supervisors to take a broader view of the potential effects of changes in market interest rates on bank earnings and to factor these broader effects into their estimated earnings under different interest rate environments.  Economic Value Perspective: Variation in market interest rates can also affect the economic value of a bank's assets, liabilities and OBS positions. Thus, the sensitivity of a bank's economic value to fluctuations in interest rates is a particularly important consideration of shareholders, management and supervisors alike. The economic value of an instrument represents an assessment of the present value of its expected net cash flows, discounted to reflect market rates. By extension, the economic value of a bank can be viewed as the present value of bank's expected net cash flows, defined as the expected cash flows on assets minus the expected cash flows on liabilities plus the expected net cash flows on OBS positions. In this sense, the economic value perspective reflects one view of the sensitivity of the net worth of the bank to fluctuations in interest rates.  Since the economic value perspective considers the potential impact of interest rate changes on the present value of all future cash flows, it provides a more comprehensive view of the potential long-term effects of changes in interest rates than is offered by the earnings perspective. This comprehensive view is important since changes in near-term 114 CU IDOL SELF LEARNING MATERIAL (SLM)

earnings - the typical focus of the earnings perspective - may not provide an accurate indication of the impact of interest rate movements on the bank's overall positions.  Embedded losses: The earnings and economic value perspectives discussed thus far focus on how future changes in interest rates may affect a bank's financial performance. When evaluating the level of interest rate risk, it is willing and able to assume, a bank should also consider the impact that past interest rates may have on future performance. In particular, instruments that are not marked to market may already contain embedded gains or losses due to past rate movements. These gains or losses may be reflected over time in the bank's earnings. For example, a long-term fixed rate loan entered into when interest rates were low and refunded more recently with liabilities bearing a higher rate of interest will, over its remaining life, represent a drain on the bank's resources. 6.6 SUMMARY  Translation exposure is inevitable for companies operating in other countries than their home country. It is usually a legal requirement for regulators; it does not change cash flow but only changes the reporting of consolidated financials. The translation is done on time of reporting, not at the time of realization, only resulting in notional profit and losses.  Translation exposure poses a threat at the time of presenting unpredicted figures in financial statements in front of shareholders, which might result in questions for the management of the company. Many times, such kind of scenarios occur due to fluctuation in the foreign exchange rate and considered normal.  A company trying to mitigate translation exposure have various measurements in hands through hedging and minimalizing effect on numbers. To maintain the confidence of investors and to avoid any legal hassles, a firm needs to report, manage as well as present such exposure.  The investment decisions of an MNC are influenced by various risks arising due to different politics and country specific factors. Country related risk factors are economic factors like fiscal administration, exchange rate regimes, government expenditure and ability of the country to absorb the shock and geographical factors are related border issues and natural calamities.  On the other hand, social factors and company related factors are responsible for political risk. The MNCs should identify, assess and try to instigate the impact of risks related to country and political specific conditions.  Interest rate risk is the exposure of a bank's financial condition to adverse movements in interest rates. Accepting this risk is a normal part of banking and can be an important source of profitability and shareholder value.  However, excessive interest rate risk can pose a significant threat to a bank's earnings and capital base. Changes in interest rates affect a bank's earnings by changing its net 115 CU IDOL SELF LEARNING MATERIAL (SLM)

interest income and the level of other interest-sensitive income and operating expenses.  Changes in interest rates also affect the underlying value of the bank's assets, liabilities and off-balance sheet instruments because the present value of future cash flows (and in some cases, the cash flows themselves) change when interest rates change. Accordingly, an effective risk management process that maintains interest rate risk within prudent levels is essential to the safety and soundness of banks. 6.7 KEYWORDS Balance of Payment Account: A statistical record of the flow of payments into and out of a country during an interval of time. Provides a record of the sources of supply of and demand for a country’s currency. Balance of Payment on Capital Account: The difference between the value of a country’s assets sold to non-residents and the value of asset bought from non-residents during an interval of time. Balance of Trade: A commonly used abbreviation for the balance on trade, and equal to merchandise exports minus merchandise imports. Political Risk: Uncertainty surrounding payment from abroad or assets held abroad because of political events. A special case of country risk, which includes economic and socially based uncertainty as well as political uncertainty. Portfolio Investment: Investment in bonds and in equities where the investor’s holding is too small to provide effective control. 6.8 LEARNING ACTIVITY 1. Discuss the impact of present Government on Interest rate ……………………………………………………………………………………………… ……………………………………………………………………………………………… 2. Discuss the impact of present International market growth on Interest rate ………………………………………………………………………………………………… ………………………………………………………………………………………………… 6.9 UNIT END QUESTIONS A. Descriptive Questions 116 CU IDOL SELF LEARNING MATERIAL (SLM)

Short Questions 1. Discuss various factors which determine the extent of political risk? 2. What is the process of political risk management and how do you assess the economic health of a nation? 3. How economic policies of a nation are affected by political risk? 4. Explain Balance Sheet Hedge in Translation Exposure? 5. Explain Derivatives Hedge in Translation Exposure? Long Questions 1. Discuss methods of measuring translation exposure? 2. Explain Political risk and its measurement? 3. Explain Country Related Factors in Political risk? 4. Explain Interest rate risk and sources of interest rate risk? 5. Discuss Opportunity Risk. B. Multiple Choice Questions 117 1. Any item that remains on the balance sheet for more than a year is a a. Current Item b. Non-current item c. Asset d. None of these 2. All monetary accounts are converted at the current rate of exchange a. Historical rate of exchange b. Nominal rate of exchange c. current rate of exchange d. None of these 3. A balance sheet hedge will eliminate a. Economic exposure b. Political exposure c. Transaction exposure d. Translation exposure 4. BERI stands for a. Back Environment Risk Information b. Business Europe Risk Information CU IDOL SELF LEARNING MATERIAL (SLM)

c. Business Entry Risk Information d. Business Environment Risk Information 5. If the management is entirely foreign, the company is more vulnerable to a. Currency risk b. Economic risk c. Fund risk d. Political risk Answers 1-(b), 2-(c), 3-(d), 4-(d), 5-(d) 6.10 REFERENCES Textbooks:  Chowdhry, Bhagwan, and Jonathan B. Howe (1999), “Corporate Risk Management for Multinational Corporations: Financial and Operational Hedging Policies”, European Finance Review, Vol. 2, 229-246.  Froot, Kenneth, David Scharfstein, and Jeremy Stein (1993), “Risk Management: Coordinating Corporate Investment and Financing Policies”, The Journal of Finance, Vol. 48 No. 5, 1629- 1658.  He, Jia and Lilian K. Ng (1998), “The Foreign Exchange Exposure of Japanese Multinational Corporations”, The Journal of Finance 53 (2), 733-753.  Jorion, Philippe (1990), “The Exchange Rate Exposure of U.S. Multinationals”, Journal of Business 63 (3), 331-45.  Laurent L. Jacque (1981), “Management of Foreign Exchange Risk: A Review Article”, Journal of International Business Studies, Spring/Summer. 118 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-7: FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT III STRUCTURE 7.0 Learning Objectives 7.1 Introduction 7.2 Hedging Against Foreign Exchange Exposure 7.2.1 Hedging Tools and Techniques for Foreign Exchange Exposure 7.2.2 External Techniques 7.2.3 Internal Techniques 7.3 Hedging Through Mixed Currency Invoicing 7.4 Country Risk Analysis 7.4.1 Country Risk: A Case of India 7.5 Summary 7.6 Keywords 7.7 Learning Activity 7.8 Unit End Questions 7.9 References 7.0 LEARNING OBJECTIVES After studying this unit, student will be able to:  Explain hedging against foreign exchange exposure.  Explain hedging tools and techniques for foreign exchange exposure.  Explain country risk analysis. 7.1 INTRODUCTION With the fall of fixed exchange regime in 1973, exchange rates between currencies were determined by market forces of demand and supply leading to the advent of fluctuating 119 CU IDOL SELF LEARNING MATERIAL (SLM)

