INTL FIN CH37

Chapter 37
INTERNATIONAL FINANCIAL
MANAGEMENT

© Centre for Financial Management , Bangalore

OUTLINE
• World monetary system
• Foreign exchange markets and rates
• International parity relationships
• International capital budgeting
• Financing foreign operations
• Raising foreign currency finance
• Financing exports
• Insuring exports
• Documents in international trade
• Foreign exchange exposure
• Management of foreign exchange exposure

DISTINGUISHING FEATURES
The basic principles of financial management are the same
whether a firm is a domestic firm or an international firm
- a firm that has a significant foreign operation is called an
international firm or a multinational firm. However,
international firms must consider several financial factors
that do not directly have a bearing on purely domestic
firms. These include foreign exchange rates, variations in
interest rates across countries, different tax regimes,
complex accounting methods, barriers to financial flows,
and intervention of foreign governments.

WORLD MONETARY SYSTEM
• In 1971 the US dollar was delinked with gold. Put differently, it
was allowed to “float”. This brought about a dramatic change
in the international monetary system. The system of fixed
exchange rates, where devaluations and revaluations occurred
only very rarely, gave way to a system of floating exchange
rates.
• Since governments of most countries intervene in the exchange
markets, in a smaller or bigger way, we have ‘managed’ or
‘dirty float’.
• The exchange rate regime of the Indian rupee has evolved over
time moving in the direction of less rigid controls and current
account convertibility.

GLOBALISATION OF THE WORLD ECONOMY: RECENT TRENDS

The following trends have contributed to the process of globalisation.
• The 1980s and 1990s witnessed a rapid integration of international capital
and financial markets, the impetus for which came from the deregulation of
the foreign exchange and capital markets by the governments of major
countries.
• The advent of the euro at the beginning of 1999 heralded a new era, which
may possibly lead to a bipolar international monetary system.
• There was rapid expansion of international trade from 1950. This is being
pushed further at the global level (by WTO) and the regional level (by EU,
NAFTA and others).
• Economic integration and globalisation that started in 1980s gathered
momentum in 1990s,©thanksfor Financial Management , Bangalore
Centre to massive privatisation initiatives.

MULTINATIONAL CORPORATIONS
Companies go global for the following reasons:
•

Trade barriers

•

Imperfect labour markets

•

Intangible assets

•

Vertical integration

•

Product life cycle

•

Diversification

•

Shareholder diversification

FOREIGN EXCHANGE MARKETS
AND RATES
The foreign exchange market is the market where one
country’s currency is traded for another’s. It is the largest
financial market in the world. The daily turnover in this
market in mid –2003 was estimated to be about $ 1500
billion. Most of the trading, however, is confined to a few
currencies: the U.S dollar ($) , the Japanese Yen (¥), the
Euro (€), the British pound sterling (£) , and the Swiss
franc (SF), Exhibit 37.1 lists some of the currencies along
with their symbols

CURRENCIES AND THEIR SYMBOLS
Country
Australia
Canada
Denmark
EMU
Finland
India
Iran
Japan
Kuwait
Mexico
Norway
Saudi Arabia
Singapore
South Africa
Sweden
Switzerland
United Kingdom
United States

Currency
Dollar
Dollar
Krone
Euro
Markka
Rupee
Rial
Yen
Dinar
Peso
Krone
Riyal
Dollar
Rand
Krona
Franc
Pound
Dollar

Symbol
A$
Can $
Dkr
€
FM
Rs
Rl
¥
KD
Ps
NKr
SR
S$
R
Skr
SF
£
$


INTERNATIONAL FOREIGN
EXCHANGE MARKET
• The key participants are importers, exporters, traders,
brokers, speculators, and portfolio managers.
• Essentially an ‘over the counter’ market.
• Virtually a 24-hour market.
• Speculative transactions account for more than 95
percent of turnover

FOREIGN EXCHANGE
MARKET IN INDIA
• RBI, banks, and business firms are the key
participants
• RBI plays a key role in setting the day-to-day
rates.
• Business firms can’t resort to speculative
transactions

CROSS-CURRENCY RATES


SPOT RATES
In the foreign exchange market, a spot rate refers to the rate applicable to
transactions in which settlement is done in two business days after the
date of transaction. To understand spot rate quotations, we will use the
ACI (Association Cambiste International) conventions, which are
followed in the inter-bank market. These conventions are as follows:
• A pair of currencies is denoted by the 3-letter SWIFT codes for
the currencies separated by an oblique or a hyphen.
Examples: GBP/CHF : Great Britain Pound-Swiss Franc
USD/INR : US Dollar-Indian Rupee
• In a pair, the first currency is the ‘base’ currency and the second
currency is the ‘quoted’ currency.
• The exchange rate quotation reflects the number of units of the quoted
currency per unit of the base currency. Thus a GBP/INR quotation
reflects the number of India rupees for British pound.

