Depending on the principle, the PPP approach predicts that the exchange rate will adjust by offsetting the price changes occurring due to inflation. For example, say the prices in the U.S. are predicted to go up by 4% over the next year and the prices in Australia are going to rise by only 2%. Then, the inflation differential between America and Australia is: 4% – 2% = 2% According to this assumption, the prices in the U.S. will rise faster in relation to prices in Australia. Therefore, the PPP approach would predict that the U.S. dollar will depreciate by about 2% to balance the prices in these two countries. So, in case the exchange rate was 90 cents U.S. per one Australian dollar, the PPP would forecast an exchange rate of (1 + 0.02) × (US $0.90 per AUS $1) = US $0.918 per AUS $1 So, it would now take 91.8 cents U.S. to buy one Australian dollar. Relative Economic Strength Model The relative economic strength model determines the direction of exchange rates by taking into consideration the strength of economic growth in different countries. The idea behind this approach is that a strong economic growth will attract more investments from foreign investors. To purchase these investments in a particular country, the investor will buy the country's currency – increasing the demand and price (appreciation) of the currency of that particular country. Another factor bringing investors to a country is its interest rates. High interest rates will attract more investors, and the demand for that currency will increase, which would let the currency to appreciate. Conversely, low interest rates will do the opposite and investors will shy away from investment in a particular country. The investors may even borrow that country's low-priced currency to fund other investments. This was the case when the Japanese yen interest rates were extremely low. This is commonly called carry-trade strategy. The relative economic strength approach does not exactly forecast the future exchange rate like the PPP approach. It just tells whether a currency is going to appreciate or depreciate. Econometric Models It is a method that is used to forecast exchange rates by gathering all relevant factors that may affect a certain currency. It connects all these factors to forecast the exchange rate. The factors are normally from economic theory, but any variable can be added to it if required. 51 CU IDOL SELF LEARNING MATERIAL (SLM)
For example, say, a forecaster for a Canadian company has researched factors he thinks would affect the USD/CAD exchange rate. From his research and analysis, he found that the most influential factors are the interest rate differential (INT), the GDP growth rate differences (GDP), and the income growth rate (IGR) differences. The econometric model he comes up with is − USD/CAD (1 year) = z + a(INT) + b(GDP) + c(IGR) Now, using this model, the variables mentioned, i.e., INT, GDP, and IGR can be used to generate a forecast. The coefficients used (a, b, and c) will affect the exchange rate and will determine its direction (positive or negative). Time Series Model The time series model is completely technical and does not include any economic theory. The popular time series approach is known as the autoregressive moving average (ARMA) process. The rationale is that the past behaviours and price patterns can affect the future price behaviours and patterns. The data used in this approach is just the time series of data to use the selected parameters to create a workable model. To conclude, forecasting the exchange rate is an ardent task and that is why many companies and investors just tend to hedge the currency risk. Still, some people believe in forecasting exchange rates and try to find the factors that affect currency-rate movements. For them, the approaches mentioned above are a good point to start with. 3.5 INTERNATIONAL PARITY CONDITIONS In the past three decades of a floating period on exchange rates, a substantial amount of research has been devoted to identifying linkages in international markets. The most prominent among these linkages are the uncovered-interest parity (UIP), purchasing-power parity (PPP), and international stock-return parity (ISP). The importance of these conditions stems not only from their significance as building blocks for international finance theory, but also from their application in guiding resource allocation in the international money, capital, and goods markets. Purchasing Power Parity relationship A Swedish economist, Gustav Cassel, stated in 1918 that purchasing power of a currency is determined by the amount of goods and services that can be purchased with one unit of that currency. If there are two currencies, it would be fair to say that the exchange rate between 52 CU IDOL SELF LEARNING MATERIAL (SLM)
these two currencies would be such that it reflects their respective purchasing power. This principle is referred to as Purchasing Power Parity (PPP). If the current exchange rate is such that it does not reflect purchasing power parity, it is a situation of disequilibrium. It is expected that, eventually, the exchange rate between the two currencies will move in such a manner as to reflect purchasing power parity. Let us illustrate this concept with the help of an example. Suppose at the period zero, a basket of goods and services is costing £100 in the UK and $180 in USA. There is no restriction of buying this basket of goods and services either from the UK or from the SUA. Then, it would be correct to conclude that the two amounts paid in respective currencies are equivalent. In other words, £100 = $180 or £I = $1.80 Or, we can simply say that the exchange rate at the time zero is $1.80/£. If we use the symbol S0 to designate this exchange rate, then we write: S0 = $1.80/£ Say after one year (period 1), the same basket of goods and services costs £103 in the UK market while it costs $186 in the USA market. Again, it is reasonable to say that these twos sums are equal. That is, £103=$186 or £1 =$1.80.58 or the exchange rate, S1, at the period 1 is: $1.8050/£ By looking at the two exchange rates S0 and SI, it is clear that pound sterling has slightly appreciated vis-a-vis US dollar over the period of past one year. And what can we say about the price changes? In the UK, the prices went up from £100 to £103 and in the USA, they went up from $180 to $186. This price change is known as inflation and the rates of inflation can be calculated as follows: Rate of inflation in the UK, rUK = (103 - 100)/100 = 0.03 or 3% Rate of inflation in the USA, rUSA = (186 - 180)/180 = 0.0333 OR 3.33% This shows that the rate of inflation is higher in the USA than in the UK. It is inferred, then, that the currency of the country where inflation rate is higher is likely to depreciate vis-a-vis the currency of the country with lower rate of inflation. Now this illustration can be generalized by taking any two countries, A and B. At the reference point of time (time zero), the price of the given basket is PA0 in the country A and PB0 in the country B. Therefore, PA0 = S0 x PB0 (Equation 1) 53 CU IDOL SELF LEARNING MATERIAL (SLM)
At a later period (time 1), the price changes to PA1 and PB1 respectively. Therefore, PA1 = S1 x PB1 (Equation 2) The relation between prices at different points of time is linked through the inflation rate. That is, PA1 = PA0 (1 + rA) (Equation 3) and PB1 = PB0 (1 + rB) (Equation 4) Where rA and rB are the rates of inflation in the Country A and Country B respectively. From Equation 1 and Equation 2, S0 = (PA0/ PB0) S1 = (PA1/ PB1) Using Equation 3 and Equation 4, we can write: S1 = PA0 (1+rA) / PB0 (1+rB) Or S1 = (PA0/ PB0) * ((1+rA) / (1+rB)) Or S1 = S0 ((1+rA) / (1+rB)) Equation 5 The Equation 5 is known as purchasing power parity relationship. This equation links the exchange rates inflation rates in two countries. It should be noted that, often inflation rates are calculated by using price indices rather than taking prices of individual goods or services. Generally, all countries have developed some price index series which are readily available from economic databases and can be used to calculate inflation rates. Solved examples that follow illustrate the use of purchasing parity relationship to predict the future exchange rate. In India, prices changed from Rs 4500 to Rs 5500 over a period of three years for the same basket of goods whereas they changed from $100 to $110 over the same period in the USA. What was initial exchange rate (S0)? What is expected exchange rate after 3 years (S3)? From the data, at the beginning Rs 4500 = $ 100 or Rs 45 = $1 or exchange rate, S0 = Rs 45/$ 54 CU IDOL SELF LEARNING MATERIAL (SLM)
After three years, Rs 5500 = $ 100 or Rs 50 = $ 1 or exchange rate, S3 = Rs 50/$ Thus, rupee has depreciated whereas dollar has appreciated. 3.6 SUMMARY The Balance of Payments or BoP is a statement or record of all monetary and economic transactions made between a country and the rest of the world within a defined period (every quarter or year). These records include transactions made by individuals, companies and the government. Keeping a record of these transactions helps the country to monitor the flow of money and develop policies that would help in building a strong economy. The BoP statement provides a clear picture of the economic relations between different countries. It is an integral aspect of international financial management. the BoP statement provides information pertaining to the demand and supply of the country’s currency. The trade data shows a clear picture of whether the country’s currency is appreciating or depreciating in comparison with other countries. Next, the country’s BoP determines its potential as a constructive economic partner. In addition, a country’s BoP indicates its position in international economic growth. By studying its BoP statement and its components closely, a country would be able to identify trends that may be beneficial or harmful to the economy and take appropriate measures. Foreign exchange markets are one of the most important financial markets in the world. Their role is of utmost importance in the system of international payments. In order to play their role efficiently, it is necessary that their operations/dealings be trustworthy. Trustworthy is concerned with contractual obligations being honoured. For example, if two parties have entered into forward contract of a currency pair (means one is purchasing and the other is selling), both of them should be willing to honour their side of contract as the case may be. Exchange rate forecasts are necessary to evaluate the foreign denominated cash flows involved in international transactions. Thus, exchange rate forecasting is very important to evaluate the benefits and risks attached to the international business environment In international exchange, parity refers to the exchange rate between the currencies of two countries making the purchasing power of both currencies substantially equal. 55 CU IDOL SELF LEARNING MATERIAL (SLM)
Theoretically, exchange rates of currencies can be set at a parity or par level and adjusted to maintain parity as economic conditions change 3.7 KEYWORDS Dollarize: A country that is not the United States uses the U.S. dollar as its currency. Exchange Rate: The price of one currency expressed in terms of units of another currency. Foreign Exchange Market: The market in which people use one currency to buy another currency. Hedge: It is using a financial transaction as protection against risk. Portfolio Investment: An investment in another country that is purely financial and does not involve any management responsibility. 3.8 LEARNING ACTIVITY 1. Arlington Co. has substantial translation exposure in European subsidiaries. The treasurer of Arlington Co. suggests that the translation effects are not relevant because the earnings generated by the European subsidiaries are not being remitted to the U.S. parent, but are simply being reinvested in Europe. Nevertheless, the vice president of finance of Arlington Co. is concerned about translation exposure because the stock price is highly dependent on the consolidated earnings, which are dependent on the exchange rates at which the earnings are translated. Who is correct? ……………………………………………………………………………………………… ……………………………………………………………………………………………… 2. Salem Exporting Co. purchases chemicals from U.S. sources and uses them to make pharmaceutical products that are exported to Canadian hospitals. Salem prices its products in Canadian dollars and is concerned about the possibility of the long-term depreciation of the Canadian dollar against the U.S. dollar. It periodically hedges its exposure with short-term forward contracts, but this does not insulate against the possible trend of continuing Canadian dollar depreciation. How could Salem offset some of its exposure resulting from its export business? ……………………………………………………………………………………………… ……………………………………………………………………………………………… 56 CU IDOL SELF LEARNING MATERIAL (SLM)