exchange rate regime. This brought with its randomness and unpredictability in exchange rates. Exchange rates have become more volatile than they were expected. This random fluctuation in exchange rate has made cash flows and asset value of companies dealing in different currencies unpredictable, that is to say, cash flows and asset value of MNCs in their respective domestic currency are at stake of exchange rate between its domestic currency and foreign currency. Thus, Foreign Exchange Exposure is risk associated with unanticipated changes in exchange rate. With globalization and liberalization of Indian economy in nineties, scope of business for Indian companies with the rest of world has broadened and foreign corporations too have become much interested in India. In India, exchange rates were deregulated and were allowed to be determined by markets in 1993. This volatility in exchange rates can have detrimental effect on the firm’s financial position and negative effect on its competitive position in the market and value of firm, if ignored it can paralyze the company. Foreign Exchange Risk Management Identification and Quantification of Exposure: Business cycle of the company is analysed to identify where foreign exchange risk exists. Future cash flow which are confirmed to arise out of contracts already entered and future foreign currency cash flows which are not confirm over the time period are forecasted and measured to get the foreign exchange exposure. After measuring the level of exposure of the company, decision is to be made regarding what magnitude of risk is to be hedged and how much risk is to be covered. Policy Formulation: Effective requires well-framed policies, clear objectives and parameters within which the strategy is to be controlled. These policies should clearly mention the principles which is to be followed and extent of hedging (risk coverage) which are needed. Objectives should set standard for bank’s exposure to foreign exchange risk; and personnel are appointed who have the authority to trade in foreign exchange on behalf of company; and should mention the different currencies, which have been approved for transaction within the company. There should be some stop loss arrangements to prevent the firm from abnormal losses if the forecasts turn out wrong. There should be monitoring systems to detect critical levels in the foreign exchange rates where appropriate measure is required. Hedging: After formulating policies, the firms then decide about an appropriate hedging strategy keeping in mind the principles and objectives and extent of exposure coverage. There are various financial instruments available for the firm to mitigate its risk- futures, forwards, options and swaps and issue of foreign debt. Hedging strategies and instruments are explained later. Reporting and Review: Risk management policies are periodically reviewed based on periodic reports prepared. These periodic reports measure the effectiveness of hedging strategy adopted by the company to mitigate its foreign exchange exposure. The review of 120 CU IDOL SELF LEARNING MATERIAL (SLM)

risk management policies is done to judge the validity of benchmarks set; whether they are effective in controlling the exposures; what the market trends are and whether the overall strategy is enough, or change is required in it. 7.2 HEDGING AGAINST FOREIGN EXCHANGE EXPOSURE 7.2.1 External Techniques Forward Contracts Forward contracts involve an agreement between two parties to buy/sell a specific quantity of an underlying asset at a fixed price on a specified date in the future. In other words, Forward contracts are those where counterparty agrees to exchange a specified quantity of an asset at a future date for a price agreed today. These are the most commonly used foreign exchange risk management tools. The corporations can enter into forward contracts for the foreign currencies which it need for payment or which it will receive in future. Since the rate of exchange is already fixed for the future transaction, there will be no variability in the cash flows. Hence, changes that take place between the contract date and the actual transaction date does not make any impact. This will eliminate the foreign exchange exposure. The future settlement date can be an exact date or any time between two agreed dates. Currency Futures Currency futures contract involves a standardized contract between two parties to buy/sell an amount of currency at a fixed price on a specified date in the future and are traded on organized exchanges. Futures contracts are more liquid than forward contracts as they are traded in an organized exchange. A depreciation of currency can be hedged by selling futures and currency appreciations can be hedged by buying futures. Thus, inflow and outflow of different currencies with respect to each other can be fixed by selling and buying currency futures, eliminating the Foreign Exchange Exposure. Currency Options Currency options are contracts which provides the holder the right to buy or sell a specified amount of currency for a specified price over a given time period. Currency options give the owner of the agreement the right to buy or sell but not an obligation. The owner of the agreement has a choice whether to use or not to use the option based on the exchange rates. He/she can choose to sell or buy the currency or let the option lapse. The writer of the option gets a price for granting this option. The price payable is known as premium. The fixed price at which the owner can sell or buy the currency is called as strike price or the exercise price. Options giving the holder a right to buy are called call options and Options giving the holder a right to sell is called put options. It is possible to take advantage of the potential gains 121 CU IDOL SELF LEARNING MATERIAL (SLM)

through currency options. For example, If an Indian business firm has to purchase capital goods from the USA in US$ after three months, the company should buy a currency call option. There are two possibilities. First, if the dollar depreciates, then the exchange rates will be favourable as spot rate will be less than the strike price and the company can buy the US$ at the prevailing spot rate, as it will cost less. Second, if the dollar appreciates, then the exchange rates will be unfavourable as spot rate will be more than the strike price and the company can opt to use its right and buy the US$ at the strike price. Hence, in both the cases the company will be paying the less to buy the dollar to pay for the goods. Currency Swaps A currency swap involves an agreement between two parties to exchange a series of cash flows in one currency for a series of cash flows in another currency, at agreed intervals over an agreed period. This is done to convert a liability in one currency to some other currency. Its purpose is to raise funds denominated in other currency. One party holding one currency swaps it for another currency held by other party. Each party would pay the interest for the exchanged currency at regular interval of time during the term of the loan. At maturity or at the termination of the loan period each party would exchange the principal amount in two currencies. Foreign Debt Foreign debts are an effective way to hedge the foreign exchange exposure. This is supported by the International Fischer Effect relationship. For example, a company is expected to receive a fixed number of Euros at a future date. There is a possibility that the company can experience loss if the domestic currency appreciates against the Euros. To hedge this, company can take a loan in Euros for the same time period and convert the foreign currency into domestic currency at the spot exchange rate. And when the company receives Euros, it can pay off its loan in Euros. Hence the company can completely eliminate its foreign exchange exposure. Cross Hedging Cross Hedging means taking opposing position in two positively correlated currencies. It can be used when hedging of a particular foreign currency is not possible. Even though hedging is done in a different currency, the effects would remain the same and hence cross hedging is an important technique that can be used by companies. Currency Diversification Currency Diversification means investing in securities denominated in different currencies. Diversification reduces the risk even if currencies are non-correlated. It will give the company global exposure, minimize foreign exchange exposure and capitalize on exchange rate disparities. 122 CU IDOL SELF LEARNING MATERIAL (SLM)

7.2.3 Internal Techniques Netting Netting implies offsetting exposures in one currency with exposure in the same or another currency, where exchange rates are expected to move high 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. It is of two types of bilateral netting & multilateral netting. In bilateral netting, each pair of subsidiaries nets out their own positions with each other. Flows are reduced by the lower of each company’s purchases from or sales to its netting partner. Matching Matching refers to the process in which a company matches its currency inflows with its currency outflows with respect to amount and timing. When a company has receipts and payments in same foreign currency due at same time, it can simply match them against each other. Hedging is required for unmatched portion of foreign currency cash flows. This kind of operation is referred to as natural matching. Parallel matching is another possibility. When gains in one foreign currency are expected to be offset by losses in another, if the movements in two currencies are parallel is called parallel matching. Leading and Lagging These involve adjusting the timing of the payment or receivables. Leading is accelerating payment of strengthening currencies and speeding up the receipt of weakening currencies. Lagging is delaying payment of weakening currencies and postponing receipt of strengthening currencies. In these the payable or receivable of the foreign currency is postponed in order to benefit from the movements in exchange rates. Pricing Policy There can be two types of pricing tactics: price variation and currency of invoicing policy. Price variation can be done as increasing selling prices to offset the adverse effects of exchange rate fluctuations. However, it may affect the sales volume. So proper analysis should be done regarding customer loyalty, market position, competitive position before increasing price. Secondly, foreign customers can be insisted to pay in home currency and paying all imports in home currency Government Exchange Risk Guarantee Government agencies in many countries provide insurance against export credit risk and introduce special export financing schemes for exporters in order to promote exports. In recent years a few of these agencies have begun to provide exchange risk insurance to their exporters and the usual export credit guarantees. The exporter pays a small premium on his 123 CU IDOL SELF LEARNING MATERIAL (SLM)

