2. Functions of Forex Market
Transfer of funds from one nation & currency to
another.
Why exchange?
# Import & Export of goods
# Import & Export of services
# Tourism
# Investment
Eg. A US commercial bank has oversupply of
pounds, then sell excess pounds, then finally a
nation pays for its tourist exp. imports, investments
etc.
3. Participants in Forex Market:
Level 1:
Tourists, importers, exporters, investorsimmediate users & suppliers of foreign
currencies.
Level 2:
Commercial banks- they act as clearing
houses between users and earners, do not
actually buy & sell- Retail market
4. Participants in Forex Market:
Level 3:
Forex brokers- They deal with commercial
banks.
Level 4:
Nation’s central bank:
Act as Lender/ Buyer of last resort- Interbank
market/ wholesale market
5. Entities in Forex market
Authorised dealers-are commercial banks
Money changers- Buy/ sell form customersdeal in notes, coins and travelers’ cheque.
FEDAI- Forex Dealers’ Association of India
6. The Foreign Exchange Rates
Definition- An exchange rate quotation is the
price of a currency stated in terms of another.
For eg. Rs 50/ $
This means that price of one dollar is Rs 50.
It is like quoting the price of a commodity.
7. The Foreign Exchange Rates
Suppose there are two nations: US and UK
and the exchange rate is R.
R=2,
i.e. R= 2 $/ £
or
R= $/ £ = 2
i.e. 2 dollars are required to buy one pound.
8. Exchange Rate Strategies:
Flexible vs fixed exchange rates
Foreign exchange market is the market on which currencies of various
nations are traded
Flexible exchange rate is a system that sets the exchange rate according to
demand and supply of a country's currency
Fixed exchange rate is an exchange rate set by official government policy
Can be set independently or by agreement with a number of other
governments
Fixed rates can be set relative to the dollar, the euro, or even gold
9. Flexible Exchange Rate in the
Short Run
Countries that have flexible exchange rates see the values of their currencies
change continually.
Exchange rates are set by supply and demand in the foreign exchange
market
US supplies dollars to buy foreign exchange in order to buy foreign goods
or foreign assets
Not the same as the money supply controlled by the Fed
Supply of dollars in the foreign exchange market is the number of dollars
offered for sale for a given foreign currency
10. Supply of Dollars in Foreign
Exchange Market
Anyone who holds dollars is a potential supplier
US households and firms are the most common suppliers
Supply curve has a positive slope
The more foreign currency per dollar, the larger the quantity of dollars
supplied
This makes foreign goods cheaper
When $1 = ¥ 100, a ¥ 5,000 item costs $50
If $1 = ¥ 200, that same ¥ 5,000 item costs $25
When the dollar appreciates, quantity of dollars supplied increases
11. Demand for Dollars in Foreign
Exchange Market
Anyone who holds yen can demand dollars
Japanese households and firms are the most common demanders
Demand curve has a negative slope
The more foreign currency per dollar, the smaller the quantity of dollars
demanded
This makes US goods more expensive
When $1 = ¥ 100, a $30 item costs ¥ 3,000
If $1 = ¥ 200, that same $30 item costs ¥ 6,000
When the dollar appreciates, quantity of dollars demanded decreases
12. The Dollar – Yen Market
Market for Dollars
Dollar appreciates
Market equilibrium
equates the number of
dollars supplied and the
number demanded at an
exchange rate, e*
Dollar appreciates if the
exchange rate exceeds e*
Dollar depreciates if the
exchange rate is less than
e*
Yen/dollar exchange rate
Supply
of dollars
e*
Demand for
dollars
Q*
Quantity of dollars
13. Supply of Dollars in Foreign
Exchange Market
Supply of dollars for Japanese yen is
determined by
The preference for Japanese goods
US real GDP
The stronger the preference, the greater the supply of
dollars
The higher GDP, the greater the supply of dollars
Real interest rate on Japanese assets and the
real interest rate on US assets
Supply of dollars will be greater if
Real interest rate on Japanese assets are higher
Real interest rate on US assets is lower
14. An Increase in the Supply of
Dollars
Initial equilibrium at E
Suppose consumers prefer the
new video game system made in
Japan
Shift in preferences
Increase in the supply of dollars
shifts dollar supply curve to the
right
New equilibrium at F
Dollar depreciates to e*'
Quantity of dollars traded
increases to Q*'
Yen / dollar exchange rate
S
S'
e*
e*'
E
F
D
Q* Q*'
Quantity of dollars
15. Demand for Dollars in Foreign
Exchange Market
Demand for dollars by holders of yen is determined by
The preference for US goods
The stronger the preference, the greater the demand for dollars
Real GDP in Japan
The higher GDP, the greater the demand for dollars
Real interest rate on Japanese assets and real interest rate on US assets
Supply of dollars will be greater if
Real interest rate on Japanese assets are lower
Real interest rate on US assets is higher
16. Factors that affect the
Equilibrium Exchange Rate
1. Relative inflation rates- Eg. R= 2$ / £, If
inflation in US in higher than in UK, then US
goods will be costlier than that of UK goods
and therefore, UK will export more goods to
US and US will export less goods to UK.