3.9 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What do you understand by Purchasing Power Parity (PPP)? Explain with examples. 2. Does PPP predict the exchange rates accurately? If not, why not? 3. Explain interest rate parity and reasons for deviations. 4. How does an arbitrage opportunity arise in forward exchange market? 5. Calculate exchange rate after one year if the inflation rates are 6 per cent and 3 per cent respectively in India and the UK. The reference rate is Rs 80/£. Long Questions 1. How does BOP situation affect exchange rate? 2. Discuss the influence of foreign exchange reserves on exchange rate. 3. Explain Balance of Payments and its elements. 4. Explain major Foreign Exchange Markets. 5. Explain forecasting Foreign Exchange rates. B. Multiple Choice Questions 1. Which of the following does not form part of current account under balance of payments? a. Export and import of goods b. Export and import of services c. Income receipts and payments d. Capital receipts and payments 2. A country is said to be in debt trap if_____________. a. It has to abide by the conditionality imposed by the International Monetary Fund b. It is required to borrow money to make interest payments on outstanding loans c. It has been refused loans or aid by creditors d. The World Bank charges a very high rate of interest on outstanding as well as new loans 3. Balance in capital account refer to the_____________. 57 a. Nation’s net exports of goods and services b. Nation’s net exports of financial claims c. Nation’s net exports of international official reserve assets CU IDOL SELF LEARNING MATERIAL (SLM)
d. Nation’s sum of net exports of goods, services and financial claims 4. Which of the following are the components of balance of payments? a. Financial capital transfer b. External loan and investment c. Foreign institutional investment d. All of these 5. Which of the following steps can be taken to reduce current account deficit in India? a. Setting the import quota limits b. reducing export duty on products c. Setting restrictions on repatriation of profits earned on foreign investment d. All of these Answers 1-(d), 2-(b), 3-(b), 4-(d), 5-(d) 3.10 REFERENCES Textbooks: Hodrick, R.J. (1987) The Empirical Evidence On The Efficiency Of Forward And Futures Foreign Exchange Markets. New York: Harwood Academic Cochrane, J.H. (2001) Asset Pricing. Princeton and Oxford: Princeton University Press. Newey, W. K. and West, K. D. (1987) A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix. Econometrica Journals: Korajczyk, R. A. and Viallet, C. J. (1992) Equity risk premia and the pricing of foreign exchange risk. Journal of International Economics, 33, 199-220. Giovannini, A. and Jorion P. (1987) Interest rates and risk premia in the stock market and in the foreign exchange market. Journal of International Money and Finance, 6, 107-124. Fisher, E. and Park, J. (1991) Testing purchasing power parity under the null hypothesis of cointegration. Economic Journal, 101, 1476-1484 58 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-4: INTERNATIONAL FINANCIAL MARKETS AND INSTITUTIONS STRUCTURE 4.0 Learning Objectives 4.1 Introduction 4.2 International Financial Institutions 4.2.1 African Development Bank 4.2.2 Asian Development Bank 4.2.3 Caribbean Development Bank 4.2.4 European Bank for Reconstruction & Development 4.2.5 Inter-American Development Bank 4.2.6 World Bank 4.2.7 Other IFIs & Institutions 4.3 International Bond Market 4.3.1 Domestic and Foreign Bonds 4.4 International Equity Markets 4.4.1 Market Structure and Trading Practices 4.4.2 Futures and Options on Foreign Exchange 4.5 Currency and Interest Rate Swaps 4.5.1 Interest Rate Swap 4.6 International Portfolio Investment 4.6.1 Advantages and Limitations 4.7 Summary 4.8 Keywords 4.9 Learning Activity 59 CU IDOL SELF LEARNING MATERIAL (SLM)
4.10 Unit End Questions 4.11 References 4.0 LEARNING OBJECTIVES After studying this unit, student will be able to: Explain international financial institutions. Explain international bond and equity market. Explain currency and interest rate swap. 4.1 INTRODUCTION In many parts of the world, international financial institutions (IFIs) play a major role in the social and economic development programs of nations with developing or transitional economies. This role includes advising on development projects, funding them and assisting in their implementation. Characterized by AAA-credit ratings and a broad membership of borrowing and donor countries, each of these institutions operates independently. All, however, share the following goals and objectives: to reduce global poverty and improve people's living conditions and standards. to support sustainable economic, social and institutional development. to promote regional cooperation and integration. IFIs achieve these objectives through loans, credits and grants to national governments. Such funding is usually tied to specific projects that focus on economic and socially sustainable development. IFIs also provide technical and advisory assistance to their borrowers and conduct extensive research on development issues. In addition to these public procurement opportunities, in which multilateral financing is delivered to a national government for the implementation of a project or program, IFIs are increasingly lending directly to non- sovereign guaranteed (NSG) actors. These include sub-national government entities, as well as the private sector. During recent years, IFIs have made considerable progress in harmonizing the way they procure goods and services. In many cases, they are now using similar policies and procedures, although the interpretation of these approaches may still vary at the level of the individual institution All IFIs use country strategy documents, as these are fundamental to establishing an IFI's lending priorities for a particular country. Based on the country's own vision for its long-term 60 CU IDOL SELF LEARNING MATERIAL (SLM)
development and written by the IFI, the document lays out the IFI's support program for the nation. 4.2 INTERNATIONAL FINANCIAL INSTITUTIONS 4.2.1 African Development Bank The African Development Bank (AfDB) is a multilateral development bank whose shareholders consist of 54 regional member countries in Africa, and 26 countries elsewhere in the world. The Bank is headquartered in Abidjan, Ivory Coast. The AfDB's authorized capital as of December 31, 2013 was 66.99 billion UA (Units of Account), or approximately C$108 billion. Bank group operations at the end of December 2013, amounted to UA 4.39 billion, an increase of about 3 percent compared to 2012. During the year, the Bank explored a number of options to boost business development, including whether to amend the Bank’s credit policy to allow low-income Regional Member Countries (RMCs) direct access to the ADB sovereign window under well stipulated conditions; scaling up public-private partnerships and co-financing opportunities; and exploring new financing sources, including equity, pension funds and the emerging economies. Most of the Bank's support is in the form of loans and grants for specific development projects and investment programs in the agriculture, energy, transport, water, sanitation, health, education and environment sectors. The AfDB also participates in the financing of private-sector projects in the region. 4.2.2 Asian Development Bank The Asian Development Bank (ADB) is a multilateral development bank dedicated to reducing poverty in the Asia-Pacific region by means of sustainable economic growth, social development and good governance. Established in 1966, it is owned by 67 member countries, mostly from the region. Canada is the second-largest shareholder of ADB's non-regional members and, overall, its seventh-largest shareholder. In 2013, ADB's operations totalled US$21.02 billion, (all dollar figures are in US dollars) of which $14.38 billion was financed by ADB's ordinary capital resources (OCR) and Special Funds resources and US$6.65 billion by financing partners. Sovereign operations, including official and technical assistance financing, totalled $16.48 billion. No sovereign operations, including financing, totalled $4.54 billion. Disbursements totalled $8.54 billion, a decrease of $49.98 million (0.58%) from 2012. The top five ADB borrowers in 2013, excluding co-financing, were India ($2.5 billion), People's Republic of China (PRC) ($2.1 billion), Pakistan ($1.5 billion), Indonesia ($1.0 billion) and the Philippines ($0.9 billion). Including co-financing, the five largest borrowers were India ($2.7 billion), Pakistan ($2.6 billion), PRC ($2.4 billion), Viet Nam ($2.1 billion), and Indonesia ($2.1 billion). 61 CU IDOL SELF LEARNING MATERIAL (SLM)
The ADB's main financial instruments are loans, technical assistance and grants. Most lending is in the public sector, primarily for large infrastructure projects. The Bank also provides technical assistance grants and loans to developing member countries so they can hire consultants to help identify and prepare development projects. ADB infrastructure lending is, for the most part, in the following sectors: transportation and urban development, including road, rail, marine port and airport projects. the environment, including water supply, waste treatment and environmental management. energy, including electric power, renewable energy, and oil and gas. agriculture and natural resources. information technology and telecommunications. 4.2.3 Caribbean Development Bank The Caribbean Development Bank (CDB), established in 1969, is a regional, multilateral development bank headquartered in Bridgetown, Barbados. The Bank's membership consists of 28 member countries, including 19 regional borrowing member countries. The regional members are the nine island states in the Organization of Eastern Caribbean States and the Bahamas, Barbados, Belize, Colombia, Cayman Islands, Guyana, Haiti (a member since 2007), Jamaica, Mexico, Trinidad and Tobago, Turks and Caicos Islands, and Venezuela. The non-regional members are Canada, China, Germany, Italy and the United Kingdom. However, the Bank is interested in expanding its non-borrowing membership and is currently in discussion about possible membership with at least four additional countries. The CDB has set itself a number of strategic objectives and works to achieve them by means of a set of well-defined corporate priorities. These priorities focus on the social and economic development of the Bank's borrowing member countries, in accordance with its overall goal of reducing poverty in those nations. The CDB's corporate priorities include the following: strengthening and modernizing public utilities and infrastructure that support economic development. improving the competitiveness of business enterprises, particularly for tourism and SMEs. increasing support for agriculture and rural development. supporting the creation of a modern, effective and accountable public sector capable of delivering valued public services. 62 CU IDOL SELF LEARNING MATERIAL (SLM)
promoting social partnerships and wider participation in national decision-making and consensus-building, including support for institutions in civil society and the private sector. improving the quality of, and opportunities for, access to education and training. promoting the mainstreaming of gender issues. promoting the building of social capital and social risk management. strengthening the capacities of regional institutions that promote regional economic integration. 4.2.4 European Bank for Reconstruction & Development The European Bank for Reconstruction and Development (EBRD) is the largest single investor in the region that extends from central Europe to central Asia. It is owned by 65 countries and two intergovernmental institutions and, despite its public-sector shareholders, it invests mainly in private enterprises, usually in cooperation with commercial partners The EBRD provides project financing for banks, industries and businesses, and funds both new ventures and investments in existing firms. It also works with publicly owned companies to support privatization, the restructuring of state-owned businesses and improvement of municipal services. In addition, the Bank also uses its close relationship with governments in the region to promote policies that can strengthen the business environment. The mandate of the EBRD stipulates that it must work only in countries that are committed to democratic principles. Respect for the environment is part of the strong corporate governance attached to all EBRD investments 4.2.5 Inter-American Development Bank The Inter-American Development Bank (IDB) is the largest regional development bank in Latin America and the Caribbean and is the region's major source of long-term financing and expertise for sustainable economic, social and institutional development. The IDB consists of 48 members, 26 of which are borrowing member countries. Canada holds 4 percent of the IDB's voting power and is the third-largest, non-borrowing shareholder after the United States (30 percent of votes) and Japan (5 percent of votes). The IDB's principal goal is poverty reduction and improved social equity. To attain these objectives, the Bank concentrates on four major development areas: the \"Opportunities for the Majority\" initiative. water and sanitation. sustainable energy and climate change. education and innovation. 63 CU IDOL SELF LEARNING MATERIAL (SLM)