• A quotation consists of two prices separated by a hyphen or slash.
The first price is the bid price; this is the price at which the dealer is
willing to buy. The second price is the ask price; this is the price at
which the dealer is willing to sell. An illustrative quotation is given
below:
USD/INR Spot : 45,000/45,5400
This quotation means that the dealer will buy one US dollar for Rs.
45,000 and will sell one US dollar for Rs. 45,5400.


BID-ASK SPREAD
The bid-ask spread - the difference between bid and ask prices –
reflects the breadth, depth, and volatility of the currency market. The
spread in normally expressed in percentage terms as follows:
Percent spread =

Ask price – Bid price
Bid price

x

100

For example, the percentage spread for the dollar quote Rs. 45,5000
– 45,5400 works out to 0.088 percent.
Percent spread =

45,5400 – 45,5000
45,5000

X

100 = 0.088 percent


CROSS-EXCHANGE RATE QUOTATIONS
To develop the concept of a cross-rate, let us for the time being
ignore the transaction cost. Given the exchange rate between
currencies A and B and currencies B and C, you can derive the
exchange rate between currencies A and C. In general,
S (A/C) = s (A/B) x S (B/C)
Note that S (A/C) represents the spot rate between currencies
A and C, and so on.
To illustrate consider the following rates:
S (INR/USD) = 0.0226
S (USD/CHF) = 1.2381

CROSS-EXCHANGE RATE QUOTATIONS
Given the above rates you can calculate the exchange rate
between INR and CHF.
S (INR/CHF) = S (INR/USD) x S (USD/CHF)
= 0.0226 x 1.2381 = 0.0280

Most commonly, cross-rate calculations are done to establish
the exchange rates between two currencies that are quoted
against the US dollar but are not quoted against each other.


FORWARD RATE QUOTATION
In the foreign exchange market, forward transactions are also
possible in which the rate is fixed today but the settlement is at
some specified date in the future. Such rates are called forward
rates. Banks normally quote forward rates for maturities in whole
calendar months – such as 1, 2, 3, and 6 months – but will tailor a
forward deal to suit the customer’s requirements.
For commercial customers banks usually give an outright
quotation in the same way as they give for a spot transaction. Thus
a quote like
USD/INR 3 – Month Forward: 46.5220/46.6210
means that the bank (dealer) will buy one US dollar for Rs.
46.5220 or sell one US dollar for Rs. 46.6210 for a delivery to be
made after 3 months.

SWAP POINTS
In the interbank market, however, forward quotes are given as a
pair of “swap points” to be added to or subtracted from the spot
quotation. A typical swap quotation is as follows:
USD/INR Spot
1 month swap

46.5015 / 46.5020
: 12 / 9

The swap quotation is expressed in such a way that the last digit
coincides with the same place as the last digit of the spot price.
Thus in the USD/INR quote give above, the number “12/9” mean
INR 0.0012 / INR 0.0009.


CONVERSION OF SWAP RATE INTO OUTRIGHT
RATE
You can convert a swap rate into an outright rate by adding the premium to, or
subtracting the discount from, the spot rate. The swap rates do not carry plus or
minus signs but you can easily determine whether the forward rate is at a
premium or discount, in relation to the spot rate, using the following rule.
If the forward bid rate in points is less (more) than the
offer rate in points, the forward rate is at a premium (discount).
So add (subtract) the points to the respective spot rate to get the
outright quote.
Let us apply this rule to the USD/INR example given above. In that
example the bid rate in points (12) is more than the offer rate in points (9). So
the forward rate is at a discount in relation to the spot rate. Hence we subtract
the points from the respective spot quotation to get the outright forward
quotation. Thus, the outright forward quotation is:
USD/INR

One-Month Forward : 46.5003 / 46.5120

FORWARD PREMIUMS AND DISCOUNTS
Consider the following spot and forward quotes
USD/INR Spot

:

USD/INR 1-month forward :

46.5020 / 46.5120
46.5420 / 56.5620

The US dollar is costlier in the forward market than in the spot
market. Put differently, it is at a forward premium in relation to the
Indian rupee.
With two-way quotations, you cannot quantify the premium or
discount in a unique way. One way to quantify the annual percentage
premium or discount is as follows.
Forward (USD/INR)mid – Spot (USD/INR)mid
Spot (USD/INR)mid

x 12 x 100


FORWARD PREMIUMS AND DISCOUNTS
In this formula, the mid rate is simply the arithmetic average of the
bid and ask rates. Note that multiplication by 12 converts the monthly
premium (or discount) to annual premium (or discount) and
multiplication by 100 translates it into percentage terms.
Applying this formula to the USD/INR spot and forward quotes
given above, we get:
46.5520 – 46.5070
46.5070

= 1.16 percent

This means that the annual forward premium on US dollar in relation
to Indian rupee is 1.16 percent.