This means that value of Dollar has
Depreciated w.r.t. Pounds, or
Value of Pounds has Appreciated w.r.t. US
dollars.
17. Factors that affect the
Equilibrium Exchange Rate
2. Relative interest rates
If real interest rates of US are higher than that of
UK, then the dollar is said to have appreciated as
compared to pound.
Real interest rate = Nominal interest rate Inflation
If interest rate of US > int. rate of UK (because of
inflation, then wrong picture).
Therefore, real interest rate should be considered.
18. Factors that affect the
Equilibrium Exchange Rate
3. Relative economic growth rates:
Strong economic growth- attract investment
4. Political & Economic risk:
High risk currency- more valuable
19. Exchange Rate Quotations:
1.
American Quote/ Direct quote:
No. of units of home currency for one unit of
foreign currency.
eg. Rs 50/ $, means that 50 rupees are
required to buy one unit of foreign currency/
dollar.
20. Exchange Rate Quotations:
2. European Quote/ Indirect quote:
No. of units of foreign currency required to buy one
unit of home currency. i.e. for one unit of home
currency, how many units of foreign currency is
required?
eg. $0.02/ Rs 1, means that 0.02 dollars are
required to buy one unit of home currency/ rupees.
FF 0.1462/ Rs 1, 0.1462 French Franc per rupee.
21. Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country
Currency Symbol
UK
Pound
Sterling
US
US Dollar $
43.30
Canada
Canadian Can$
Dollar
29.10
£/ GBP
Direct
quote
66.92
Indirect
quote
22. Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country
Currency Symbol
Direct
quote
Indirect
quote
UK
Pound
Sterling
66.92
0.0149
US
US Dollar $
43.30
0.0231
Canada
Canadian Can$
Dollar
29.10
0.0344
£/ GBP
23. Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country
Currency Symbol
Germany Deutsch
mark
Euro
Netherlan Dutch
ds
Guilder
Direct
quote
DM/DEM 22.94
€
44.87
DG/$f/
NLG
20.36
Indirect
quote
24. Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country
Currency Symbol
Germany Deutsch
mark
Euro
Netherlan Dutch
ds
Guilder
Direct
quote
Indirect
quote
DM/DEM 22.94
0.0436
€
44.87
0.0223
DG/$f/
NLG
20.36
0.0491
25. Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country
Currency Symbol
Direct
quote
Indirect
quote
Switzerla Swiss
nd
franc
sFr
0.0358
France
French
franc
FF/ FRF
0.1462
Italy
Swedish
krona
SKr
0.1931
26. Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country
Currency Symbol
Direct
quote
Indirect
quote
Switzerla Swiss
nd
franc
sFr
27.97
0.0358
France
French
franc
FF/ FRF
6.84
0.1462
Italy
Swedish
krona
SKr
5.18
0.1931
27. Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country
Currency Symbol
Italy
Italian lira Lira/ Lit/
ITL
43.2901
Japan
Japanese ¥
Yen
2.4994
Australia
Australia
n dollar
0.0360
AU$
Direct
quote
Indirect
quote
28. Exchange Rate Quotations:
Spot rates for a number of currencies (in
Rupees)
Country
Currency Symbol
Direct
quote
Indirect
quote
Italy
Italian lira Lira/ Lit
/ITL
0.0231
43.2901
Japan
Japanese ¥
Yen
0.4001
2.4994
Australia
Australia
n dollar
27.76
0.0360
AU$
29. Numerator and Denominator
The higher fraction is supposed to be the
numerator and the Denominator corresponds
to its lower part.
Eg. EUR / USD,
EUR is the basic currency (Numerator) &
USD is the counter currency (Denominator).
30. Buying and selling a currency
Buy/ Long EUR/ USD, means that you want
to buy EUR and sell USD.
Sell / Short EUR/ USD, means that you want
to sell the basic currency and buy the counter
currency i.e. sell EUR and buy USD.
Short sell
31. Bid and Ask Rates
A bank is ready to buy and sell a currency at
different prices.
Buy price- Bid rate
Sell price- Ask rate
Spread- Difference between Bid and Ask rate is
called Bid- ask Spread.
It is more in retail market and less in interbank
market as there is more volume, greater liquidity and
lower counterparty risk in interbank transactions.
32. Causes of spread are:
Transaction cost
Return on capital employed
Reward / Compensation for taking risk
Mid rate- Arithmetic mean of bid and ask
rates i.e. when one rate is mentioned.
33. Important conventions
regarding quotes:
a) The bid rate always precedes the ask rate.
E.g Rs/$ 45.45 / 45.50
b) The bid and ask rates are always separated either
by slash(/) or (-).
c) The quote is always from the banker’s point of view.
Rs/$ 45.45 / 45.50
E.g The banker is ready to buy dollar at 45.45
and sell at 45.50. i.e. Banker’s buy rate= Customer’s
sell rate.
d) The Bid is always lower than the ask. (ask rate- Bid
rate = profit)
34. Interbank quote vs Merchant
quote
Merchant quote is by bank to its retail
customers.
Interbank quote is given by one bank to
another bank.