export sales and for this premium the government agency absorbs all exchange losses and gains beyond a certain level. 7.3 HEDGING THROUGH MIXED CURRENCY INVOICING While it is usually a simple matter to arrange hedging via forwards, futures, options, or swaps, we should not overlook an obvious way for importers or exporters to avoid exposure, namely, by invoicing trade in their own currency. For example, if Aviva can negotiate the price of its imported denim cloth in terms of US dollars, it need not face any foreign exchange risk or exposure on its imports. Indeed, in general, when business convention or the power that a firm holds in negotiating its purchases and sales results in agreement on prices in terms of the home currency, the firm that trades abroad will face no more receivables and payables exposure than the firm with strictly domestic interests. However, even when trade can be denominated in the importer’s or exporter’s local currency, only part of the risk and exposure is resolved. For example, an American exporter who charges for his or her products in US dollars will still find the level of sales dependent on the exchange rate, and hence faces operating exposure and risk. This is because the quantity of exports depends on the price the foreign buyer must pay, and this is determined by the rate of exchange between the dollar and the buyer’s currency. Therefore, even when all trade is in local currency, some foreign exchange exposure – operating exposure – will remain. Of course, only one side of an international deal can be hedged by stating the price in the importer’s or exporter’s currency. If the importer has his or her way, the exporter will face the exchange risk and exposure, and vice versa. When there is international bidding for a contract, it may be wise for the company calling for bids to allow the bidders to state prices in their own currencies. For example, if Aviva invites bids to supply it with denim cloth, Aviva may be better off allowing the bids to come in stated in pounds, euros, and so on, rather than insisting on dollar bids. The reason is that the bidders cannot easily hedge because they do not know if their bids will succeed (they can use options, but options contracts from options exchanges are contingent on future spot exchange rates rather than the success of bids for orders, and so are not ideally suited for the purpose). When all the foreign-currency-priced bids are in, Aviva can convert them into dollars at the going forward exchange rates, choose the cheapest bid, and then buy the appropriate foreign currency at the time it announces the successful bidder. This is a case of asymmetric information, where the buyer can hedge and the seller cannot, and where the seller may therefore add a risk premium to the bid. When the seller is inviting bids, as when equipment or a company is up for sale, the seller knows more than the buyer, and so bidding should be in the buyer’s currency. The seller can convert the foreign-currency bids into their own currency, choose the highest bid, and then sell the foreign currency forward at the same time as they inform the successful bidder. When hedging is difficult because tendering 124 CU IDOL SELF LEARNING MATERIAL (SLM)

companies insist on being quoted in their own currency, the shorter is the cycle between quoting prices and contracts being signed, the smaller is the bidder’s risk. The tendering company might bear this in mind, knowing that a short cycle between receiving quotes and announcing winners could translate into lower prices: the bidding company may translate lower risk into lower quotes. So far we have considered situations in which all of the exposure is faced by the importer or the exporter. However, another way of hedging, at least partially, is to mix the currencies of trade. Hedging via Mixed-currency Invoicing If the British mill were to invoice its denim at £1 million, Aviva would face the exchange exposure. If instead Aviva agreed to pay the equivalent in dollars, for example, $1.5 million, then it would be the British mill that accepted the exposure. In between these two extreme positions is the possibility of setting the price at, for example, £500,000 plus $750,000. That is, payment could be stated partly in each of the two currencies. If this were done and the exchange rate between dollars and pounds varied, Aviva’s exposure would involve only half of the funds payable – those that are payable in pounds. Similarly, the British mill would face exposure on only the dollar component of its receivables. The mixing of currencies in denominating sales contracts can go further than a simple sharing between the units of currency of the importer and exporter. It is possible, for example, to express a commercial agreement in terms of a composite currency unit – a unit that is formed from many different currencies. A prominent composite unit is the Special Drawing Right, or SDR. This unit is constructed by taking a weighted average of five of the major world currencies. Another officially maintained currency unit is the European Currency Unit (ECU), which consists of an average of the exchange rates of all the European Union countries, not just those in the Euro-zone: the ECU includes, for example, the British pound and Swedish crown. Besides the official SDR and ECU units, there are private currency baskets, or cocktails, which are also designed to have a relatively steady value. They are formed by various weighted averages of a number of different currencies. The composite currency units will reduce risk and exposure because they offer some diversification benefits. However, they cannot eliminate risk and exposure as can a forward contract, and they themselves can be difficult to hedge forward. It is perhaps because of this that cocktails and baskets are not as common in denominating trade, where forward, futures, options, and swaps are frequently available, as they are in denominating long-term debt, where these other hedging techniques are not as readily available. A large fraction of the world’s trade is, by convention and for convenience, conducted in US dollars. This is an advantage for American importers and exporters in that it helps them avoid exchange rate exposure on receivables and payables. However, when the US dollar is used in an agreement 125 CU IDOL SELF LEARNING MATERIAL (SLM)

between two non-American parties, both parties experience exposure. This situation occurs often. For example, a Japanese firm may purchase Canadian raw materials at a price denominated in US dollars. Often both parties can hedge, for example, by engaging in forward exchange contracts. The Japanese importer can buy, and the Canadian exporter can sell the US dollars forward against their own currencies. In the case of some of the smaller countries where foreign business is often expressed in dollar terms, there may not be regular forward, futures, options, or swap markets in the country’s currency. However, the denomination of trade in US dollars might still be seen as a way of reducing exposure and risk if the firms have offsetting business in the dollar or view the dollar as less volatile in value than the currency of either party involved in the trade. Hedging According to Predictive Accuracy of Cash Flows While we have spoken as if foreign-currency receivables or payables are known with certainty, this may not be the case. It may well be that a company knows with great accuracy what is to be received or paid in the next 30 days, because settlement practices may be to pay invoices within 30 days. However, the amount to be received or paid more than 30 days in the future may not be quite so well known. These amounts will depend on sales and purchases yet to be made. Some sales and purchases might be relatively certain, being the result of ongoing discussions: they may be awaiting settlement of a few technical details or even sitting on a manager’s desk waiting for a final signature. In such a case, a company may hedge all the amount to be paid or received. Other sales or purchases may be less certain. Perhaps negotiations are ongoing, with the final decision still in some doubt. In such a situation, it may be prudent to nevertheless hedge, but perhaps not 100 percent of what is paid or received if the deal is completed. Perhaps the hedge could be 50 percent or 75 percent depending on the likelihood that the payable or receivable will occur. A company could consider establishing a hedging protocol. This might be to hedge all already contracted amounts, 90 percent of highly likely amounts, 75 percent of probable amounts, 50 percent of reasonable expected amounts, and so on. It should be pointed out, however, that this just applies to receivables and payables, and really hedging should be based on the effects of exchange rates on the value of a company, if indeed hedging is deemed by management to be in the interest of shareholders. 7.4 COUNTRY RISK ANALYSIS For corporations that are searching for foreign suppliers and customers, as well as those that are evaluating investment opportunities, the analysis of country risks has attained a new importance and a new complexity. More careful differentiation among countries and business sectors is now required. For example, instead of viewing Southeast Asia as a group of tigers that have been involved in an economic miracle and subsequent downfall, it is now necessary to carefully analyze the situation that each individual country faces. 126 CU IDOL SELF LEARNING MATERIAL (SLM)