The IDB provides support for public and private investment projects and for policy reforms, and helps countries cope with disasters or financial crises. It delivers this support in the form of loans, grants and guarantees, which it provides to national, provincial, state and municipal governments, and to autonomous public institutions. IDB-financed projects generate more than 12,000 contracts per year. In FY 2013 the Bank approved over US$14 billion in lending and grants. Current sector priorities for the IDB include: sustainable energy and climate change. Infrastructure. water and sanitation. education and innovation. environment. 4.2.6 World Bank With 189 member countries, the World Bank Group (WB) is the largest multilateral development bank (MDB) and the only MDB that is not bound to a specific region. Its mission is to help people help themselves and their environment by providing resources, sharing knowledge, building capacity and forging partnerships in the public and private sectors. The World Bank Group is currently involved in more than 1,800 projects in virtually every sector and developing country. In FY2016, the WB provided US$64.2 billion in loans, grants, equity investments, and guarantees to its members and to private businesses, for projects in developing countries worldwide. Its investments generated around 40,000 contracts, ranging in size from a few thousand dollars to multimillion-dollar expenditures for the delivery of a vast range of goods and services. The WB provides an extensive array of services and advice and facilitates private sector finance and investment in developing countries. The World Bank Group is made up of five institutions: International Bank for Reconstruction and Development (IBRD) International Development Association (IDA) International Finance Corporation (IFC) Multilateral Investment Guarantee Agency (MIGA) International Centre for Settlement of Investment Disputes (ICSID) IBRD and IDA are the World Bank Group's instruments for public lending. Together they are referred to as the World Bank (WB). IBRD provides low-interest loans to middle income and creditworthy poor countries. IDA is the world's largest source of interest-free loans and 64 CU IDOL SELF LEARNING MATERIAL (SLM)
grants to the poorest countries, many of which are in Africa. IDA's funds are replenished every three years by donor countries. Through IBRD and IDA the World Bank offers two basic types of loans and credits: development policy operations, which provide financing to support a country's policy and institutional reforms and investment operations, which countries can invest in development projects in a broad range of economic and social sectors. Investment projects generate procurement of goods, works and services and therefore, business opportunities. The procurement process for both institutions is the same. The WB's most important development themes include: Financial and Private Sector Development; Public Sector Governance; Rural Development; and Social Protection and Risk Management. 4.2.7 Other IFIs & Institutions The following international financial institutions (IFIs) play a smaller part in development funding than do the six main IFIs. They are very important sources of loans and grants for many countries, however, and can provide attractive procurement opportunities for businesses. Arab Fund for Economic and Social Development (AFESD) European Investment Bank (EIB) Global Environment Facility (GEF) Islamic Development Bank (IsDB) North American Development Bank (NADB) Organization of American States (OAS) 4.3 INTERNATIONAL BOND MARKET Unlike Equity and Money markets, there is no specific bond market to trade bonds. However, there are domestic and foreign participants who sell and buy bonds in various bond markets. A bond market is much larger than equity markets, and the investments are huge too. However, bonds pay on maturity and they are traded for short time before maturity in the markets. Bonds also have risks, returns, indices, and volatility factors like equity and money markets. The international bond market is composed of three separate types of bond markets: Domestic Bonds, Foreign Bonds, and Eurobonds. 4.3.1 Domestic and Foreign Bonds Domestic Bonds 65 CU IDOL SELF LEARNING MATERIAL (SLM)
Domestic bonds trade is a part of the international bond market. Domestic bonds are dealt in local basis and domestic borrowers issue the local bonds. Domestic bonds are bought and sold in local currency. Foreign Bonds In foreign bond market, bonds are issued by foreign borrowers. Foreign bonds normally use the local currency. The concerned local market authorities supervise the issuance and sale of foreign bonds. Foreign bonds are traded in the foreign bond markets. Some special characteristics of the foreign bond markets are − Issuers of bonds are usually governments and private sector utilities: It is a standard practice to underwrite and organize underwriting the risks. Issues are generally pledged by the retail and the institutional investors. In the past, Continental private banks and old merchant houses in London linked the investors with the issuers. Eurobonds Eurobonds are not sold in any specific national bond market. A group of multinational banks issue Eurobonds. A Eurobond of any currency is sold outside the nation that has the currency. A Eurobond in the US dollar would not be sold in the United States. The Euromarkets is the trading place of Eurobonds, Eurocurrency, Euro notes, Euro commercial Papers, and Euro equity. It is commonly an offshore market. International Bond market participants Bond market participants are either buyers (debt issuer) or sellers (institution) of funds and often both of these. Participants include − Institutional investors Governments Traders Individuals Since there is a specificity of individual bond issues, and a condition of lack of liquidity in case of many smaller issues, a significantly larger chunk of outstanding bonds is often held by institutions, such as pension funds, banks, and mutual funds. In the United States, the private individuals own about 10% of the market. 66 CU IDOL SELF LEARNING MATERIAL (SLM)
International Bond Market Size Amounts outstanding on the global bond market on March 2012 were about $100 trillion. That means in March 2012, the bond market was much larger than the global equity market that accounted for a market capitalization of around $53 trillion. The outstanding value of international bonds in 2011 was about $30 trillion. There was a total issuance of $1.2 trillion in the year, which was down by around one fifth of the 2010’s total. In 2012, the first half saw a strong start with issuance of over $800 billion. International Bond Market Volatility For the market participants owning bonds, collecting coupons and holding it till maturity, market volatility is not a matter to ponder over. The principal and interest rates are pre- determined for them. However, participants who trade bonds before maturity face many risks, including the most important one – changes in interest rates. When interest rates increase, the bond-value falls. Therefore, changes in bond prices are inversely proportional to the changes in interest rates. Economic indicators and paring with actual data usually contribute to market volatility. Only little price movement is seen after the release of \"in-line\" data. When economic release does not match the consensus view, a rapid price movement is seen in the market. Uncertainty is responsible for more volatility. Bond Investments Bonds have (generally) $1,000 increments. Bonds are priced as a percentage of par value. Many bonds have minimums imposed on them. Bonds pay interests at given intervals. Bonds with fixed coupons usually divide the coupon according to the payment schedule. Bonds with floating rate coupons have set calculation schedules. The rate is calculated just before the next payment. Zero-coupon bonds are issued at a deep discount, but they don’t pay interests. Bond interest is taxed, but in contrast to dividend income that receives favourable taxation rates, they are taxed as ordinary. Many government bonds are, however, exempt from taxation. Individual investors can participate through bond funds, closed-end funds, and unit- investment trusts offered by investment companies. Bond Indices A number of bond indices exist. The common American benchmarks include Barclays Capital Aggregate Bond Index, Citigroup BIG, and Merrill Lynch Domestic Master. 67 CU IDOL SELF LEARNING MATERIAL (SLM)
4.4 INTERNATIONAL EQUITY MARKETS International equity markets are an important platform for global finance. They not only ensure the participation of a wide variety of participants but also offer global economies to prosper. To understand the importance of international equity markets, market valuations and turnovers are important tools. Moreover, we must also learn how these markets are composed and the elements that govern them. Cross-listing, Yankee stocks, ADRs and GRS are important elements of equity markets. 4.4.1 Market Structure and Trading Practices The secondary equity markets provide marketability and share valuation. Investors or traders who purchase shares from the issuing company in the primary market may not desire to own them forever. The secondary market permits the shareholders to reduce the ownership of unwanted shares and lets the purchasers to buy the stock. The secondary market consists of brokers who represent the public buyers and sellers. There are two kinds of orders − Market order − A market order is traded at the best price available in the market, which is the market price. Limit order − A limit order is held in a limit order book until the desired price is obtained. There are many different designs for secondary markets. A secondary market is structured as a dealer market or an agency market. In a dealer market, the broker takes the trade through the dealer. Public traders do not directly trade with one another in a dealer market. The over the counter (OTC) market is a dealer market. In an agency market, the broker gets client’s orders via an agent. Not all stock market systems provide continuous trading. For example, the Paris Bourse was traditionally a call market where an agent gathers a batch of orders that are periodically executed throughout the trading day. The major disadvantage of a call market is that the traders do not know the bid and ask quotations prior to the call. Crowd trading is a form of non-continuous trade. In crowd trading, in a trading ring, an agent periodically announces the issue. The traders then announce their bid and ask prices and look for counterparts to a trade. Unlike a call market which has a common price for all trades, several trades may occur at different prices. Trading in International Equities 68 CU IDOL SELF LEARNING MATERIAL (SLM)
A greater global integration of capital markets became apparent for various reasons − First, investors understood the good effects of international trade. Second, the prominent capital markets got more liberalized through the elimination of fixed trading commissions. Third, internet and information and communication technology facilitated efficient and fair trading in international stocks. Fourth, the MNCs understood the advantages of sourcing new capital internationally. Cross-Listing Cross-listing refers to having the shares listed on one or more foreign exchanges. In particular, MNCs do this generally, but non-MNCs also cross-list. A firm may decide to cross-list its shares for the following reasons − Cross-listing provides a way to expand the investor’s base, thus potentially increasing its demand in a new market. Cross-listing offers recognition of the company in a new capital market, thus allowing the firm to source new equity or debt capital from local investors. Cross-listing offers more investors. International portfolio diversification is possible for investors when they trade on their own stock exchange. Cross-listing may be seen as a signal to investors that improved corporate governance is imminent. Cross-listing diminishes the probability of a hostile takeover of the firm via the broader investor base formed for the firm’s shares. Yankee Stock Offerings In 1990s, many international companies, including the Latin Americans, have listed their stocks on U.S. exchanges to prime market for future Yankee stock offerings, that is, the direct sale of new equity capital to U.S. public investors. One of the reasons is the pressure for privatization of companies. Another reason is the rapid growth in the economies. The third reason is the expected large demand for new capital after the NAFTA has been approved. American Depository Receipts (ADR) An ADR is a receipt that has a number of foreign shares remaining on deposit with the U.S. depository’s custodian in the issuer’s home market. The bank is a transfer agent for the ADRs that are traded in the United States exchanges or in the OTC market. ADRs offer various investment advantages. These advantages include − 69 CU IDOL SELF LEARNING MATERIAL (SLM)