FORWARD PREMIUM OR DISCOUNT
Forward rate – Spot rate

Forward premium =
or discount

12
x

Spot rate

Forward contract
length in months

For example if the spot rate of the U.S dollar is Rs.43.26 and the
three month forward rate is Rs.43.80, the annualised forward
premium works out to :
43.80 - 43.26
Forward premium

=

12
x

43.26

3

= 0.0499 or 4.99 percent

CURRENCY FUTURES
Instead of using the forward market, you can use the
futures

market.

Currency

futures

contracts

are

standardised currency forward contracts. Such contracts
are standardised in terms of the size of the contract and
delivery dates and exist only for major currencies. They
trade on organised futures exchanges.


CURRENCY FUTURES
Both forward contracts and futures contracts impose a
definite obligation on you to take(or give) delivery of the
currency contracted. By contrast a currency option
contract gives you the right, without imposing the
obligation, to sell (put) or buy (call) the foreign currency
at a predetermined price and maturity date. You can buy a
tailor made currency option contract from a bank or a
standardised currency option contract on an options
exchange. Of course, in either case you have to pay a nonrefundable premium to enjoy the option.

INTERNATIONAL PARITY
RELATIONSHIP
• Interest rate parity
• Purchasing power parity
• Expectations theory and forward exchange rates
• Fisher effect and international Fisher effect


INTEREST RATE PARITY (IRP)
When IRP exists, the difference between the forward rate and the spot
rate is just enough to offset the difference between the interest rates in
the two currencies. The IRP condition implies that the home interest
rate must be higher (lower) than the foreign interest rate by an amount
equal to the forward discount (premium) on the home currency.
Formally, IRP is stated as follows :
F

1 + rh
=

So
where F

1 + rf

= direct quote forward rate

So = direct quote spot rate
rh = home (or domestic) interest rate
rf = foreign interest rate

EXAMPLE OF IRP
The 90-day interest rate is 1.25 percent in the U.S. and 2.00
percent in U.K and the current spot exchange rate is
$1.50/£. What will be the 90-day forward rate?
F

(1 + 0.015)
=

$1.50

(1 + 0.025)

F = $1.4854
In this case the U.S. dollar appreciates in value
relative to the British pound. Explain why this happens.

PURCHASING POWER PARITY
• The law of one price in economics implies that the
exchange rate between the currencies of two countries
will be equal to the ratio of the price indexes in these
countries. In its absolute version this relationship is
called purchasing power parity (PPP)
• In reality, of course, the PPP does not hold because of
the costs of moving goods and services and the presence
of various barriers.

RELATIVE PURCHASING POWER PARITY
A less restrictive form of PPP is called the relative purchasing power
parity. It says that the difference in the rates of inflation between
two countries will be offset by a change in the exchange rate. For
example, if the expected inflation rate is 6 percent in India and 2
percent in the U.S., then the Indian rupee will depreciate relative to
the U.S. dollar at a rate of approximately 4 percent. More precisely,
the relative PPP is expressed as follows :
Se1
1 + ih
S
1 +=
i
o

f

where Se1 = expected spot rate a year from now
So = current spot rate
ih = expected inflation rate in home country
if

= expected inflation rate in foreign country.

EXAMPLE
The current spot rate for U.S. dollar is Rs.45. The expected
inflation rate is 6 percent in India and 2 per cent in the
U.S. What is the expected spot rate of dollar a year hence?
S e1

1 + 0.06
=

45.0
S e1

1+ 0.02
= Rs.46.75


EXPECTATIONS THEORY AND FORWARD
EXCHANGE RATES
If foreign exchange markets are efficient, the forward rate
equals the expected future spot rate.
F1 = Se1
For example if the market participants expect the one-year
future spot rate (Se1) for the U.S dollar to be Rs.45.00, then the
one year forward rate (F1) will also be Rs.45.00. If F1 were
lower than Se1, market participants would buy dollars forward,
thereby pushing F1 upward till it equals Se1. On the other hand,
if F1 were higher than Se1, market participants would sell
dollars forward, thereby pushing F1 downward till it equals Se1.

EXPECTATIONS THEORY AND FORWARD
EXCHANGE RATES
The expectations theory has two important implications
for financial managers. First, financial managers should
not spend money to buy exchange rate forecasts since
unbiased forecasts are freely available in the currency
market. Second, forward contracts are a cost-effective way
of hedging foreign currency risk.


FISHER EFFECT
According to the Fisher effect, the nominal interest rate is
equal to the real interest rate plus an adjustment for
inflation :
(1 + Nominal interest rate) =
(1 + Real interest rate) (1 + Inflation rate)
For example, if the real interest rate is 6 percent and the
inflation rate is 5 per cent, the nominal interest rate will be :
(1 + 0.06) (1 + 0.05) - 1 = 0.113 or 11.3 percent

GENERALISED FISHER EFFECT
If risk is held constant the real returns are equalised across
countries due to arbitrage operation.
This implies that in equilibrium the nominal interest differential will
be equal to the expected inflation differential. In symbols,
1 + rh

1 + ih
=

1 + rf

1 + if

where rh = home interest rate in nominal terms
rf = foreign interest rate in nominal terms
ih = expected inflation rate in home country
if = expected inflation rate in foreign country.