Managers should prepare themselves accordingly, with an analysis of interest rates and stock prices, the country’s balance of payments, projections of probable macroeconomic policies, and fiscal and current-account deficits. It is important to examine alternative potential scenarios and projections and assign probabilities to each scenario in order to determine the risks and rewards connected with particular business opportunities. PricewaterhouseCoopers has developed an index that indicates how one may quantify the impact of country risks in terms of equivalent tax rates and rates of return. The events of September 11 and the subsequent conflicts have added another dimension to country risk. How to preserve the personal security of employees has gained new prominence in corporate strategies. Here, significant differences exist among countries, as some appear to be experiencing a heightened antipathy towards foreigners. Specific plans for protection and exit must be based on an analysis of each country. The relative significance of various country risks differs from one corporation to another, depending on features such as the type of business activity, experience in managing a certain risk, and financial strength. Hence, each corporation has to develop its unique country risk strategies. In the context of globalization, the New Economy and the changing role of governments, the analysis and management of country risks is now of paramount importance. Since negotiation with the host government is a part of the risk management policy, therefore these should be done carefully remembering that these can be time consuming and frustrating because the two sides often see the same situation very differently. In this section, some of the viewpoints are discussed for improving the negotiation process. In all the economies, FDI is an important component of economic development process and in particular for LDCs. But in all the economies the presence of foreign subsidiaries is looked as foreign presence and foreign influence. Therefore, a serious concern of the governments is to regulate the activities of foreign subsidiaries if not fully at least partially. In general, the MNC's objective of FDI is to establish operations that fit its overall strategy and provide a reasonable return in a relatively risk-free environment. The host government's objective is a positive contribution to its development objective. The objectives of the firm and the host country may not be in conflict, the aim of the negotiation should be to establish the means by which each party can accomplish its objectives and find ways in which operations can be mutually beneficial. Although, it is true that the MNC's objectives need not be in conflict with those of the host, the different views of the same situation by the host and the MNC often make it seem that their objectives are in conflict. To reach an agreement with the host and to achieve its own objectives, the MNC needs to understand how the host views a particular situation. In any negotiation, MNC must know its strengths and the view of the host government so that the best possible agreement could be reached. 127 CU IDOL SELF LEARNING MATERIAL (SLM)

MNC's Views and its Strength for Negotiation FDI is always looked as positively adding to the development efforts. MNCs help nations in the following manner: FDI Provide Capital for Development: MNCs add capital to the overall capital mobilizing effort of the host government for growth and development. This capital is attracted from abroad. Sometimes large concessions and subsidies are announced by governments to attract this capital. MNCs Introduce Modern Technology: In developing countries. Often the technology adopted by MNC is not available locally, therefore the MNCs enrich the countries with new technology. MNCs Provide Business Skill to Industry: In most of developing countries, business know- how is not available, and the MNCs introduce this know-how through their entry in the economy. MNCs Provide Access to foreign Markets: MNCs exert influence and control over many markets, therefore it is possible for them to export from production location in a developing country to the markets that these MNCs control. MNCs make Positive Contribution to Balance of Trade: The products and services of many MNCs are import substitutes, therefore, the pressure on imports is reduced resulting in the improvement in balance of trade. MNCs add to the Efforts of Employment: MNCs local operations provide employment for the host country nationals thus adding to the government's effort for increasing employment. MNCs Provide much Needed Foreign Exchange: Many developing countries have limited amounts of foreign currency which they need to pay for imports. Through exports and investments, the MNCs provide foreign exchange to the economy. MNCs add to the Tax Revenue Collection: MNCs are subject to local corporate tax law and tariffs, and their employees, both local and foreign-pay income taxes. These payments contribute to government revenue. Development of Entrepreneurs: Developing countries in general lack in sufficiently skilled local entrepreneurs. MNCs believe that they provide an example as well as a starting place for host country nationals who are potential entrepreneurs. These are the strong arguments in favour of foreign direct investment which can be placed while negotiating and these prove that the MNC's investment is extremely positive. But the host have a different view of the investment. 128 CU IDOL SELF LEARNING MATERIAL (SLM)

Host Country's View Host's viewpoint and its negotiating strength is being discussed below. Host governments also see point in the above arguments, but they also see negative side of the investment. The negative aspects of the investment are being explained below: Increased Dependence on Foreign Sources: Although the provision of needed resources such as capital, technology, and expertise appear positive but may be seen as increasing local dependence on the outside world. In addition to this, MNCs are seen aligned with the elite group of the country and thus these tend to strengthen the status quo of the social structure rather than work for a social change. Decreased Sovereignty: The supply of the needed resources makes the host country dependent on MNCs and consequently results into the loss of control by the host government. Particularly for smaller countries, the possible harmful impact can be on economic, social and political system, e.g., the MNCs encourage west values, consumerism or may support a particular party. Due to increased consumerism, the savings in the economy is decreased. Exploitation of the Host Country: MNCs are often found using non-renewable resources, repatriating valuable foreign exchange to its parent and generally profiting at the expense of local community. Obsolete Technology: It is believed that the technology provided by MNCs is either outdated or too advanced. Sometimes it is felt that the MNC is getting rid of its old technology by instituting a subsidiary in a developing country. Inappropriate Technology: All local technologies embed local factor endowments therefore the technology is most suited to that nation only where it has been invented. Now if this technology is exported to another nation, the technology will be inappropriate. For example, the American technology will be a labour saving because labour is difficult to be found whereas the technology which employs more labour will be more appropriate for India. Displacement of Local Firms: The MNCs enter markets after evaluating their competitive advantages against domestic firms and therefore the local firms feel uncomfortable. These firms cannot compete with the MNC therefore forego investments or search new markets for investments. There is flight of capital from domestic economy to foreign economies. Outflow of Foreign Exchange: The apparent foreign exchange benefits from investment and exports can be more than offset over time, because once the investment is done, thereafter the repatriation starts and the much-needed foreign exchange starts flowing towards the parent thus putting pressure on foreign reserves. 129 CU IDOL SELF LEARNING MATERIAL (SLM)

Since the perceptions of the government is different from that of the MNCs, therefore MNC, must understand the concerns of the government and negotiate in the light of above perceptions without compromising the competitive position of company. The host government wants the potential contribution of FDI to improve economic conditions, trade balance, increased employment, increased power but fears the potential negative consequences such as loss of sovereignty, technological dependence and control of key economic sectors. This can lead to conflicting emotions; therefore, the relationship is that of love and hate. The host government's policies are so designed, that on one side the government tries to attract foreign investment and on the other it tries to regulate the activities of the MNCs. The outcome of a negotiating process is partial and the outcome favouring a particular party depends on how much each party needs the other and how much control each side can exert on the other. If the government has many options of getting foreign investment, then government is strong on its wicket, but if the company can provide a particular service or product and there is no offering with the government then the company has a favourable climate for negotiation. The bargaining position a particular company or country should adopt, depends on the structure of incentives and restrictions enumerated below: Table 7.1 Government Incentives and Restrictions The bargaining posture which an MNC or government can take, depends on how one side needs the other. The different postures can be:  When both sides are weak, the negotiation would be quiet, mutually adjusting and little room for taking a stand.  When one side is relatively strong, the party will be assertive, competitive and aims at dominating. 130 CU IDOL SELF LEARNING MATERIAL (SLM)