ADRs are denominated in dollars, trade on a US stock exchange, and can be purchased through the investor’s regular broker. This is easier than purchasing and trading in US stocks by entering the US exchanges. Dividends received on the shares are issued in dollars by the custodian and paid to the ADR investor, and a currency conversion is not required. ADR trades clear in three business days as do U.S. equities, whereas settlement of underlying stocks vary in other countries. ADR price quotes are in U.S. dollars. ADRs are registered securities, and they offer protection of ownership rights. Most other underlying stocks are bearer securities. An ADR can be sold by trading the ADR to another investor in the US stock market, and shares can also be sold in the local stock market. ADRs frequently represent a set of underlying shares. This allows the ADR to trade in a price range meant for US investors. ADR owners can provide instructions to the depository bank to vote the rights. There are two types of ADRs: sponsored and unsponsored. Sponsored ADRs are created by a bank after a request of the foreign company. The sponsoring bank offers lots of services, including investment information and the annual report translation. Sponsored ADRs are listed on the US stock markets. New ADR issues must be sponsored. Unsponsored ADRs are generally created on request of US investment banking firms without any direct participation of the foreign issuing firm. Global Registered Shares (GRS) GRS are a share that are traded globally, unlike the ADRs that are receipts of the bank deposits of home-market shares and are traded on foreign markets. The GRS are fully transferrable — GRS purchased on one exchange can be sold on another. They usually trade in both US dollars and euros. The main advantage of GRS over ADRs is that all shareholders have equal status and the direct voting rights. The main disadvantage is the cost of establishing the global registrar and the clearing facility. Factors Affecting International Equity Returns Macroeconomic factors, exchange rates, and industrial structures affect international equity returns. Macroeconomic Factors 70 CU IDOL SELF LEARNING MATERIAL (SLM)
Solnik (1984) examined the effect of exchange rate fluctuations, interest rate differences, the domestic interest rate, and changes in domestic inflation expectations. He found that international monetary variables had only weak influence on equity returns. Asprem (1989) stated that fluctuations in industrial production, employment, imports, interest rates, and an inflation measure affect a small portion of the equity returns. Exchange Rates Adler and Simon (1986) tested the sample of foreign equity and bond index returns to exchange rate changes. They found that exchange rate changes generally had a variability of foreign bond indexes than foreign equity indexes. However, some foreign equity markets were more vulnerable to exchange rate changes than the foreign bond markets. Industrial Structure Roll (1992) concluded that the industrial structure of a country was important in explaining a significant part of the correlation structure of international equity index returns. In contrast, Eun and Resnick (1984) found that the correlation structure of international security returns could be better estimated by recognized country factors rather than industry factors. Heston and Rouwenhorst (1994) stated that “industrial structure explains very little of the cross-sectional difference in country returns volatility, and that the low correlation between country indices is almost completely due to country-specific sources of variation.” 4.4.2 futures and options on foreign exchange Depending on the selection of buying or selling the numerator or denominator of a currency pair, the derivative contracts are known as futures and options. There are various ways to earn a profit from futures and options, but the contract-holder is always obliged to certain rules when they go into a contract. There are some basic differences between futures and options and these differences are the ways through which investors can make a profit or a loss. Long and Short Currency Trading Currency futures and options are derivative contracts. These contracts derive their own values from utilization of the underlying assets, which, in this case, are currency pairs. Currencies are always traded in pairs. For example, the Euro and U.S. Dollar pair is expressed as EUR/USD. When someone buys this pair, they are said to be going long (buying) with the numerator, or the base, currency, which is the Euro; and thereby selling the denominator (quote) currency, which is the Dollar. 71 CU IDOL SELF LEARNING MATERIAL (SLM)
When someone sells the pair, it is selling the Euro and buying the Dollar. When the long currency appreciates against the short currency, people make money. Foreign Currency Futures Currency futures make the buyer of the contract to buy the long currency (numerator) by paying with the short currency (denominator) for it. The seller of a contract has the reverse obligation. The obligation of the contact is usually due on the expiration date of the future. The ratio of currencies, bought and sold, is settled in advance between the parties involved. People make a profit or loss depending on the gap between the settled price and the real, effective price on the date of expiration. Margins are deposited for the futures trades – cash is the important part that serves as the performance bond to make sure that both parties are obliged to fulfil their obligations. Options on Currency Pairs The party that purchases a currency pair call option may also decide to settle for an execution or to sell out the option on or before the date of expiration. There is a strike price of the option that shows a particular exchange ratio for the given pair of currencies. When the actual price of the currency pair is more than the strike price, the call holder earns a profit. It is said to execute the option by buying the base and selling the quote at a profitable term. A put buyer always bets on the denominator or quote currency appreciating against the numerator or the base currency. Options on Currency Futures Instead of having to buy and sell currency pairs, options in a currency future offers the contract-holders the right, but not an obligation, to purchase a futures contract on the particular currency pair. The strategy in such a case is that the option buyer can profit from the futures market without having to put down any margin in the contract. When the futures contract appreciates, the call or contract holder can just sell the call for a profit. The call holder does not need to buy the underlying futures contract. A put buyer can easily earn a profit if the futures contract loses value. Difference between Options and Futures The basic and most prominent difference between options and futures is related with the obligations they create on part of the buyers and sellers. 72 CU IDOL SELF LEARNING MATERIAL (SLM)
An option offers the buyer the basic right, but not an obligation, to buy (or sell) a certain kind of asset at a decided or settled price, which is specific at any time while the contract is alive. On the other hand, a futures contract offers the buyer the obligation to buy a specific asset, and the seller the obligation to sell and deliver that asset on a specific future date, provided the holder does not close the position prior to expiration. An investor can go in into a futures contract with no upfront cost apart from commissions, whereas purchasing an options position does not need to pay a premium. While comparing the absence of any upfront cost of futures, the premium of the option can be considered as the fee for not being obligated to purchase the underlying asset in the case of an adverse movement in prices. The premium paid on the option is the maximum value a purchaser can lose. Another important difference between futures and options is the size of the given or underlying position. Usually, the underlying position is considerably bigger in case of futures contracts. Moreover, the obligation to purchase or sell this given amount at a settled price turns the futures a bit riskier for an inexperienced investor. The final and one of the prominent differences between futures and options is the way the gains or earnings are obtained by the parties. In case of an option, the gains can be realized in the following three ways −Exercising the option when it is deep in the money; Going to the market and taking the opposite position or Waiting until expiry and gaining the gap between the asset and the strike prices. On the other hand, gains on the futures positions are naturally 'marked to market' every day. This means that the change in the price of the positions is assigned to the futures accounts of the parties at the end of every trading day. However, a futures call-holder can also realize gains by going to the market and opting for the opposite position 4.5 CURRENCY AND INTEREST RATE SWAPS A currency swap contract (also known as a cross-currency swap contract) is a derivative contract between two parties that involves the exchange of interest payments, as well as the exchange of principal amounts in certain cases, that are denominated in different currencies. Although currency swap contracts generally imply the exchange of principal amounts, some swaps may require only the transfer of the interest payments. A currency swap consists of two streams (legs) of fixed or floating interest payments denominated in two currencies. The transfer of interest payments occurs on predetermined dates. In addition, if the swap counterparties previously agreed to exchange principal amounts, those amounts must also be exchanged on the maturity date at the same exchange rate. 73 CU IDOL SELF LEARNING MATERIAL (SLM)
Currency swaps are primarily used to hedge potential risks associated with fluctuations in currency exchange rates or to obtain lower interest rates on loans in a foreign currency. The swaps are commonly used by companies that operate in different countries. For example, if a company is conducting business abroad, it would often use currency swaps to retrieve more favourable loan rates in their local currency, as opposed to borrowing money from a foreign bank. For example, a company may take a loan in the domestic currency and enter a swap contract with a foreign company to obtain a more favourable interest rate on the foreign currency that is otherwise is unavailable. In order to understand the mechanism behind currency swap contracts, let’s consider the following example. Company A is a US-based company that is planning to expand its operations in Europe. Company A requires €850,000 to finance its European expansion. On the other hand, Company B is a German company that operates in the United States. Company B wants to acquire a company in the United States to diversify its business. The acquisition deal requires US$1 million in financing. Neither Company A nor Company B holds enough cash to finance their respective projects. Thus, both companies will seek to obtain the necessary funds through debt financing. Company A and Company B will prefer to borrow in their domestic currencies (that can be borrowed at a lower interest rate) and then enter into the currency swap agreement with each other. The currency swap between Company A and Company B can be designed in the following manner. Company A obtains a credit line of $1 million from Bank A with a fixed interest rate of 3.5%. At the same time, Company B borrows €850,000 from Bank B with the floating interest rate of 6-month LIBOR. The companies decide to create a swap agreement with each other. According to the agreement, Company A and Company B must exchange the principal amounts ($1 million and €850,000) at the beginning of the transaction. In addition, the parties must exchange the interest payments semi-annually. Company A must pay Company B the floating rate interest payments denominated in euros, while Company B will pay Company A the fixed interest rate payments in US dollars. On the maturity date, the companies will exchange back the principal amounts at the same rate ($1 = €0.85). Types of Currency Swap Contracts 74 CU IDOL SELF LEARNING MATERIAL (SLM)
Similar to interest rate swaps, currency swaps can be classified based on the types of legs involved in the contract. The most commonly encountered types of currency swaps include the following: Fixed vs. Float: One leg of the currency swap represents a stream of fixed interest rate payments while another leg is a stream of floating interest rate payments. Float vs. Float (Basis Swap): The float vs. float swap is commonly referred to as basis swap. In a basis swap, both swaps’ legs both represent floating interest rate payments. Fixed vs. Fixed: Both streams of currency swap contracts involve fixed interest rate payments. 4.5.1 Interest Rate Swap An interest rate swap is a type of a derivative contract through which two counterparties agree to exchange one stream of future interest payments for another, based on a specified principal amount. In most cases, interest rate swaps include the exchange of a fixed interest rate for a floating rate. Similar to other types of swaps, interest rate swaps are not traded on public exchanges – only over the counter (OTC). Fixed Interest Rate vs. Floating Interest Rate Interest rate swaps usually involve the exchange of one stream of future payments based on a fixed interest rate for a different set of future payments that are based on a floating interest rate. Thus, understanding the concepts of fixed-rate loans vs. floating rate loans is crucial to understanding interest rate swaps. A fixed interest rate is an interest rate on a debt or other security that remains unchanged during the entire term of the contract, or until the maturity of the security. In contrast, floating interest rates fluctuate over time, with the changes in interest rate usually based on an underlying benchmark index. Floating interest rate bonds are frequently used in interest rate swaps, with the bond’s interest rate based on the London Interbank Offered Rate (LIBOR). Briefly, the LIBOR rate is an average interest rate that the leading banks participating in the London interbank market charge each other for short-term loans. The LIBOR rate is a commonly used benchmark for determining other interest rates that lenders charge for various types of financing. Basically, interest rate swaps occur when two parties – one of which is receiving fixed-rate interest payments and the other of which is receiving floating-rate payments – mutually agree that they would prefer the other party’s loan arrangement over their own. The party being paid based on a floating rate decides that they would prefer to have a guaranteed fixed rate, 75 CU IDOL SELF LEARNING MATERIAL (SLM)