INTERNATIONAL FISHER EFFECT
If we combine purchasing power parity with generalised Fisher
effect, the result is the international Fisher effect.
Se1
Purchasing power parity :

1 + ih
=

So

1 + if

1 + rh
Generalised Fisher effect :

1 + ih
=

1 + rf

1 + if

Se1
International Fisher effect :

1 + rh
=

So

1 + rf


AN INTEGRATED PICTURE OF
INTERNATIONAL PARITY RELATIONSHIP

Forward Rate as an unbiased
estimator of the future
spot rate

Forward premium or
discount on foreign
currency (observed)
- 5%

Interest rate parity

Forecasted future spot
exchange rate - 5%
rupee weakens; $
appreciates

International fisher effect

Difference in nominal
interest rates
(observed)
+ 5%

Relative purchasing
power parity

Difference in expected
inflation rates
(forecasted) + 5%

Fisher effect


INTERNATIONAL CAPITAL BUDGTING
There are two ways of analysing a foreign investment proposal:
Home Currency Approach
• Convert all the dollar cash flows
into rupees (use forecasted

Foreign Currency Approach
• Calculate the NPV in dollars
(use the dollar discount rate)

exchange rates)
• Calculate the NPV in rupees
(using the rupee discount rate)

• Convert the dollar NPV into
rupees(use the spot exchange rate)


FINANCING FOREIGN OPERATIONS
 Long-term financing
• Parent company’s stake in equity
• Optimal capital structure
• Sources of long-term funds
 Short-term and intermediate financing


RAISING FOREIGN
CURRENCY FINANCE
• Foreign currency term loans from financial
institutions
• Export credit schemes
• External currency borrowings
• Euroissues
• Issues in foreign domestic markets

FOREIGN CURRENCY TERM LOANS FROM
FINANCIAL INSTITUTIONS
Financial institutions provide foreign currency term loans
for meeting the foreign currency expenditures towards
import of plant, machinery, and equipment and also
towards payment of foreign technical knowhow fees. The
periodical liability for interest and principal remains in the
currency/currencies of the loans and is translated into
rupees at the then prevailing rate of exchange for making
payments to the financial institution.

EXPORT CREDIT SCHEMES
Export credit agencies have been established by the
governments

of

major

industrialised

countries

for

financing exports of capital goods and related services.
Two kinds of export credit are provided : buyer’s credit
and supplier’s credit.


EXPORT CREDIT SCHEMES
Buyer’s Credit Under this arrangement, credit is provided
directly to the Indian buyer for purchase of capital goods
and/or technical services form the overseas exporter.
Supplier’s Credit This is a credit provided to the overseas
exporters so that they can make available medium-term
finance to Indian importers.


EXTERNAL COMMERCIAL BORROWING
Subject to certain terms and conditions, the Government
of India permits Indian firms to resort to external
commercial borrowings for the import of plant and
machinery. Corporates are allowed to raise upto $100
million from the global markets through the automatic
route.

Companies wanting to raise more than $ 100

million have to get an approval of the MOF.

FEATURES OF EUROCURRENCY LOANS
A eurocurrency is simply a deposit of currency in a bank
outside the country of the currency. For example, a
eurodollar is a dollar deposit in a bank outside the U.S.
The main features of eurocurrency loans, which represent
the principal form of external commercial borrowings, are:
• Syndication
• Floating rate
• Interest period
• Currency option
• Repayment and prepayment

FEATURES OF
EUROCURRENCY LOANS
• Eurocurrency loans are often syndicated loans, wherein
a group of lenders, particularly banks, jointly lend.
• The interest on eurocurrency loans is a floating rate
• The interest period may be 3,6,9 or 12 months in
duration
• The borrower often enjoys the multi-currency option
• The loans are repayable in instalments or in the form of
a bullet payment, as agreed to by the parties.

EUROISSUES
Euroissues are issues of bonds and equities in the euro
market. The two principal mechanisms used by
Indian Companies are Depository Receipts mechanism
and the Euroconvertible Issues. The former represents
indirect equity investment while the latter is debt with an
option to convert it into equity.


GLOBAL DEPOSITORY
RECEIPTS (GDRs)
In the depository receipts mechanism the shares issued by a firm are held
by a depository, usually a large international bank, who receives dividends,
reports, etc., and issues claims against these shares. These claims are called
depository receipts with each receipt being a claim on a specified number
of shares. The underlying shares are called depository shares. The
depository receipts are denominated in a convertible currency- usually
U.S. dollars. The depository receipts may be listed and traded on major
stock exchanges or may trade in the currency which is converted into
dollars by the depository and distributed to the holders of depository
receipts. This way the issuing firm avoids listing fees and onerous
disclosure and reporting requirements which would be obligatory if it were
to be directly listed on the stock exchange. Global Depository
Receipts(GDRs), which can be used to tap multiple markets with a single
instrument, have been the most popular instrument used by Indian firms.