 When one side is relatively weak, it will adopt cooperative and accommodative posture and aims at satisfying the other party.  When the relative strengths of the two parties are unclear, the parties would adopt compromising, bargaining posture and aims at trade-offs.  When both the sides are strong, the parties would adopt collaborative, informative posture, which aims for integration of concerns. Another important factor that affects the process and outcome of negotiations is the relationship between the home government and the host government. A positive relationship between the two governments is likely to make negotiations smoother. Interest of the home government coincide with that of the MNC, therefore in the event of unwanted political activities by the host government, the home government will support the MNC and would try to influence the host in respect of the unwanted activities. Although the interest of the MNC and home country coincide but here also there is a conflict. Investing abroad does not mean investing at home, therefore some groups would be adversely affected at home. For example, had the investment been done at home, more jobs would have been created. The government and people of the home country also often expect the firm to act in the best interest of the home nation rather than in the best interest of the firm. 7.4.1 Country risk: A Case of India Over the year, the government has accorded various benefits to the Indian IT service industry. Key among these is the 10-year income tax holiday granted to software and IT-enabled services (ITeS) exporters registered under specified schemes. But if the law’s complexities and recent actions by the revenue authorities are any indication, the income tax holiday has proved to be a problem for several players. Complex laws are an anathema to the taxpayer and, as the following illustrations reveal, the provisions which seek to grant a tax holiday do not fully or clearly answer questions fundamental to their enjoyment. While the government has notified 15 IT-enabled services as eligible for tax holiday, the specific nature of activities to be covered under each head is not clearly explained. As a result, revenue authorities have, in several cases, denied the income tax benefits, citing ineligibility. The tax benefit is available with respect to ‘profits of the business’, in the proportion that the ‘export turnover’ from eligible activities bears to the ‘total turnover’. However, the terms ‘profits of the business’ and ‘total turnover’ have not been defined. This has triggered a spate of litigation. For example, the revenue department has, in several cases, been treating credits such as foreign exchange gains, bad debt recoveries, reversal of excess prior year deductible provisions etc., as profits ineligible for a tax holiday and subjected the same to taxes. Besides, 131 CU IDOL SELF LEARNING MATERIAL (SLM)

the department has been excluding items from computation of ‘export turnover’ without effecting corresponding exclusions in the ‘total turnover’ (in the process, disregarding judicial precedents which clearly negate such inconsistent adjustments), and thereby reducing the quantum of profits eligible for tax holiday. Software Technology Park (STP) units are being denied a tax holiday in cases where they have been registered with the STP authorities after commencement of manufacturing, based on the plain text of the provisions, unlike 100 per cent export-oriented units (EOUs), where the holiday has been specifically clarified to be available in similar circumstances. The government would do well to address this inconsistency and amend the law or clarify that the benefit should be available from the date of STP registration for the unexpired period of the tax holiday (within 10 years from the year of commencement of manufacturing). Several other ambiguities exist. These relate, among other things, to the stage of claiming tax holiday deduction in computing taxable income, treatment of unabsorbed depreciation from prior years in computing the current year’s tax holiday benefit, circumstances and extent to which subcontracting is permitted under alternative business scenarios, availability of the tax holiday to the transfer of company in case of mid-year amalgamations or demergers, and interpretation of the specific anti-abuse provisions in cases involving internal and external business reorganizations. Simplicity and certainty in tax laws are globally recognized as the best form of tax incentive that any government can offer its taxpayers. In the context of the income tax incentives introduced for the IT industry, for some time now, the gaps between legislative intent, enactment and administration have been fairly apparent, only fuelling further complexity in the Indian tax system. In this backdrop, a set of clear amendments or comprehensive rules and clarifications explaining the law are needed. With income tax benefits related to STPs or 100 per cent EOUs currently scheduled to lapse by March 2009, one hopes that contentious issues will be put to rest at the earliest, so that taxpayers are not burdened with the ignominy of protracted litigation after the tax holiday period. 7.5 SUMMARY  Foreign exchange exposure management is too important to be ignored by businesses across the world, including emerging world like India.  Businesses which did not give due care to it have paid the penalty. Business firms need to be proactive in foreign exchange risk management. Firms need to look at instituting a sound risk management system and also need to formulate their hedging strategy that suits their specific firm characteristics and exposures. 132 CU IDOL SELF LEARNING MATERIAL (SLM)

 In India, regulation has been steadily eased and turnover and liquidity in the foreign currency derivative markets have increased, although the use is mainly in shorter maturity contracts of one year or less.  Forward and option contracts are the more popular instruments. Initially only certain banks were allowed to deal in this market however now corporate can also write option contracts.  Indian companies are actively hedging their foreign exchanges risks with forwards and currency swaps and different types of options. Introduction of cross-currency futures and exchange traded option contracts by the RBI will further enhance the companies’ ability to effectively manage foreign exchange exposure.  A larger interactive model capable of culminating all facets of enterprise-wide risk management needs to be developed. It is concluded that business and industry should invariably hedge their actual risk exposures without exception as a base case strategy as it is most conservative and prudent strategy.  Government should make appropriate policy and took measures that can accelerate the process of further development of foreign exchange market. Companies should upgrade their foreign exchange risk management (ferm) process and employ innovative tools to mitigate foreign exchange exposure.  Country risk is described as the economic, political and business risks that are distinctive to a specific country, and that might result in unforeseen investment losses.  Mainly, country risk refers to the risk of investing or lending in a country, arising from possible modifications in the business environment that may unfavourably affect operating profits or the value of assets in the country.  Country risk signifies the potentially adverse impact of a country's environment on the MNC'S cash flows. Country risk covers factors to influence the default risk of the country resulting from economic deterioration, political events, currency depreciation and so on. 7.6 KEYWORDS Hedging: It is a risk management strategy employed to offset losses in investments by taking an opposite position in a related asset. The reduction in risk provided by hedging also typically results in a reduction in potential profits. Hedging strategies typically involve derivatives, such as options and futures contracts. Forward Contracts : It is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging. 133 CU IDOL SELF LEARNING MATERIAL (SLM)

Futures: They are derivative financial contracts that obligate the parties to transact an asset at a predetermined future date and price. The buyer must purchase, or the seller must sell the underlying asset at the set price, regardless of the current market price at the expiration date. Options: They are financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date. Call options and put options form the basis for a wide range of option strategies designed for hedging, income, or speculation. Entrepreneurs: An individual who creates a new business, bearing most of the risks and enjoying most of the rewards. The process of setting up a business is known as entrepreneurship. The entrepreneur is commonly seen as an innovator, a source of new ideas, goods, services, and business/or procedures. 7.7 LEARNING ACTIVITY 1. Discuss Gold as heading instrument? ……………………………………………………………………………………………… ……………………………………………………………………………………………… 2. Discuss is Gold a Hedge or Safe heaven? ……………………………………………………………………………………………… ……………………………………………………………………………………………… 7.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain different methods of measuring country risk. 2. Explain the case of Indian scenario in terms of political and country risk with suitable illustrations? 3. Explain Forward Contracts in Hedging? 4. Explain Currency options in Hedging? 5. Explain Internal techniques in Hedging? Long Questions 134 1. Explain MNC's Views and its Strength for Negotiation? CU IDOL SELF LEARNING MATERIAL (SLM)

2. Explain Host Country's View and its Negotiation Strength? 3. Explain Country risk with India as an Example. 4. Explain types of Heading against Foreign Exchange exposure? 5. Explain Hedging via mixed-currency invoicing? B. Multiple Choice Questions 1. Forward contracts involve an agreement between two parties to buy/sell a specific quantity of an underlying asset. a. Asset b. Payables c. Working capital d. None of these 2. Currency futures contract involves a standardized contract between two parties to buy/sell an amount of currency. a. Products b. Currency c. Gold d. None of these 3. Foreign debts are an effective way to hedge the foreign exchange exposure. a. Transaction exchange exposure b. Domestic exchange exposure c. Foreign exchange exposure d. Foreign legal exposure 4. Cross Hedging means taking opposing position in two _______ correlated currencies. a. Positively b. Negatively c. Neutral d. None of these 5. Matching refers to the process in which a company matches its GATS. a. Currency inflows with its asset outflows b. Currency inflows with its currency outflows c. Currency inflows with its Gold outflows d. Asset inflows with its currency outflows 135 CU IDOL SELF LEARNING MATERIAL (SLM)