while the party that is receiving fixed-rate payments believes that interest rates may rise, and to take advantage of that situation if it occurs – to earn higher interest payments – they would prefer to have a floating rate, one that will rise if and when there is a general uptrend in interest rates. In an interest rate swap, the only things that actually get swapped are the interest payments. An interest rate swap, as previously noted, is a derivative contract. The parties do not take ownership of the other party’s debt. Instead, they merely make a contract to pay each other the difference in loan payments as specified in the contract. They do not exchange debt assets, nor pay the full amount of interest due on each interest payment date – only the difference due as a result of the swap contract. A good interest rate swap contract clearly states the terms of the agreement, including the respective interest rates each party is to be paid by the other party, and the payment schedule (e.g., monthly, quarterly, or annually). In addition, the contract states both the start date and maturity date of the swap agreement, and that both parties are bound by the terms of the agreement until the maturity date. Note that while both parties to an interest rate swap get what they want – one party gets the risk protection of a fixed rate, while the other gets the exposure to potential profit from a floating rate – ultimately, one party will reap a financial reward while the other sustains a financial loss. If interest rates rise during the term of the swap agreement, then the party receiving the floating rate will profit and the party receiving the fixed rate will incur a loss. Conversely, if interest rates decline, then the party getting paid the guaranteed fixed rate return will benefit, while the party receiving payments based on a floating rate will see the amount of the interest payments it receives go down. Risks of Interest Rate Swaps Interest rate swaps are an effective type of derivative that may be of benefit to both parties involved in using them, in a number of different ways. However, swap agreements also come with risks. One notable risk is that of counterparty risk. Because the parties involved are typically large companies or financial institutions, counterparty risk is usually relatively low. But if it should happen that one of the two parties’ defaults and is unable to meet its obligations under the interest rate swap agreement, then it would be difficult for the other party to collect. It would have an enforceable contract but following the legal process might well be a long and twisting road. Just dealing with the unpredictable nature of floating interest rates also adds some inherent risk for both parties to the agreement. 76 CU IDOL SELF LEARNING MATERIAL (SLM)
4.6 INTERNATIONAL PORTFOLIO INVESTMENT An international portfolio appeals to investors who want to diversify their assets by moving away from a domestic-only portfolio. This type of portfolio can carry increased risks due to potential economic and political instability in some emerging markets, there also is the risk that a foreign market's currency will slip in value against the U.S. dollar. The worst of these risks can be reduced by offsetting riskier emerging-market stocks with investments in industrialized and mature foreign markets. Or, the risks can be offset by investing in the stocks of American companies that are showing their best growth in markets abroad. The most cost-effective way for investors to hold an international portfolio is to buy an exchange-traded fund (ETF) that focuses on foreign equities, such as the Vanguard FTSE Developed Markets ETF or the Schwab International Equity ETF. Risky and Less Risky Choices Over the recent past, the growth of the economies of China and India greatly exceeded those of the U.S. That created a rush to invest in the stocks of those countries. Both are still growing fast, but an investor in the stocks of either nation now would have to do some research to find stocks that have not already seen their best days. The search for new fast-growing countries has led to some winners and losers. Not long ago, investors going for fast growth were looking to the CIVETS nations. They were Colombia, Indonesia, Vietnam, Egypt, Turkey, and South Africa. Not all of those countries would still be on any investor's list of promising economies. Meanwhile, in the more industrialized world, there are names that will be familiar to any American investor and they are available, directly or through mutual funds and ETFs. For example, the biggest holdings in Vanguard's Total International Stock Fund Index are China's Alibaba, Switzerland's Nestle, China's Tencent Holdings, South Korea's Samsung, and Taiwan Semiconductor. It's worth noting that, as of early 2020, only 22.50% of the fund's holdings were invested in emerging markets, with 41.50% in European assets and the rest spread around the globe. 4.6.1 Advantages and Limitations International Portfolio Advantages May Reduce Risk: Having an international portfolio can be used to reduce investment risk. If U.S. stocks underperform, gains in the investor’s international holdings can smooth out returns. For example, an investor may split a portfolio evenly between foreign and domestic holdings. The domestic portfolio may decline by 10% while the international portfolio could 77 CU IDOL SELF LEARNING MATERIAL (SLM)
advance 20%, leaving the investor with an overall net return of 10%. Risk can be reduced further by holding a selection of stocks from developed and emerging markets in the international portfolio. Diversifies Currency Exposure: When investors buy stocks for an international portfolio, they are also effectively buying the currencies in which the stocks are quoted. For example, if an investor purchases a stock that is listed on the London Stock Exchange, the value of that stock may rise and fall with the British pound. If the U.S. dollar falls, the investor's international portfolio helps to neutralize currency fluctuations. Market Cycle Timing: An investor with an international portfolio can take advantage of the market cycles of different nations. For instance, an investor may believe U.S. stocks and the U.S. dollar are overvalued and may look for investment opportunities in developing regions, such as Latin America and Asia, that are believed to benefit from capital inflow and demand for commodities. International Portfolio Limitations Political and Economic Risk: Many developing countries do not have the same level of political and economic stability that the United States does. This increases risk to a level that many investors don't feel they can tolerate. For example, a political coup in a developing country may result in its stock market declining by 40%. Increased Transaction Costs: Investors typically pay more in commission and brokerage charges when they buy and sell international stocks, which reduces their overall returns. Taxes, stamp duties, levies, and exchange fees may also need to be paid, which dilute gains further. Many of these costs can be significantly reduced or eliminated by gaining exposure to an international portfolio using ETFs or mutual funds. 4.7 SUMMARY The most familiar World Bank of all the international financial organisations was formally known as the International Bank for Reconstruction and Development (IBRD). The World Bank has two affiliates that are legally and financially distinct entities, the International Development Association (IDA) and the International Finance Corporation (IFC). Exhibit 1 provides a comparison among IBRD, IDA and IFC in terms of their objectives, member countries, lending terms, lending qualifications as well as other details. All three organisations have the same central goals: to promote economic and social progress in poor or developing countries by helping raise standards of living and productivity to the point at which development becomes self-sustaining. 78 CU IDOL SELF LEARNING MATERIAL (SLM)
Toward this common objective, the World Bank, IDA and IFC have three interrelated functions, and these are to lend funds, to provide advice and to serve as a catalyst in order to stimulate investments by others. The foreign bond market includes the bonds that are sold in a country, using that country’s currency, but issued by a non-domestic borrower. For example, the Yankee bond market is the U.S. dollar version of this market. This is because they are sold in the U.S. using the dollar, but issued by a syndicate outside of the U.S. Other examples include the Samurai market and the Bulldog market. The Samurai market is Yen-denominated bonds issued in Japan but by non-Japanese borrowers. The Bulldog market is pound-denominated bonds issued in the U.K. by non-British groups. Equity markets are meeting points for issuers and buyers of stocks in a market economy. Equity markets are a method for companies to raise capital and investors to own a piece of a company. Stocks can be issued in public markets or private markets. Depending on the type of issue, the venue for trading changes. Most equity markets are stock exchanges that can be found around the world, such as the New York Stock Exchange and the Tokyo Stock Exchange. 4.8 KEYWORDS World Bank: The World Bank is an international financial institution that provides loans and grants to the governments of low- and middle-income countries for the purpose of pursuing capital projects. Equity: It represents the value that would be returned to a company's shareholders if all of the assets were liquidated and all of the company's debts were paid off. We can also think of equity as a degree of residual ownership in a firm or asset after subtracting all debts associated with that asset. Eurobonds: It is a debt instrument that's denominated in a currency other than the home currency of the country or market in which it is issued. Eurobonds are important because they help organizations raise capital while having the flexibility to issue them in another currency. Stock market: A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks (also called shares), which represent ownership claims on businesses; these may include securities listed on a public stock exchange, as well as stock that is only 79 CU IDOL SELF LEARNING MATERIAL (SLM)
traded privately, such as shares of private companies which are sold to investors through equity crowdfunding platforms. International Development Association: It is an international financial institution which offers concessional loans and grants to the world's poorest developing countries. The IDA is a member of the World Bank Group and is headquartered in Washington, D.C. in the United States. 4.9 LEARNING ACTIVITY Discuss below mentioned projects funded by World Bank in INDIA 1. World Bank and Government of India Sign $250 Million Agreement to Boost Rural Incomes Across 13 States in India ……………………………………………………………………………………………… ……………………………………………………………………………………………… 2. World Bank Signs Agreement to Provide Additional Funding of $137 million to Enhance Dam Safety in India ……………………………………………………………………………………………… ……………………………………………………………………………………………… 4.10 UNIT END QUESTIONS 80 A. Descriptive Questions Short Questions 1. Explain International Financial Institutions. 2. Explain International Bond Market. 3. Explain Foreign and Domestic Bonds. 4. Enumerate the important purposes of the World Bank. 5. What are the objectives of the Asian Development Bank? Long Questions 1. Describe advantages and limitations of International Portfolio Investment. 2. Explain Futures and Options on Foreign exchange. 3. Explain World Bank and its objectives. 4. Explain Market structure and trading practices. 5. Explain different Bank’s under International Financial Institutions. B. Multiple Choice Questions CU IDOL SELF LEARNING MATERIAL (SLM)