ISSUES IN FOREIGN
DOMESTIC MARKETS
Indian firms can also issue bonds and equities in the
domestic capital market of a foreign country.
• Reliance Industries Limited, for example, issued bonds
in the US domestic capital market (Yankee bonds).
• Infosys, for example, tapped the US equity market by
issuing American Depository Shares (ADSs).


FINANCING EXPORTS
Pre-shipment Finance
• Clean packing credit
• Packing credit against hypothecation of goods
• Packing credit against pledge of goods.
Post-shipment Finance
• Purchase/discounting of documentary export bills
• Advance against export bills sent for collection
• Advance against duty drawbacks, cash subsidy, etc.

FORFAITING
Basically forfaiting refers to non-recourse discounting of
medium term (1 year to 5 years) export receivables. In a
forfaiting transaction, the exporter surrenders, without
recourse to him, his rights to claim for payment of goods
delivered to an importer, in return for immediate cash
payment from the forfaiter. As a result, the exporter is
able to convert a credit sale into a cash sale with no
recourse to him. Under this arrangement the export
receivables are usually guaranteed by the importer’s bank
(referred to as the ‘avalling’ bank).

DOCUMENTS IN
INTERNATIONAL TRADE
• Trade draft
• Bill of lading
• Letter of credit


TRADE DRAFT
The international trade draft, also referred to as a bill of
exchange, is a written order by the exporter (the drawer)
asking the importer (the drawee) to pay a specified amount
of money at a certain time. The draft may be a sight draft
(which is payable on presentation) or a usance draft
(which is payable a certain number of days after
presentation).

BILL OF LADING
A bill of lading is a document of shipping employed when
the exporter transports goods to the importer. It serves
several functions: (i) It is a document of title to goods. (ii)
It is a receipt given by the transportation company to
deliver the goods to a specified party at a certain
destination.


LETTER OF CREDIT
A letter of credit is issued by a bank on behalf of the
importer. As per this document, the bank agrees to honour
the draft drawn on the importer provided certain
conditions are satisfied. Through the letter of credit
arrangement, the credit of the importer is substituted by
the credit of bank. Hence it virtually eliminates the risk of
the exporter when he sells to an unknown importer in a
foreign country. This arrangement is further reinforced if
the letter of credit is confirmed by a bank in the exporter’s
country.

FOREIGN EXCHANGE EXPOSURE
Foreign exchange exposure can be classified into three
broad categories:
• Transaction exposure
• Translation exposure
• Operating exposure
Of these, the first and the third together are
sometimes called “cash flow exposures” while the second is
referred to as “accounting exposure” or “balance sheet
exposure”.

TRANSACTION EXPOSURE
When a firm has a payable or receivable denominated in a
foreign currency, a change in the exchange rate will alter the
amount of local currency received or paid. Such a risk or
exposure is referred to as transaction exposure. For example, if
an Indian exporter has a receivable of $100,000 due three
months hence and if in the meanwhile the dollar depreciates
relative to the rupee a cash loss occurs. Conversely, if the dollar
appreciates relative to the rupee, a cash gain occurs. In the case
of a payable, the outcome is of an opposite kind: a depreciation
of the dollar relative to the rupee results in a gain, whereas an
appreciation of the dollar relative to the rupee results in a loss.

TRANSACTION EXPOSURE
In the books of accounts, the foreign currency amount is expressed in the
reporting currency by applying the exchange rate prevailing on the
transaction date. If an item is settled during the current account period, it is
revalued at the rate prevailing on the settlement day. This may result in loss
or gain.
At each balance sheet date, foreign currency monetary items are reported
using the exchange rate on the balance sheet date, non-monetary items
carried at historical cost are reported using the exchange rate on the
transaction date, and non-monetary items carried at fair value are reported
using the exchange rate that existed when the fair values were determined.
Exchange differences arising from either settlement or restatement of
monetary items on the balance sheet date should be recognised as income or
expense in the period in which they arise.
When a forward exchange contract is entered into as a hedge, the
premium or discount arising at the inception of the contract should be
amortised as expense or income over the life of the contract.

TRANSLATION EXPOSURE
Translation exposure, also called accounting exposure, stems from
the need to convert the financial statements of foreign operations
from foreign currencies to domestic currency for purposes of
reporting and consolidation. If there is a change in exchange rates
since the previous reporting period, the translation or restatement
of foreign-currency denominated assets, liabilities, revenues, and
expenses will result in foreign exchange gains or losses.
Translation gains/losses do not involve cash flows as they are
purely paper gains/losses, except when they have some tax
implications.