Answers 1-(a), 2-(b), 3-(c), 4-(c), 5-(b) 7.9 REFERENCES Textbooks:  Pringle, John J. (1991), “Managing Foreign Exchange Exposure”, Journal of Applied Corporate Finance 73-82.  Schrand, Catherine, and Haluk Unal (1998), “Hedging and Coordinated Risk Management: Evidence from Thrift Conversions”, Journal of Finance, Vol. 53, No. 3, 979-1013.  Shapiro, Alan C. (1996), “Multinational Financial Management”, 5th edition, Prentice Hall Inc., Upper Saddle River, New Jersey.  Sohnke Bartram (2004),“Linear and Nonlinear Foreign Exchange Rate Exposures of German Nonfinancial Corporations”, Journal of International Money and Finance, Vol. 23, No. 4, pp. 673-699, June .  Brown, Gregory W., and Klaus Bjerre Toft (1999), “How Firms Should Hedge?”, University of North Carolina Working Paper. 136 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-8: MULTINATIONAL FINANCIAL MANAGEMENT STRUCTURE 8.0 Learning Objectives 8.1 Introduction 8.2 Nature and Scope of International Financial Management 8.3 Evolution of MNC’s 8.4 Theory and Practice of International Financial Management 8.5 Summary 8.6 Keywords 8.7 Learning Activity 8.8 Unit End Questions 8.9 References 8.0 LEARNING OBJECTIVES After studying this unit, student will be able to:  Explain the factors responsible for emergence of globalized financial markets.  Outline the meaning, nature and scope of international financial management.  Describe goals for international financial management. 8.1 INTRODUCTION Financial management is mainly concerned with how to optimally make various corporate financial decisions, such as those pertaining to investment, capital structure, dividend policy, and working capital management, with a view to achieving a set of given corporate objectives. In Anglo-American countries as well as in many advanced countries with well- developed capital markets, maximizing shareholder wealth is generally considered the most important corporate objective. Why do we need to study “international” financial management? The answer to this question is straightforward: We are now living in a highly globalized and integrated world economy. 137 CU IDOL SELF LEARNING MATERIAL (SLM)

American consumers, for example, routinely purchase oil imported from Saudi Arabia and Nigeria, TV sets and camcorders from Japan, Italy, and wine from France. Foreigners, in turn, purchase American-made aircraft, software, movies, jeans, wheat, and other products. Continued liberalization of international trade is certain to further internationalize consumption patterns around the world. Recently, financial markets have also become highly integrated. This development allows investors to diversify their investment portfolios internationally. In the words of a recent Wall Street Journal article, “Over the past decade, US investors have poured buckets of money into overseas markets, in the form of international mutual funds. At the same time, Japanese investors are investing heavily in US and other foreign financial markets in efforts to recycle their economies trade surpluses. In addition, many major corporations of the world, such as IBM, DaimlerBenz (now, Daimler Chrysler), and Sony, have their shares cross-listed on foreign stock exchanges, thereby rendering their shares internationally tradable and gaining access to foreign capital as well. Consequently, Daimler-Benz’s venture, say, in China can be financed partly by American investors who purchase Daimler-Benz shares traded on the New York Stock Exchange. During last few decades a rapid internationalization of business has occurred. With the increase in demand of goods and services due to opening of borders of countries around world, the requirement of capital, machinery and technological know-how has reached to the topmost level. Now no single country can boast of self-sufficiency because in a global village a vast population of multidimensional tastes, preferences and demand exists. Undoubtedly, we are now living in a world where all the major economic functions- consumption, production, and investment– are highly globalized. It is thus essential for financial managers to fully understand vital international dimensions of financial management. In order to cater to needs/demand of huge world population, a country can engage itself in multi trading activities among various nations. In the post WTO regime (after 1999 onwards), it has become pertinent to note that MNCs (Multinational corporations) with their world-wide production and distribution activities have gained momentum. An understanding of international financial management is quite important in the light of changes in international environment, innovative instruments and institutions to facilitate the international trading activities. Classical theory of trade assumes that countries differ enough from one another in terms of resources endowments and economic skills for these differences to be at the centre of any analysis of corporate competitiveness. Now there is free mobility of funds, resources, knowledge and technology which has made international trade more dynamic and complex. Capital moves around the world in huge amount; corporations are free to access different markets for raising finance. There exists an international competitiveness in different areas of trade and commerce. The enormous opportunities of investments, savings, consumption and 138 CU IDOL SELF LEARNING MATERIAL (SLM)

market accessibility have given rise to big institutions, financial instruments and financial markets. Now a days an investor in USA would like to take investment opportunity in offshore markets. The trade-off between risk of investing in global markets and return from 4 these investments is focused to achieve wealth maximization of the stakeholders. It is important to note that in international financial management, stakeholders are spread all over the world. 8.2 NATURE AND SCOPE OF INTERNATIONAL FINANCIAL MANAGEMENT Like any finance function, international finance, the finance function of a multinational firm has two functions namely, treasury and control. The treasurer is responsible for financial planning analysis, fund acquisition, investment financing, cash management, investment decision and risk management. On the other hand, controller deals with the functions related to external reporting, tax planning and management, management information system, financial and management accounting, budget planning and control, and accounts receivables etc. For maximizing the returns from investment and to minimize the cost of finance, the firms has to take portfolio decision based on analytical skills required for this purpose. Since the firm has to raise funds from different financial markets of the world, which needs to actively exploit market imperfections and the firm’s superior forecasting ability to generate purely financial gains. The complex nature of managing international finance is due to the fact that a wide variety of financial instruments, products, funding options and investment vehicles are available for both reactive and proactive management of corporate finance. Multinational finance is multidisciplinary in nature, while an understanding of economic theories and principles is necessary to estimate and model financial decisions, financial accounting and management accounting help in decision making in financial management at multinational level. Because of changing nature of environment at international level, the knowledge of latest changes in forex rates, volatility in capital market, interest rate fluctuations, macro level charges, micro level economic indicators, savings, consumption pattern, interest preference, investment behaviours of investors, export and import trends, competition, banking sector performance, inflationary trends, demand and supply conditions etc. is required by the practitioners of international financial management. Distinguishing Features of International Finance International Finance is a distinct field of study and certain features set it apart from other fields. The important distinguishing features of international finance from domestic financial management are discussed below: Foreign Exchange Risk 139 CU IDOL SELF LEARNING MATERIAL (SLM)

An understanding of foreign exchange risk is essential for managers and investors in the modern-day environment of unforeseen changes in foreign exchange rates. In a domestic economy this risk is generally ignored because a single national currency serves as the main medium of exchange within a country. When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates. The present International Monetary System set up is characterized by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests. In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy makers. At present, the exchange rates among some major currencies such as the US dollar, British pound, Japanese yen and the euro fluctuate in a totally unpredictable manner. Exchange rates have fluctuated since the 1970s after the fixed exchange rates were abandoned. Exchange rate variation affect the profitability of firms and all firms must understand foreign exchange risks in order to anticipate increased competition from imports or to value increased opportunities for exports. Political Risk Another risk that firms may encounter in international finance is political risk. Political risk ranges from the risk of loss (or gain) from unforeseen government actions or other events of a political character such as acts of terrorism to outright expropriation of assets held by foreigners. MNCs must assess the political risk not only in countries where it is currently doing business but also where it expects to establish subsidiaries. The extreme form of political risk is when the sovereign country changes the ‘rules of the game’ and the affected parties have no alternatives open to them. For example, in 1992, Enron Development Corporation, a subsidiary of a Houston based energy company, signed a contract to build India’s longest power plant. Unfortunately, the project got cancelled in 1995 by the politicians in Maharashtra who argued that India did not require the power plant. The company had spent nearly $ 300 million on the project. The Enron episode highlights the problems involved in enforcing contracts in foreign countries. Thus, episode highlights the problems involved in enforcing contracts in foreign countries. Thus, political risk associated with international operations is generally greater than that associated with domestic operations and is generally more complicated. Expanded Opportunity Sets 140 CU IDOL SELF LEARNING MATERIAL (SLM)