1. Largest number of buyers and sellers, greater the a. Liquidity b. Speculation c. Hedging d. Forward rate 2. Exchange rate entail delivery of trade currency within two business days know as a. Forward rate b. Future rate c. Spot rate d. Bid rate 3. Differences in nominal interest rates are removed in exchange rate is a. Fisher effect b. Leontief paradox. c. Combined equilibrium theory. d. Purchasing power parity 4. Eurobonds are admired because a. They are less risky than traditional bonds b. European companies are considered very stable c. Of absence of government regulation d. They are always denominated in euro 5. Objective of international capital market is a. Reducing cost of money to borrowers b. Reducing investor risk c. Expanding money supply for borrowers d. All of these Answers 1-(a), 2-(c), 3-(a), 4-(c), 5-(d) 4.11 REFERENCES Textbooks: Madhu Vij: Multinational Financial Management, Excel Books, 2001. Apte, PG: International Finance, TMH, ed. 2001. Kanneth J. Thygorson: Financial Market Institution, John Willey, 1998. 81 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-5: FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT I STRUCTURE 5.0 Learning Objectives 5.1 Introduction 5.2 Management of Economic Exposure 5.2.1 Techniques to Reduce Economic Exposure 5.3 Management of Transaction Exposure 5.3.1 Financial Techniques to Manage Transaction Exposure 5.4 Operating Exposure 5.5 Summary 5.6 Keywords 5.7 Learning Activity 5.8 Unit End Questions 5.9 References 5.0 LEARNING OBJECTIVES After studying this unit, student will be able to: Explain economic exposure. Explain technics to reduce economic exposure. Explain management of transaction exposure. 5.1 INTRODUCTION Economic indicators are reports released by the government or a private organization that detail a country’s economic performance. Economic reports are the means by which a country’s economic health is directly measured but do remember that a great deal of factors and policies will affect a nation’s economic performance. 82 CU IDOL SELF LEARNING MATERIAL (SLM)
These reports are released at scheduled times, providing the market with an indication of whether a nation’s economy has improved or declined. The effects of these reports are comparable to how earnings reports, SEC filings and other releases may affect securities. In forex, as in the stock market, any deviation from the norm can cause large price and volume movements. You may recognize some of these economic reports, such as the unemployment numbers, which are well publicized. Others, like housing stats, receive little coverage. However, each indicator serves a particular purpose, and can be useful. Here we outline major reports, some of which are comparable to particular fundamental indicators used by equity investors: Gross National Product (GNP) The Gross National Product measures the economic performance of the whole economy. This indicator consists, at macro scale, of the sum of consumption spending, investment spending, government spending, and net trade. The gross national product refers to the sum of all goods and services produced by United States residents, either in the United States or abroad. Gross Domestic Product (GDP) The Gross Domestic Product (GDP) refers to the sum of all goods and services produced in the country, either by domestic or foreign companies. The differences between the two are nominal in the case of the economy of the United States. GDP figures are more popular outside the United States. In order to make it easier to compare the performances of different economies, the United States also releases GDP figures. Consumption Spending Consumption is made possible by personal income and discretionary income. The decision by consumers to spend or to save is psychological in nature. Consumer confidence is also measured as an important indicator of the propensity of consumers who have discretionary income to switch from saving to buying. Investment Spending Investment – or gross private domestic spending – consists of fixed investment and inventories. Government Spending Government spending is very influential in terms of both sheer size and its impact on other economic indicators, due to special expenditures. For instance, United States military expenditures had a significant role in total U.S. employment until 1990. The defence cuts that occurred at the time increased unemployment figures in the short run. Net Trade Net trade is another major component of the GNP. Worldwide internationalization and the economic and political developments since 1980 have had a sharp impact on the United States’ ability to compete overseas. 83 CU IDOL SELF LEARNING MATERIAL (SLM)
Industrial Production Industrial production consists of the total output of a nation’s plants, utilities, and mines. From a fundamental point of view, it is an important economic indicator that reflects the strength of the economy, and by extrapolation, the strength of a specific currency. Therefore, foreign exchange traders use this economic indicator as a potential trading signal. Capacity Utilization Capacity utilization consists of total industrial output divided by total production capability. The term refers to the maximum level of output a plant can generate under normal business conditions. In general, capacity utilization is not a major economic indicator for the foreign exchange market. However, there are instances when its economic implications are useful for fundamental analysis. A “normal” figure for a steady economy is 81.5 percent. If the figure reads 85 percent or more, the data suggests that the industrial production is overheating, that the economy is close to full capacity. High-capacity utilization rates precede inflation, and expectation in the foreign exchange market is that the central bank will raise interest rates in order to avoid or fight inflation. Factory Orders Factory orders refer to the total of durable and nondurable goods orders. Nondurable goods consist of food, clothing, light industrial products, and products designed for the maintenance of durable goods. Durable goods orders are discussed separately. The factory orders indicator has limited significance for foreign exchange traders. Durable Goods Orders Durable goods orders consist of products with a life span of more than three years. Examples of durable goods are autos, appliances, furniture, jewellery, and toys. They are divided into four major categories: primary metals, machinery, electrical machinery, and transportation. In order to eliminate the volatility pertinent to large military orders, the indicator includes a breakdown of the orders between defence and nondefense. Inflation Indicators The rate of inflation is the widespread rise in prices. Therefore, gauging inflation is a vital macroeconomic task. Traders watch the development of inflation closely, because the method of choice for fighting inflation is raising the interest rates, and higher interest rates tend to support the local currency. Moreover, the inflation rate is used to “deflate” nominal interest rates and the GNP or GDP to their real values in order to achieve a more accurate measure of the data. The values of the real interest rates or real GNP and GDP are of the utmost importance to the money managers and traders of international financial instruments, allowing them to accurately compare opportunities worldwide. 84 CU IDOL SELF LEARNING MATERIAL (SLM)
To measure inflation traders use following economic tools: Producer Price Index (PPI): Producer price index is compiled from most sectors of the economy, such as manufacturing, mining, and agriculture. The sample used to calculate the index contains about 3400 commodities. The weights used for the calculation of the index for some of the most important groups are food - 24 percent; fuel - 7 percent; autos - 7 percent; and clothing - 6 percent. Unlike the CPI, the PPI does not include imported goods, services, or taxes. Consumer Price Index (CPI): Consumer price index reflects the average change in retail prices for a fixed market basket of goods and services. The CPI data is compiled from a sample of prices for food, shelter, clothing, fuel, transportation, and medical services that people purchase on daily basis. The weights attached for the calculation of the index to the most important groups are housing - 38 percent; food - 19 percent; fuel - 8 percent; and autos - 7 percent. Gross National Product Implicit Deflator: Gross national product implicit deflator is calculated by dividing the current dollar GNP figure by the constant dollar GNP figure. Gross Domestic Product Implicit Deflator: Gross domestic product implicit deflator is calculated by dividing the current dollar GDP figure by the constant dollar GDP figure. Both the GNP and GDP implicit deflators are released quarterly, along with the respective GNP and GDP figures. The implicit deflators are generally regarded as the most significant measure of inflation. Commodity Research Bureau’s Futures Index (CRB Index): The Commodity Research Bureau’s Futures Index makes watching for inflationary trends easier. The CRB Index consists of the equally weighted futures prices of 21 commodities. 5.2 MANAGEMENT OF ECONOMIC EXPOSURE Economic exposure is the toughest to manage because it requires ascertaining future exchange rates. However, economists and investors can take the help of statistical regression equations to hedge against economic exposure. There are various techniques that companies can use to hedge against economic exposure. Five such techniques have been discussed in this chapter. It is difficult to measure economic exposure. The company must accurately estimate cash flows and the exchange rates, as transaction exposure has the power to alter future cash flows 85 CU IDOL SELF LEARNING MATERIAL (SLM)
while fluctuation of the currency exchange rates occurs. When a foreign subsidiary gets positive cash flows after it corrects for the currency exchange rates, the subsidiary’s net transaction exposure is low. Economic exposure, also sometimes called operating exposure, is a measure of the change in the future cash flows of a company as a result of unexpected changes in foreign exchange rates (FX). Economic exposure cannot be easily mitigated because it is caused by the unpredictable volatility of currency exchange rates. Increasing globalization and economic relations between countries make economic exposure a source of risk almost for all companies and consumers. Effects of Economic Exposure Since unanticipated rate changes affect a company’s cash flows, economic exposure can result in serious negative consequences for the company’s operations and profitability. A stronger foreign currency may make production inputs more expensive, causing decreased profits. Furthermore, economic exposure can undermine the company’s competitive position. For example, if the local currency strengthens, local manufacturers will face more intense competition from foreign manufacturers whose products will become cheaper. Mitigation of Economic Exposure There are two main strategies to mitigate economic exposure: operational and currency risk mitigation. Operational Strategy Operational strategy is aiming to adjust or change the current company’s operations to prevent possible risks associated with future currency fluctuations. The operational mitigation strategy may involve the following steps: Diversification of production facilities and markets of products: The expansion of operating facilities and sales to a mixture of markets. Sourcing flexibility: A company considers the acquisition of its key inputs from different regions. Diversification of financing: A company may seek financing from capital markets in different regions. Currency Risk Mitigation Strategy 86 CU IDOL SELF LEARNING MATERIAL (SLM)
The main goal of the currency risk mitigation strategy is to minimize or eliminate economic exposure through hedging. Some of the currency risk mitigation strategies are: Matching Currency Flows: A company matches the foreign currency outflows with foreign currency inflows. Currency Risk-sharing Agreements: A company enters into a currency risk-sharing agreement with its supplier/customer. According to this agreement, the sale/purchase contract is executed at a predetermined price. Thus, both parties share the potential currency risk. Currency Swaps: A company can use currency swaps to obtain the required cash flows in foreign currency at the desired exchange rate. The counterparties will exchange the interest and principal in one currency for the same in another currency at fixed dates until the maturity of the swap. Regression Equation Analysts can measure economic exposure by using a simple regression equation, shown in Equation 1. P = α + β.S + ε (1) Suppose the United States is the home country and Europe are the foreign country. In the equation, the price, P, is the price of the foreign asset in dollars while S is spot exchange rate, expressed as Dollars per Euro. The Regression equation estimates the connection between price and the exchange rate. The random error term (ε) equals zero when there is a constant variance while (α) and (β) are the estimated parameters. Now, we can say that this equation will give a straight line between P and S with an intercept of (α) and a slope of (β). The parameter (β) is expressed as the Forex Beta or Exposure Coefficient. β indicates the level of exposure. We calculate (β) by using Equation 2. Covariance estimates the fluctuation of the asset's price to the exchange rate, while the variance measures the variation of the exchange rate. We see that two factors influence (β): one is the fluctuations in the exchange rate and the second is the sensitivity of the asset's price to changes in the exchange rate. β = Covariance (P,S)/Variance (S) Economic Exposure – A Practical Example Suppose you own and rent out a condominium in Europe. A property manager recruited by you can vary the rent, making sure that someone always rents and occupies the property. 87 CU IDOL SELF LEARNING MATERIAL (SLM)