Indian accounting standards require consolidation of the accounts of
foreign subsidiaries or branches with those of the parent firm in India.
The method used for translating foreign currency statements depends on
the nature of relationship between the parent and the foreign operations.
From this point of view, foreign operations are classified into two
categories.
• Integral Foreign Operations: An integral operation carries out
business as it is an extension of the operations of the parent. For
example, the foreign operation may just sell goods imported from the
parent and remit the proceeds of the same to its parent.
• Independent Foreign Operations: An independent or non-integral
foreign operation is run independently, as if it is a separate enterprise. It
is also referred to as a foreign entity.

The financial statements of an integral foreign operation are
translated using the rules that we discussed under transaction
exposure.
The assets and liabilities, both monetary and nonmonetary, of
the non-integral foreign operation are translated at the rates
prevailing on the balance sheet date. The profit and loss items
of such operations are translated at the exchange rates
prevailing on the date of the transactions. All the resulting
exchange differences are accumulated in a foreign currency
translation reserve until the disposal of the foreign operations.

The Income Tax Act requires that foreign currency liabilities
are “marked to market” at the exchange rate prevailing on the
date of casting the balance sheet. If the foreign currency
liability increases (decreases) on account of such revaluation,
the value of the fixed asset which is financed by the foreign
currency borrowing is correspondingly increased (decreased).
Depreciation is admissible on such revalued assets.


TRANSLATION METHODS
Internationally, four methods of foreign currency translation
are used in practice.
•

Current / Non current Method

•

Monetary / Non monetary Method

•

Temporal Method

•

Current Rate Method


FACTORS INFLUENCING
TRANSLATION GAINS/LOSSES
Foreign currency depreciates
Exposed

Translation loss

Exposed

vis-à-vis rupee

occurs

Liabilities

Foreign currency appreciates

Translation gain

vis-à-vis rupee

occurs

Foreign currency depreciates

Translation gain

Exposed

vis-à-vis rupee

occurs

Liabilities

Foreign currency appreciates

Translation loss

vis-à-vis rupee

occurs

>
Assets

Exposed
<
Assets


OPERATING EXPOSURE
Operating exposure, like transaction exposure, involves an
actual or potential gain or loss. While the former is specific
to a transaction, the latter, much broader in nature, relates
to an entire investment. The essence of operating exposure
is that exchange rate changes significantly alter the cost of
a firm's inputs and the prices of its output and thereby
influence its competitive position substantially.


OPERATING EXPOSURE : AN EXAMPLE
An example may be given to explain this concept. Volkswagen had a
highly successful export market for its 'Beetle' model in the U.S.
before 1970. With the breakdown of the Brettonwood system of fixed
exchange rates, the Deutschemark appreciated significantly against
the dollar. This created problems for Volkswagen as its expenses
were mainly in Deutschemark but its revenues in dollars. However,
in a highly price-sensitive U.S. market, such an action caused a
sharp decrease in sales volume - from 600,000 vehicles in 1968 to
200,000 in 1976. (Incidentally, Volkswagen's 1973 losses were the
highest, as of that year, suffered by any company anywhere in the
world).

MANAGEMENT OF TRANSACTION EXPOSURE

Transaction exposure arises on account of imports,
exports, and foreign currency borrowings. To cope with
such exposure, the following may be used:
• Forward market hedge
• Option forwards
• Money market hedge
• Financial swaps
• Currency options
• Leading and lagging
• Netting and offsetting

FORWARD MARKET HEDGE
In a forward market hedge, a net liability (asset) position is
covered by an asset (liability) in the forward market. To illustrate
the mechanism of the forward market hedge, consider the case of
an Indian firm which has a liability of $100,000 payable in 60 days
to an American supplier on account of credit purchases. The firm
may employ the following steps to cover its liability position:
Step 1 Enter into a forward contract to purchase $100,000 in 60
days from a foreign exchange dealer. The 60-day forward
contract rate is, say, Rs.46.90 per dollar.
Step 2 On the sixtieth day pay the dealer Rs.4,690,000 ($100,000
x Rs.46.90).

ROLLOVER CONTRACT
In the foreign exchange market in India, a forward contract for a maturity
period exceeding six months is not ordinarily possible because in the interbank market, quotations beyond six months are not available. So, an
Indian firm which has a foreign currency borrowing payable over an
extended period of time, will have to go for a 'rollover' contract, if it wants
a forward cover. Essentially this means that the borrower buys forward
the entire amount to be covered for a date which synchronises with the
next instalment date. Come that date, the borrower uses a portion of the
forward contract to meet the instalment amount and rolls over the balance
of the contract to the next instalment date - this means he sells the balance
in the spot market and buys it in the forward market. This is continued till
the last instalment is paid.
Under the rollover contract, the basic rate of exchange is fixed.
However, each rollover may result in some cost (or gain) depending on
(the) a premium (or discount) at the time of each rollover.