When firms go global, they also tend to benefit from expanded opportunities which are available now. They can raise funds in capital markets where cost of capital is the lowest. In addition, firms can also gain from greater economies of scale when they operate on a global basis. Market Imperfections The final feature of international finance that distinguishes it from domestic finance is that world markets today is highly imperfect. There are profound differences among nations’ laws, tax systems, business practices and general cultural environments. Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolio. Though there are risks and costs in coping with these market imperfections, they also offer managers of international firm’s abundant opportunities. 8.3 EVOLUTION OF MNCS The 1980s and 90s saw a rapid integration of international capital and financial markets. The impetus for globalized financial markets initially came from the governments of major countries that had begun to deregulate their foreign exchange and capital markets. For example, in 1980 Japan deregulated its foreign exchange market, and in 1985 the Tokyo Stock Exchange admitted as members a limited number of foreign brokerage firms. Additionally, the London Stock Exchange (LSE) began admitting foreign firms as full members in February 1986. Perhaps the most celebrated deregulation, however, occurred in London on October 27, 1986, and is known as the “Big Bang.” On that date, as on “May Day” in 1975 in the United States, the London Stock Exchange eliminated fixed brokerage commissions. Additionally, the regulation separating the order-taking function from the market-making function was eliminated. In Europe, financial institutions are allowed to perform both investment-banking and commercial-banking, functions. Hence, the London affiliates of foreign commercial banks were eligible for membership on the LSE. These changes were designed to give London the most open and competitive capital markets in the world. It has worked, and today the competition in London is especially fierce among the world's major financial centres. The United States recently repealed the Glass-Steagall Act, which restricted commercial banks from investment banking activities (such as underwriting corporate securities), further promoting competition among financial institutions. Even developing countries such as Chile, Mexico, and Korea began to liberalize by allowing foreigners to directly invest in their financial markets. Deregulated financial markets and heightened competition in financial services provided a natural environment for financial innovations that resulted in the intro-duction of various instruments. Examples of these innovative instruments include, currency futures and options, multicurrency bonds, international mutual funds, country funds, and foreign stock index futures and options. Corporations also played an active role in integrating the world financial 141 CU IDOL SELF LEARNING MATERIAL (SLM)

markets by listing their shares across national treasury hard-currency foreign reserves. The sale proceeds are often used to pay down sovereign debt that has weighed heavily on the economy. Additionally, privatization is often seen as a cure for bureaucratic inefficiency and waste; some economists estimate that privatization improves efficiency and reduces operating costs by as much as 20 per cent. The International Finance in Practice box on pages 12-13 further describes the privatization process. There is no one single way to privatize state-owned operations. The objectives of the country seem to be the prevailing guide. For the Czech Republic, speed was the overriding factor. To accomplish privatization en masse, the Czech government essentially gave away its businesses to the Czech people. For a nominal fee, vouchers were sold that allowed Czech citizens to bid on businesses as they went on the auction block. From 1991 to 1995, more than 1,700 companies were turned over to private hands. Moreover, three-quarters of the Czech citizens became stockholders in these newly privatized firms. In Russia, there has been an ‘irreversible’ shift to private ownership, according to the World Bank. More than 80 per cent of the country’s non- farm workers are now employed in the private sector. Eleven million apartment units have been privatized, as have half of the country’s 240,000 other business firms. Additionally, via a Czech-style voucher system, 40 million Russians now own stock in over 15,000 medium- to large-size corporations that recently became privatized through mass auctions of state-owned enterprises International financial management is related to managing finance of MNCs. There are five methods by which firms conduct international business activities– licensing, franchising, joint ventures, management contracts and establishing new foreign subsidiaries. Licensing: A firm in one country licenses the use of some or all of its intellectual property (patents, trademarks, copyrights, brand names) to a firm of some other country in exchange for fees or some royalty payment. Licensing enables a firm to use its technology in foreign markets without a substantial investment in foreign countries. Franchising: A firm in one country authorizing a firm in another country to utilize its brand names, logos etc. in return for royalty payment. Joint ventures: A corporate entity or partnership that is jointly owned and operated by two or more firms is known as a joint venture. Joint ventures allow two firms to apply their respective comparative advantage in a given project. Establishing new Foreign Subsidiaries: A firm can also penetrate foreign markets by establishing new operations in foreign countries to produce and sell their products. The advantage here is that the working and operation of the firm can be tailored exactly to the firm’s needs. However, a large amount of investment is required in this method. 142 CU IDOL SELF LEARNING MATERIAL (SLM)

Management contracts: A firms in one country agrees to operate facilities or provide other management services to a firm in another country for an agreed upon fee. Goals for International Financial Management International Financial Management is designed to provide today’s financial managers with an understanding of the fundamental concepts and the tools necessary to be effective global managers. Throughout, the text emphasizes how to deal with exchange risk and market imperfections, using the various instruments and tools that are available, while at the same time maximizing the benefits from an expanded global opportunity set. Effective financial management, however, is more than the application of the newest business techniques or operating more efficiently. There must be an underlying goal. International Financial Management is written from the perspective that the fundamental goal of sound financial management is shareholder wealth maximization. Shareholder wealth maximization means that the firm makes all business decisions and investments with an eye toward making the owners of the firm– the shareholders– better off financially, or wealthier, than they were before Whereas shareholder wealth maximization is generally accepted as the ultimate goal of financial management in ‘Anglo-Saxon’ countries, such as Australia, Canada, the United Kingdom, and especially the United States, it is not as widely embraced a goal in other parts of the world. In countries like France and Germany, for example, shareholders are generally viewed as one of the ‘stakeholders’ of the firm, others being employees, customers, suppliers, banks, and so forth. European managers tend to consider the promotion of the firm’s stakeholders’ overall welfare as the most important corporate goal. In Japan, on the other hand, many companies form a small number of interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, which arose from consolidation of family- owned business empires. Japanese managers tend to regard the prosperity and growth of their keiretsu as the critical goal; for instance, they tend to strive to maximize market share, rather than shareholder wealth. Obviously, the firm could pursue other goals. This does not mean, however, that the goal of shareholder wealth maximization is merely an alternative, or that the firm should enter into a debate as to its appropriate fundamental goal. Quite the contrary. If the firm seeks to maximize shareholder wealth, it will most likely simultaneously be accomplishing other legitimate goals that are perceived as worthwhile. Share-holder wealth maximization is a long-run goal. A firm cannot stay in business to maximize shareholder wealth if it treats employees poorly, produces shoddy merchandise, wastes raw materials and natural resources, operates inefficiently, or fails to satisfy customers. Only a well-managed business firm that profitably produces what is demanded in an efficient manner can expect to stay in business in the long run and thereby provide employment opportunities. Shareholders are the owners 143 CU IDOL SELF LEARNING MATERIAL (SLM)

of the business; it is their capital that is at risk. It is only equitable that they receive a fair return on their investment. Private capital may not have been forthcoming for the business firm if it had intended to accomplish any other objective. 8.4 THEORY AND PRACTICE OF INTERNATIONAL FINANCIAL MANAGEMENT The objective of an MNC is to maximize the value/wealth of the shareholders. Shareholders of an MNC are spread all over the globe. Financial executives in MNCs many a time have to take decisions that conflict with the objective of maximizing shareholders wealth. It has been observed that as foreign operations of a firm expand and diversify, managers of these foreign operations become much concerned about their respective subsidiaries and are tempted to make decisions that maximize the value of their subsidiaries. These managers tend to operate independently of the MNC parent and view their subsidiary its single, separate units. Thus, when a conflict of goals occurs between the managers and the shareholders, then ‘agency problem’ starts. Figure 8.1: A case of an MNC Having Two Subsidiaries Further, the goal of wealth maximization looks simply but when it is to be achieved in different circumstances and environment then MNCs are various strategies to prevent this conflict. The simplest solution is to reward the financial managers according to their contribution to the MNCs as a whole on a regular basis. Another alternative may be to fire managers responsible for not considering the goal of the parent company or probably give them less compensation/reward. Here, a holistic view of wealth maximization should be 144 CU IDOL SELF LEARNING MATERIAL (SLM)