Now, assume you receive € 1,800, € 2,000, or € 2,200 per month in cash for rent, as shown in Table 1. Let’s say each rent is a state, and as is obvious, any of the rents have a 1/3 probability. The forecasted exchange rate for each state, which is S has also been estimated. We can now calculate the asset's price, P, in U.S. dollars by multiplying that state's rent by the exchange rate State Probability Rent (Euro) Exchange Rate (S) Rent (P) 1 1/3 €1,800 $1/1.00 E $1,800 2 1/3 €2,000 $1.25/1.00 E $1.25/1.00 E 3 1/3 €2,200 $1.50/1.00 E $3,300 Table 1 – Renting out your Condo for Case 1 In this case, we calculate 800 for (β). Positive (β) shows that your cash rent varies with the fluctuating exchange rate, and there is a potential economic exposure. A special factor to notice is that as the Euro appreciated, the rent in Dollars also increased. A forward contract for € 800 at a contract price of $1.25 per €1 can be bought to hedge against the exchange rate risk. (β) is the correct hedge for Case 1. The Forward Price is the exchange rate in the forward contract and it is the spot exchange rate for a state. Suppose we bought a forward contract with a price of $1.25 per euro. If State 1 occurs, the Euro depreciates against the U.S. dollar. By exchanging € 800 into Dollars, we gain $200, and we compute it in the Yield column in Table 2. If State 2 occurs, the forward rate equals the spot rate, so we neither gain nor lose anything. State 3 shows that the Euro appreciated against the U.S. dollar, so we lose $200 on the forward contract. We know that each state is equally likely to occur, so we, on average, break even by purchasing the forward contract. 5.2.1 Techniques to Reduce Economic Exposure International firms can use five techniques to reduce their economic exposure − A company can reduce its manufacturing costs by taking its production facilities to low-cost countries. For example, the Honda Motor Company produces automobiles in 88 CU IDOL SELF LEARNING MATERIAL (SLM)
factories located in many countries. If the Japanese Yen appreciates and raises Honda's production costs, Honda can shift its production to its other facilities, scattered across the world. A company can outsource its production or apply low-cost labour. Foxconn, a Taiwanese company, is the largest electronics company in the world, and it produces electronic devices for some of the world's largest corporations. A company can diversify its products and services and sell them to clients from around the world. For example, many U.S. corporations produce and market fast food, snack food, and sodas in many countries. The depreciating U.S. dollar reduces profits inside the United States, but their foreign operations offset this. A company can continually invest in research and development. Subsequently, it can offer innovative products at a higher price. For instance, Apple Inc. set the standard for high-quality smartphones. When dollar depreciates, it increases the price. A company can use derivatives and hedge against exchange rate changes. For example, Porsche completely manufactures its cars within the European Union and exports between 40% to 45% of its cars to the United States. Porsche financial managers hedged or shorted against the U.S. dollar when the U.S. dollar depreciated. Some analysts estimated that about 50% of Porsche's profits arose from hedging activities. 5.3 MANAGEMENT OF TRANSACTION EXPOSURE There are various techniques available for managing transactional exposure. The objective here is to shun the transactions from exchange rate risks. In this chapter, we will discuss the four major techniques that can be used to hedge transactional exposure. In addition, we will also discuss some operational techniques to manage transactional exposure. 5.3.1 Financial Techniques to Manage Transaction Exposure The main feature of a transaction exposure is the ease of identifying its size. Additionally, it has a well-defined time interval associated with it that makes it extremely suitable for hedging with financial instruments. The most common methods for hedging transaction exposures are − Forward Contracts − If a firm has to pay (receive) some fixed amount of foreign currency in the future (a date), it can obtain a contract now that denotes a price by which it can buy (sell) the foreign currency in the future (the date). This removes the uncertainty of future home currency value of the liability (asset) into a certain value. Futures Contracts − These are similar to forward contracts in function. Futures contracts are usually exchange traded and they have standardized and limited contract sizes, maturity 89 CU IDOL SELF LEARNING MATERIAL (SLM)
dates, initial collateral, and several other features. In general, it is not possible to exactly offset the position to fully eliminate the exposure. Money Market Hedge − Also called as synthetic forward contract, this method uses the fact that the forward price must be equal to the current spot exchange rate multiplied by the ratio of the given currencies' riskless returns. It is also a form of financing the foreign currency transaction. It converts the obligation to a domestic-currency payable and removes all exchange risks. Options − A foreign currency option is a contract that has an upfront fee, and offers the owner the right, but not an obligation, to trade currencies in a specified quantity, price, and time period. The major difference between an option and the hedging techniques mentioned above is that an option usually has a nonlinear payoff profile. They permit the removal of downside risk without having to cut off the profit from upside risk. The decision of choosing one among these different financial techniques should be based on the costs and the penultimate domestic currency cash flows (which is appropriately adjusted for the time value) based upon the prices available to the firm. Transaction Hedging Under Uncertainty Uncertainty about either the timing or the existence of an exposure does not provide a valid argument against hedging. Uncertainty about Transaction Date Lots of corporate treasurers promise to engage themselves to an early protection of the foreign-currency cash flow. The key reason is that, even if they are sure that a foreign currency transaction will occur, they are not quite sure what the exact date of the transaction will be. There may be a possible mismatch of maturities of transaction and hedge. Using the mechanism of rolling or early unwinding, financial contracts create the probability of adjusting the maturity on a future date, when appropriate information becomes available. Uncertainty About Existence of Exposure Uncertainty about existence of exposure arises when there is an uncertainty in submitting bids with prices fixed in foreign currency for future contracts. The firm will pay or receive foreign currency when a bid is accepted, which will have denominated cash flows. It is a kind of contingent transaction exposure. In these cases, an option is ideally suited. Under this kind of uncertainty, there are four possible outcomes. The following table provides a summary of the effective proceeds to the firm per unit of option contract which is equal to the net cash flows of the assignment. 90 CU IDOL SELF LEARNING MATERIAL (SLM)
Operational Techniques for Managing Transaction Exposure Operational strategies having the virtue of offsetting existing foreign currency exposure can also mitigate transaction exposure. These strategies include − Risk Shifting − The most obvious way is to not have any exposure. By invoicing all parts of the transactions in the home currency, the firm can avoid transaction exposure completely. However, it is not possible in all cases. Currency risk sharing − The two parties can share the transaction risk. As the short-term transaction exposure is nearly a zero-sum game, one party loses and the other party gains% Leading and Lagging − It involves playing with the time of the foreign currency cash flows. When the foreign currency (in which the nominal contract is denominated) is appreciating, pay off the liabilities early and collect the receivables later. The first is known as leading and the latter is called lagging. Reinvoicing Centres − A reinvoicing centre is a third-party corporate subsidiary that uses to manage one location for all transaction exposure from intra-company trade. In a reinvoicing centre, the transactions are carried out in the domestic currency, and hence, the reinvoicing centre suffers from all the transaction exposure. Reinvoicing centres have three main advantages − The centralized management gains of transaction exposures remain within company sales. Foreign currency prices can be adjusted in advance to assist foreign affiliates budgeting processes and improve intra affiliate cash flows, as intra-company accounts use domestic currency. Reinvoicing centres (offshore, third country) qualify for local non-resident status and gain from the offered tax and currency market benefits. Operational Techniques for Managing Transaction Exposure Transaction exposures can also be managed by adopting operational strategies that have the virtue of offsetting existing foreign currency exposure. These techniques are especially important when well-functioning forward and derivative market do not exist for the contracted foreign currencies. These strategies include: Risk Shifting- The most obvious way to reduce the exposure is to not have an exposure. By invoicing all transactions in the home currency, a firm can avoid transaction exposure all together. However, this technique cannot work for everyone since someone must bear 91 CU IDOL SELF LEARNING MATERIAL (SLM)
transaction exposure for a foreign currency transaction. Generally, the firm that will bear the risk is the one that can do so at the lowest cost. Of course, the decision on who bears the currency risk may also impact the final price at which the contract is set. Currency Risk Sharing - An alternative to trying to avoid the currency risk is to have the two parties to the transaction share the risk. Since short terms transaction exposure is roughly a zero-sum game, one party's loss is the other party's gain. Thus, the contract may be written in such a way that any change in the exchange rate from an agreed upon rate for the date for the transaction will be split between the two parties. For example, a U.S. firm A contracts to pay a foreign firm B FC100 in 6 months based upon an agreed-on spot rate for six months from now of $1 = FC10, thus costing the U.S. firm $10. However, under risk sharing the U.S. firm and the foreign firm agree to share the exchange rate gain or loss faced by the U.S. firm by adjusting the FC price of the good accordingly. Thus, if the rate in 6 months turns out to be $1 = FC12, then rather than only costing the U.S. firm $100/12 = $8.50, the $1.50 gain over the agreed upon rate is split between the firms resulting in the U.S. firm paying $9.25 and the foreign firm receiving FC 111. Alternatively, if the exchange rate had fallen to $1 = FC8, then instead of paying $12.50 for the good, the exchange rate loss to the U.S. firm is shared and it only pays $11.25 and the foreign firm accepts FC90. Note that this does not eliminate the transaction exposure, it simply splits it. Leading and Lagging - Another operating strategy to reduce transaction gains and losses involves playing with the timing of foreign currency cash flows. When the foreign currency in which an existing nominal contract is denominated is appreciating, you would like to pay off the liabilities early and take the receivables later. The former is known as leading, and the latter is known as lagging. Of course, when the foreign currency in which a nominal contract is denominated is depreciating, you would like to take the receivables early and pay off the liabilities later. Reinvoicing Centres - A reinvoicing centre is a separate corporate subsidiary that manages in one location all transaction exposure from intracompany trade. The manufacturing affiliate sells the goods to the foreign distribution affiliates only by selling to the reinvoicing centre. The reinvoicing centre then sells the good to the foreign distribution affiliate. The importance of the reinvoicing centre is that the transactions with each affiliate are carried out in the affiliate’s local currency, and the reinvoicing centre absorbs all the transaction exposure. Three main advantages exist to reinvoicing centres: the gains associated with centralized management of transaction exposures from within company sales, the ability to set foreign currency prices in advance to assist foreign affiliates budgeting processes, and an improved ability to manage intra affiliate cash flows as all affiliates settle their intracompany accounts in their local currency. Reinvoicing centres are usually an offshore (third country) affiliate in order to qualify for local non-resident status and gain from the potential tax and currency market access benefits that arise with that distinction 92 CU IDOL SELF LEARNING MATERIAL (SLM)