OPTION FORWARDS
A variant of the forward contract is an option forward in which the
exchange rate between the currencies is fixed when the contract is
entered into but the delivery date is not fixed. In this contract, one of
the parties (typically the corporate customer) enjoys the option to give
or take delivery on any day between two fixed dates. For example,
Alpha Corporation enters into an option forward with National Bank
under which it agrees to sell forward $1million at Rs. 46.50 per dollar,
to be delivered on any day between the 91st day and the 120th day from
the time the contract is entered into. In this case, the period 91-120
days is the option period during which Alpha Corporation has to give
delivery. Option forwards make sense when the exact timing of a
foreign currency inflow or outflow is not known, though the amount is
known.

MONEY MARKET HEDGE
In a money market hedge, the exposed position in a foreign currency is covered
through borrowing or lending in the money market. To illustrate how the money
market hedge may be employed, consider the case of a British firm which has a
liability of $100,000 on account of purchases from a U.S. supplier, which is
payable after 30 days. Today’s spot rate is $1.692 per £. The 30-day money
market rates in the U.K. and the U.S. are, 1 percent for lending and 1.5 percent
for borrowing. In order to hedge, the British firm can take the following steps:
Step 1 Determine the present value of the foreign currency liability ($100,000)
by using the money market rate applicable to the foreign country. This
works out to :
$100,000/1.01 = $99,010.
Step 2 Obtain $99,010 on today's spot market in exchange for 58,516 pounds.
Today's spot rate is $1.692 per pound.
Step 3 Invest $99,010 in the U.S. money market. (This investment will
compound to exactly $100,000 the known future dollar liability after
30 days.)

FINANCIAL SWAPS
A financial swap basically involves an exchange of one set
of financial obligations with another. Widely used
internationally, financial swaps have in recent years
attracted the attention of firms in India. The two most
important financial swaps are the interest rate swap and
the currency swap.

CURRENCY OPTIONS
After a decade of hedging currency risk mainly through
forward contracts, the RBI allowed currency options from
July 2003. The salient features of the present guidelines are as
follows: (a) Corporates can only buy currency options, but not
write them. (b) Only banks can write currency options, that
too only plain vanilla European options. (c) Corporates can
buy currency options only for hedging underlying exposures.
(d) Corporates can buy cross-currency options.

Despite a

sluggish start, the currency options market has now picked up.

LEADING AND LAGGING
Sometimes, exposures can be managed by altering the
timing of foreign currency flows through leading and
lagging.

Leading involves advancing and lagging

involves delaying.

The general rule is to lead

payables and lag receivables in "strong" currencies.
By the same token, lead receivables and lag payables
in "weak currencies."

NETTING AND OFFSETTING
If a firm has receivables and payables in different currencies, it
can net out its exposure in each currency. Suppose an Indian
firm has exports of $100,000 to the U S and imports of
$120,000 from the U S. It can use its receivables of $100,000
and hedge only the net US dollars payable.

Even if the

timings of the flows are not matched, it can lead or lag one or
both of them to achieve a match.


MANAGEMENT OF OPERATING EXPOSURE
Transaction exposure is short-term in nature and well-identified.
Operating exposure, on the other hand, is long-term in nature and can
scarcely be identified with precision. So, the instruments of financial
hedging (forwards, options, and so on) which are helpful in hedging
short-term well-identified transaction exposure are not of much help
in hedging operating exposure.
Managing operating exposure calls for designing the firm’s
marketing, production, and financing strategy to protect the firm’s
earning power in the wake of exchange rate fluctuations.

LEVERS FOR MANAGING OPERATING
EXPOSURE
The important levers for managing operating exposure are:
• Product strategy
• Pricing strategy
• Plant location
• Sourcing
• Product cycle
• Liability structure

EXPOSURE MANAGEMENT IN PRACTICE
Several surveys have been done to study corporate foreign exchange exposure
management in practice in various countries and industries. Although detailed
findings vary, there are broad commonalities in these surveys. The principal
findings are summarised below:
1. Very few companies do a quantitative assessment of how unanticipated
changes in exchange rate impact on the value of the firm.
2. Many firms seem to believe that their exposure to exchange rate risk is not very
serious.
3. Firms that engage in systematically assessing and managing their foreign
exchange exposure seem to focus primarily on transaction exposure extending
upto a year. Here too, firms seem to prefer to deal with exposures individually
and not collectively.
4. For managing operating exposure, firms use mechanisms such as locating and
sourcing of inputs in different currency areas, upgrading products to cater to
less price-elastic market segments, resorting to borrowing in local currencies
through foreign subsidiaries, and indexing wages to the exchange rate.

SOME SUGGESTIONS
While managing its foreign exchange exposure, a firm
must bear in mind the following :
• Be selective
• Seek more than one quotation
• Choose a proper mix of currencies and interest
rates
• Establish rapport with the banker
• Act swiftly

SUMMING UP
• The basic principles of financial management are the same whether a
firm is a domestic firm or an international firm. However,
international firms must consider several financial factors that do not
directly have a bearing on purely domestic firms. These include
foreign exchange rates, variations in interest rates across countries,
different tax regimes, complex accounting methods, barriers to
financial flows, and intervention of foreign governments.
• The field of international finance has witnessed explosive growth and
dynamic changes in recent decades mainly because of a change in
international monetary system from a fairly predictable system of
exchange rates to a flexible and volatile system of exchange rates and
greater integration of the global financial system.
• The exchange rate regime of the Indian rupee has evolved over time
moving in the direction of less rigid exchange controls and current
account convertibility.