followed rather than a narrow approach. Theoretically speaking, manager of an MNC should take decisions in accordance with the latest changes/challenges from/in the environment. There may be multiplicity of currency and associated unique risks a manager of an MNC has to face. A well-diversified MNC can actually reduce risks and fluctuations in earnings and cash flows by making the diversity in geography and currency work in its favour. Sometimes the goal of value maximization cannot be attained just because of internal and external constraints. Internal constraints arise due to ‘agency problem’ while external constraints are caused by environmental laws which may tend to reduce the profit of the organization (subsidiary profits) like building codes, disposal of waste materials and pollution control etc. The regulatory constraints are caused by differing legislations affecting the business operations and profitability of subsidiary e.g., taxes, currency convertibility laws, remittance restrictions etc. On the other hand, there is no uniformity in code of conduct that is applicable to all countries. A business practice in one country may be ethical in that country but may be unethical in another. 8.5 SUMMARY  In view of globalization and its impact on the economy of the world, it is pertinent to note that financial management of multinational companies, has adapted to changes in the environment.  The theory and practice of international financial management is in consonance with the tax environment, legal obligations, foreign exchange rates, interest rate fluctuation, capital market movements, inflationary trends, political risk and country risk, micro and macro-economic environment changes, ethical constraints etc.  The objective of wealth maximization can be achieved if financial manager has the knowledge of economics, investment climate, tax implications and strategies in multinational settings.  Further the scope of multinational finance has widened its horizon with the emergence of innovative financial instruments and mechanism supported by multilateral trade agencies like WTO- and regional blocks like ASEAN, NAFTA, SAPTA etc.  There are various challenges from the environment and accordingly the scope and relevance of multinational financial management has increased in recent past. 8.6 KEYWORDS Competitive Advantage: A term coined by Michael Porter to reflect the edge a country enjoys from dynamic factors affecting international competitiveness. Factors contributing to a competitive advantage include well-motivated managers, discriminating and demanding consumers, and the existence of service and other supportive industries, as well as the necessary factor endowments. 145 CU IDOL SELF LEARNING MATERIAL (SLM)

Competitive Effect: It refers to the effect of exchange rate changes on the firm competitive position, which, in turn, affects the firm’s operating cash flows. Foreign Direct Investment (FDI): Investment in a foreign country that gives the MNC a measure of control. Foreign Exchange Risk: The risk of facing uncertain future exchange rates. General Agreement on Tariffs and Trade (GATT): A multilateral agreement between member countries to promote international trade. The GAAT played a key role in reducing international trade barriers. Multinational Corporation (MNC): It refers to a firm that has business activities and interests in multiple countries. 8.7 LEARNING ACTIVITY Duve, Inc., desires to penetrate a foreign market with either a licensing agreement with a foreign firm or by acquiring a foreign firm. 1. Discuss the differences in potential risk and return between a licensing agreement with a foreign firm and the acquisition of a foreign firm. ……………………………………………………………………………………………… ……………………………………………………………………………………………… 8.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain the objective of multinational financial management? What are various aspects of world economy which have given rise to international financial management? 2. “In globalised era the functions of finance executives of an MNC have become complexed”. In your view what are the factors responsible for decision making in international financial management? 3. Discuss the nature and scope of international financial management by a multinational firm. 4. How international financial management is different from financial management at domestic level? 5. Why international financial management is important for a globalised firm? Long Questions 146 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Explain Impact of Globalization on MNC’s ? 2. Explain Evolution on MNCs. 3. Describe Nature and Scope of International financial Management. 4. Explain Multinational Financial Management? 5. Explain practise of International Finance? B. Multiple Choice Questions 1. Which of the following are international financial considerations faced by MNC’s? a. Tax systems. b. Currency systems. c. Interest rates. d. All of these. 2. Nations with major economic expansion attract_____________. a. Imports b. Foreign Direct investment c. Exports d. Privatization 3. Bond issues simultaneously in several global financial centre is a. Domestic Bond b. Foreign Bond c. Global Bond d. Euro Bond 4. London Stock Exchange began admitting foreign firms as full members in___________. a. February 1986 b. January 1986 c. February 1987 d. January 1987 5. ______________ variation affect the profitability of firms. a. Exchange rate b. Export rate c. Import rate d. None of these Answers 1-(d), 2-(b), 3-(c), 4-(a), 5-(a) 147 CU IDOL SELF LEARNING MATERIAL (SLM)

8.9 REFERENCES Textbooks:  Bordo, Michael, D., “The Gold Standard, Bretton Woods and Other Monetary Regimes: A Historical Appraisal”, Review, Federal Reserve Bank of St. Louis, March/April 1993, pp. 123-199.  \"Capital Flows into Emerging Markets\". Cover story, Business World, 31 Oct. 2005. (pp. 44-46).  Daniels & Joseph P. & Van Hoose David, International Monetary and Financial Economics, South-Western , Thompson Learning, USA, 1988.  Holland, John, International Financial Management, Black West, Publishers, UK.  Levi, Maurice D, \"International Finance\", Tata McGraw Hill Publishing Company Ltd., New Delhi, 1988.  Ross, Stephen A., Randolph W. Westerfield, and Jeffrey F. Jaffee. Corporate Finance, 5th ed. New York, NY: Irwin/McGraw-Hill, 1999.  Seth, AK, \"International Financial Management\", Galgotia Publishing Company, New Delhi, 1998.  Shapiro, Alan C, Multinational Financial Management, PHI, New Delhi, 2002. 148 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT-9: FOREIGN DIRECT INVESTMENT STRUCTURE 9.0 Learning Objectives 9.1 Introduction 9.2 FDI Policy in INDIA 9.2.1 Recent Development in FDI Policies -2010 onwards 9.3 Cross Border Mergers and Acquisitions 9.3.1 Factors to be considered in Cross Border Mergers and Acquisitions 9.4 Summary 9.5 Keywords 9.6 Learning Activity 9.7 Unit End Questions 9.8 References 9.0 LEARNING OBJECTIVES After studying this unit, student will be able to:  Explain FDI Policy in India.  Understand recent developments in India’s FDI policy.  Understand mergers and acquisitions. 9.1 INTRODUCTION Foreign direct investment (FDI) is an investment from a party in one country into a business or corporation in another country with the intention of establishing a lasting interest. Lasting interest differentiates FDI from foreign portfolio investments, where investors passively hold securities from a foreign country. A foreign direct investment can be made by obtaining a lasting interest or by expanding one’s business into a foreign country. As mentioned above, an investor can make a foreign direct investment by expanding their business in a foreign country. Amazon opening a new headquarters in Vancouver, Canada would be an example of this. 149 CU IDOL SELF LEARNING MATERIAL (SLM)

Reinvesting profits from overseas operations, as well as intra-company loans to overseas subsidiaries, are also considered foreign direct investments. Finally, there are multiple methods for a domestic investor to acquire voting power in a foreign company. Below are some examples:  Acquiring voting stock in a foreign company  Mergers and acquisitions  Joint ventures with foreign corporations  Starting a subsidiary of a domestic firm in a foreign country Foreign direct investment offers advantages to both the investor and the foreign host country. These incentives encourage both parties to engage in and allow FDI. Below are some of the benefits for businesses:  Market diversification  Tax incentives  Lower labour costs  Preferential tariffs  Subsidies The following are some of the benefits for the host country:  Economic stimulation  Development of human capital  Increase in employment  Access to management expertise, skills, and technology Disadvantages of Foreign Direct Investment Despite many benefits, there are still two main disadvantages to FDI, such as:  Displacement of local businesses  Profit repatriation The entry of large firms, such as Walmart, may displace local businesses. Walmart is often criticized for driving out local businesses that cannot compete with its lower prices. In the case of profit repatriation, the primary concern is that firms will not reinvest profits back into the host country. This leads to large capital outflows from the host country. As a result, many countries have regulations limiting foreign direct investment. 150 CU IDOL SELF LEARNING MATERIAL (SLM)