5.4 OPERATING EXPOSURE Real exchange rate changes bring about changes in the relative prices a firm face. These changes in relative prices will generally have an impact on the competitiveness of the firm. Given that a different competitive environment implies a different economic reality, it is unlikely that the firm’s original operational choice will be optimal any linger. Therefore, depending on its perception about the persistence of the real exchange rate change, the firm may want to make changes in its operating strategy. To do this a firm needs to have existing flexibility that allows it some freedom to alter its operations in response to the exchange rate change. If this flexibility, or alternatively real operating options, does not exist, the firm may need temporary cash flow protection while the flexibility is installed or full cash flow insurance to simply ride out the adverse exchange rate fluctuation. This operating flexibility or operating options can be thought of as real hedges that the firm takes out to protect itself from real exchange rate fluctuations. The temporary protection or cash flow insurance will generally be obtained using financial instruments. Thus, both real operational and financial hedging strategies are important for the management of a firm's operating exposure to exchange rates. Operational Strategies for Managing Operating Exposure By its very definition, operating exposure is the impact of exchange rate changes on the firm's actual operations. Therefore, the first place to consider how to manage this exposure is to consider operation responses to exchange rate changes. Ideally the firm would like to set up its operations, production, sourcing, marketing such that the firm can respond to change in the real exchange rate so as to take advantage of the improved competitive positions and/or limit the harm caused by the degradation of competitiveness. These may be either ex ante actions that provide the firm an operating option, or marginal changes in activity intensity that try to mitigate the adverse impact of exchange rate fluctuations on firm value. Unlike financial hedging which provide the firm a deterministic cash flow in response to exchange rate movements without any real economic actions on the part of the firm, operational strategies require the firms to react to the new economic environments resulting from the exchange rate change and make changes to the economic behaviours of the firm. As we shall see below, there are operating strategies which will act as hedges of operating exposure in the short term and others that are more suited to hedge the long-term economic exposure of a firm. 5.5 SUMMARY Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates. There exist statistical measurements of sensitivity. 93 CU IDOL SELF LEARNING MATERIAL (SLM)
The exposure coefficient shows that there are two sources of economic exposure: The variance of the exchange rate and the covariance between the dollar value of the asset and exchange rate. Business Company has transaction exposure whenever it has contractual cash flows (receivables and payables) whose values are subject to unexpected changes in exchange rates due to a contract being denominated in a foreign currency. To realize the domestic value of its foreign-denominated cash flows, the firm must exchange foreign currency for domestic currency. As firms negotiate contracts with set prices and delivery dates in the face of a volatile foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency. It denotes to the risk associated with the change in the exchange rate between the time an enterprise initiates a transaction and settles it. A firm has economic exposure also called forecast risk to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can rigorously affect the firm's market share position with regards to its competitors, the firm's future cash flows, and finally the firm's value. Economic exposure can affect the present value of future cash flows. Any transaction that exposes the firm to foreign exchange risk also exposes the firm economically, but economic exposure can be caused by other business activities and investments which may not be mere international transactions, such as future cash flows from fixed assets. A swing in exchange rates that influences the demand for goods in some country would also be an economic exposure for a firm that sells goods. Economic Exposures cannot be fudged as well due to limited data, and it is expensive and time consuming. Economic Exposures can be managed by, product variation, pricing, branding, outsourcing. 5.6 KEYWORDS Gross National Product: It is an estimate of total value of all the final products and services turned out in a given period by the means of production owned by a country's residents. Gross Domestic Product: It is a monetary measure of the market value of all the final goods and services produced in a specific time period. Stock Market: A stock market, equity market, or share market is the aggregation of buyers and sellers of stocks, which represent ownership claims on businesses. 94 CU IDOL SELF LEARNING MATERIAL (SLM)
Net Trade: Net trade in goods is the difference between exports and imports of goods. Trade in services is not included. Consumer Price Index: It is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care. Inflation: It is the decline of purchasing power of a given currency over time. A quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time. 5.7 LEARNING ACTIVITY Compare different Economic exposure indicators for US, China and India. 1. Identify key highlights for the drivers. ……………………………………………………………………………………………… ……………………………………………………………………………………………… 2. Identify importance on India US relationship. ……………………………………………………………………………………………… ……………………………………………………………………………………………… 5.8 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Explain the life cycle of a transaction exposure. 2. Explain Forward Contracts in trading. 3. Explain Transaction Hedging Under Uncertainty. 4. Explain Futures Contracts. 5. Explain Options in currency trade. Long Questions 1. An Indian Tea Company has exported tea worth US$150,000 USA on March 1, 2010. The goods are sold on 2 months credit so that the payment due on April 30, 2010. On March 1, the dollar-rupee exchange rate is 48.5500. By March 31, the US$ depreciated to Rs. 48.2500 while by April 30 it appreciates to Rs.48.7500. Record the transaction exposures and estimate the net gain /loss. 2. Explain economic tools to measure inflation. 3. Explain techniques to Reduce Economic Exposure. 95 CU IDOL SELF LEARNING MATERIAL (SLM)
4. Explain Financial Techniques to Manage Transaction Exposure. 5. While defining foreign exchange exposure, in brief, describe various forms of foreign exchange exposures. B. Multiple Choice Questions 1. Economic exposure, also sometimes called a. Operating exposure b. Transaction exposure c. Translation exposure d. None of these 2. A company can reduce its manufacturing costs by taking its production facilities to a. Low-cost countries b. High Tax countries c. High cost countries d. None of these 3. Economic exposure is a measure of the a. No change in the future cash flows of a company b. No changes in foreign exchange rates c. Change in the future cash flows of a company as a result of unexpected changes in foreign exchange rates d. None of these 4. The decision of choosing one among these different financial techniques should be based a. Costs b. Penultimate domestic currency cash flows c. Both a) and b) d. None of these 5. Operating exposure is the impact of exchange rate changes on the firm's a. Actual operations b. Gross Operations c. Net Operations d. None of these Answers 1-(a), 2-(a), 3-(c), 4-(c), 5-(a) 96 CU IDOL SELF LEARNING MATERIAL (SLM)
5.9 REFERENCES Textbooks: Aabo, Tom (2001), “E-Commerce and Exchange Rate Exposure Management: A tilt towards Real Hedging”, Journal of E-Business, Vol. 1, Issue-1 June. Allayannis, George and E. Ofek (1997), “Exchange rate Exposure, Hedging, and the Use of Foreign Currency Derivatives”, Working Paper, University of Virginia. Allen, Linda and Christos Pantzalis (1996), “Valuation of the Operating Flexibility of Multinational Corporations”, Journal of International Business Studies, 27 (4), 633-653. Bartov, Eli and Gordon M. Bodnar (1994), “Firm Valuation, Earnings Expectations, and the Exchange rate Exposure Effect”, The Journal of Finance 44, 1755-1785. Bodnar, Gordon M. and W.M. Gentry (1993), “Exchange Rate Exposure and Industry Characteristics: Evidence from Canada, Japan and U.S.”, Journal of International Money and Finance (February), 29- 45. Bradford Cornell and Alan C. Shapiro (1983), “Managing Foreign Exchange Risks”, \"Managing Foreign Exchange Risk\", Midland Corporate Finance Journal, Fall. 97 CU IDOL SELF LEARNING MATERIAL (SLM)
UNIT-6: FOREIGN EXCHANGE EXPOSURE AND RISK MANAGEMENT II STRUCTURE 6.0 Learning Objectives 6.1 Introduction 6.2 Management of Translation Exposure 6.2.1 Hedging Translation Exposure 6.3 Management of Political Exposure 6.3.1 Political Risk and Its Measurement 6.4 Factors Affecting Political Risk 6.5 Management of Interest Rate Exposure 6.5.1 Interest Rate Risk and Sources of Interest Rate Risk 6.6 Summary 6.7 Keywords 6.8 Learning Activity 6.9 Unit End Questions 6.10 References 6.0 LEARNING OBJECTIVES After studying this unit, student will be able to: Explain management of translation exposure. Discuss management of political exposure. Explain factors affecting political risk. 6.1 INTRODUCTION International financial management is influenced by the political systems existing in different countries. Since multinational activities are operated in different parts of the globe, the impact of political, economic, social and cultural systems cannot be denied. The investment 98 CU IDOL SELF LEARNING MATERIAL (SLM)
decisions are affected by the political set up of a particular country causing political and country specific risk. Regulatory, taxation, economic and financial environments are the outcome of political behaviours of any country. Trade policies, exchange rate policies, monetary policies, fiscal policies of a particular country have a bearing on investment, capital budgeting, working capital decisions of a foreign firm operating as an MNC. It would be beneficial to understand the risk arising out of political and country specific conditions. Translation exposure is a kind of accounting risk that arises due to fluctuations in currency exchange rates. The assets, liabilities, equities, and earnings of a subsidiary of a multinational company are usually denominated in the currency of the country it is situated in. If the parent company is situated in a country with a different currency, the values of the holdings of each subsidiary need to be converted into the currency of the home country. Such conversion can lead to certain inconsistencies in calculating the consolidated earnings of the company if the exchange rate changes in the interim period. It is translation exposure. For example, an Austrian subsidiary of an American company purchases a building worth €100,000 on September 1, 2019. On this date, the euro-dollar exchange rate is €1 = $1.20, so the value of the building converted into dollars is $120,000. The company decides to convert all of its foreign holdings into dollars, to present a consolidated balance sheet on March 31, 2020. On that day, the exchange rate changes to €1 = $1.15, so the value of the building falls to $115,000. 6.2 MANAGEMENT OF TRANSLATION EXPOSURE Measurement of Translation Exposure Translation exposure can often depict a distorted representation of a company’s international holdings if foreign currencies depreciate considerably compared to the home currency. Accountants can choose among several options while converting the values of foreign holdings into domestic currency. They can choose to convert at the current exchange rate or at a historical rate prevalent at the time of occurrence of an account. Whichever rate they choose, however, needs to be used consistently for several years, in accordance with the accounting principle of consistency. The consistency principle requires companies to use the same accounting techniques over time to maintain uniformity in the books of account. In case a new technique is adopted, it should be mentioned clearly in the footnotes of the financial statements. Consequently, there are four methods of measuring translation exposure: 99 CU IDOL SELF LEARNING MATERIAL (SLM)
Current/Non-current Method The values of current assets and liabilities are converted at the exchange rate that prevails on the date of the balance sheet. On the other hand, non-current assets and liabilities are converted at a historical rate. Items on a balance sheet that are written off or converted into cash within a year are called current items, such as short-term loans, bills payable/receivable, and sundry creditors/debtors. Any item that remains on the balance sheet for more than a year is a non-current item, such as machinery, building, long-term loans, and investments. Consider the following balance sheet of a European subsidiary of an American company, which follows the method. Assume that the historical exchange rate is €1 = $1.20, and the current rate is €1 = $1.15. Table 6.1 Balance Sheet of a European Subsidiary of an American Company Monetary/Non-monetary Method All monetary accounts are converted at the current rate of exchange, whereas non-monetary accounts are converted at a historical rate. Monetary accounts are those items that represent a fixed amount of money, either to be received or paid, such as cash, debtors, creditors, and loans. Machinery, buildings, and capital are examples of non-monetary items because their market values can be different from the values mentioned on the balance sheet. The balance sheet prepared using the monetary/non-monetary method will be as follows: 100 CU IDOL SELF LEARNING MATERIAL (SLM)
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