• The foreign exchange market is the market where one country’s
currency is traded for another’s. It is the largest financial market in
the world.
• The important features of the foreign exchange market are: (a) It is
an ‘over the counter’ market. (b) It is virtually a 24-hour market. (c)
Speculative transactions account for more than 95 percent of the
turnover.
• An exchange rate represents the price of one currency expressed in
terms of another. A spot rate refers to the rate applicable to
transactions in which settlement (i.e. delivery) is made in two business
days after the date of transaction. A forward rate applies to a
transaction in which the rate is fixed today but the settlement is at
some specified date in the future.
• To develop a consistent international financial policy, you need to
understand the relationship between interest rates, inflation rates,
and exchange rates. In this context, international parity relationships
provide useful guidance.

• The interest rate parity says that the difference between the forward
rate and the spot rate is just enough to offset the difference between
the interest rates in the two currencies. The relative purchasing power
parity says that the difference in the rates of inflation between two
countries will be offset by a change in the exchange rate. The
expectations theory says that if foreign exchange markets are
efficient, the forward rate equals the expected future spot rate. The
international fisher effect says that the nominal interest differential
will be equal to the expected inflation differential.
• There are two basic ways of evaluating an international capital
budgeting proposal : the home currency approach and the foreign
currency approach. Correctly applied both the approaches yield the
same result.
• The key issues in financing foreign operations are: parent company’s
stake in the affiliate’s equity, optimal capital structure, and
dependence on the eurocurrency and eurobond markets.

• The major sources available to an Indian firm for raising foreign
currency finance are: foreign currency term loans from financial
institutions, export credit schemes, external commercial borrowings,
euroissues, and issues in foreign domestic markets.
• The main features of eurocurrency loans, which represent the
principal form of external commercial borrowings, are: syndication,
floating rate, and currency options.
• Euroissues are issues which are made in the euromarket (a market
which falls outside the regulatory purview of national regulatory
authorities). The two principal mechanisms used by Indian
companies are the Global Depository Receipts (GDRs) and the
Euroconvertible Issues. The former represents indirect equity
investment while the latter is debt with an option to convert it into
equity.
• Apart from euroissues which are made in the euromarket, Indian
firms can also issue bonds and equities in the domestic capital market
of a foreign country.

• Commercial banks, the major source of export finance in India,
provide finance before shipment of goods (pre-shipment finance) as
well as after shipment of goods (post-shipment finance). The preshipment finance typically is in the form of packing credit of which
there are three broad types: (i) clean packing credit, (ii) packing
credit against hypothecation of goods, and (iii) packing credit
against
pledge of goods. The post-shipment finance is provided in the
following ways: (i) purchase/discounting of documentary export
bills, (ii) advance against export bills sent for collection, and (iii)
advance against duty drawback, cash subsidy, etc.
• The Export Import Bank of India provides export and import finance
through a variety of schemes.
• The Export Credit & Guarantee Corporation(ECGC) provides
insurance to Indian exporters of goods and services, against the risk
of non-payment for exports. ECGC offers a variety of policies and
schemes.

• In comparison with domestic trade, international trade presents
certain special problems. In order to cope with these problems,
international trade relies considerably on three major
documents/instruments: trade draft, bill of lading, and letter of credit.
• Foreign exchange exposure may be classified into three broad
categories: transaction exposure, translation exposure, and operating
exposure.
• Foreign exchange risk is like a double-edged sword – while it can
entail losses it can also produce gains. On balance it appears that
while it may be desirable to eliminate a portion of the exchange rate
risk, it may not be worthwhile to eliminate the whole of it. Exchange
rate risk can be eliminated by proper hedging.
• To cope with foreign exchange exposures the following devices are
available: forward market hedge, rollover contracts, financial swaps,
and money market hedge.
• In a forward market hedge, the net liability (asset) position is covered
by an asset (liability) in the forward market.

• In a rollover contract the borrower buys forward the entire amount o
be covered for a date which synchronises with the next instalment
date. Come that date, the borrower uses a portion of the forward
contract to meet the next instalment amount and rolls over the
balance of the contract to the next instalment date.
• A financial swap basically involves an exchange of one set of financial
obligations for another.
• In a money market hedge, the exposed position in a foreign currency
is covered through borrowing or lending in the money market.
• While managing its foreign exchange exposure, a firm must bear in
mind the following suggestions : (a) Be selective, (ii) Seek more than
one quotation, (iii) Choose a proper mix of currencies and interest
rates, (iv) Establish rapport with the banker, and (v) Act swiftly.


INTL FIN CH37

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