Since, both the parties are banks, then whose
quote will be considered. The bank
requesting the quote will is the customer and
the other bank’s quote will be considered.
35. Basis Point (BPS)
A unit that is equal to 1/100th of 1%, and
is used to denote the change in a financial
instrument. The basis point is commonly
used for calculating changes in interest rates,
equity indexes and the yield of a fixed-income
security.
The
relationship
between
percentage
changes and basis points can be
summarized as follows: 1% change = 100
basis points, and 0.01% = 1 basis point.
36. Basis Point (BPS)
So, a bond whose yield increases from 5% to
5.5% is said to increase by 50 basis points;
or interest rates that have risen 1% are said
to have increased by 100 basis points.
37. Cross Rates / Synthetic rates
When we calculate the exchange rates
between other currencies with the dollar (or
any other currency) as the intermediate
currency.
The € / £ rate will be calculated through the
€ / $ quote and the $/ £ quote.
38. Cross Rates
Eg. We need to calculate the Switzerland
franc / Canadian Dollar (sFr/ Can$) rate from
given sFr / $ and $/ Can$ quotes.
sFr / $ : 5.5971 / 5.5978
$/ Can$ : 0.7555 / 0.7562
Synthetic (sFr/ Can$)bid rate
= 5.5971 * 0.7555
= (sFr / $)bid * ($/ Can$)bid
= 4.2286
39. Cross Rates
Eg. We need to calculate the Switzerland
franc / Canadian Dollar (sFr/ Can$) rate from
given sFr / $ and $/ Can$ quotes.
sFr / $ : 5.5971 / 5.5978
$/ Can$ : 0.7555 / 0.7562
Synthetic (sFr/ Can$)ask rate
= 5.5978 * 0.7562
= (sFr / $)ask * ($/ Can$)ask
= 4.2330
40. Appreciation & Depreciation
Q1. During 2002, the yen went from
$0.0074074 to $0.0084746.
a)
b)
By how much did the yen appreciate against
the dollar?
By how much has the dollar depreciated
against the yen?
41. Appreciation & Depreciation
a)
b)
Solution:
The yen has appreciated against the dollar by an
amount equal to (0.0084746 – 0.0074074)/
0.0074074 = 14.41%.
An exchange rate of ¥ 1= 0.0074074 translates
into an exchange rate of $ 1 = ¥135 (1/ 0.0074074
=135). Similarly, the exchange rate of ¥ 1=
$0.0084746 is equivalent to an exchange rate of $
1 = ¥118. Therefore, the dollar has depreciated
(against the yen) by an amount equal to (118-135)/
135 = -12.59%.
42. The Foreign Exchange Market
Types of Transactions
Spot- Spot quotes- Prices in spot market
Forward- Forward quote- Prices in Forward
market
43. Premium / Discount
Forward Premium- when,
Forward rate > Spot Rate
Forward Discount- when,
Forward rate < Spot Rate
The forward discount / premium is expressed in
annualised percentage terms as follows:
Forward premium/ = Forward- Spot
Discount
rate
rate * 360
Spot rate
Forward
contract no. of days
44. Arbitrage
Simultaneous purchase and sale of the same
assets / commodities on different markets to
profit from price discrepancies.
Eg. If the dollar price of pounds were $1.98 in
New York and $ 2.01 in London, an
arbitrageur would purchase pounds at $1.98
in New York and immediately resell them in
London for $2.01, thus realising a profit of
$0.03 per pound.
45. Arbitrage
As arbitrage continues, the exchange rate
between the 2 currencies tends to get
equalised in the two monetary centres.
a) Two point arbitrage- Two currencies, Two
countries
b) Three point arbitrage- Three currencies,
Three countries
46. Interest Arbitrage
It refers to the International flow of short term liquid
capital to earn a higher return abroad. It can be
covered or uncovered.
1) Uncovered Interest Arbitrage
The transfer of funds abroad from to take advantage
of higher interest rates in foreign monetary centres
usually involves the conversion of the domestic
currency to the foreign currency, to make the
investment. At the time if maturity, the funds
(principal + interest) are reconverted from the
foreign currency to the domestic currency.
47. Uncovered Interest Arbitrage
Low interest rate
country
High interest rate
country
investment
Eg. In Germany, the annualised interest rate
is 11% whereas in London it is 15%.
Suppose, a company has excess funds for 3
months. In which country one should invest?
48. Covered Interest Arbitrage
Spot purchase of foreign currency to make
the investment and offsetting the
simultaneous the simultaneous forward sale
to cover the foreign risk.
Net return= Positive interest differential (-)
Forward discount on the foreign
currency
50. Solution to Illustration1
The rule is that if the interest rate differential is
greater than the premium or discount, place the
money in the currency that has a higher rate if
interest or vice –versa.
Given the above data:
Negative interest rate differential= (12-8)= 4%
Forward premia (annualised) =
Forward rate-Spot rate * 100 * 12
Spot rate
6
= 42.8020 – 42.0010 * 100 * 12 = 3.8141 %
42.0010
6
51. Solution to Illustration1
Negative interest rate differential> forward
premia, therefore, there is a possibility of
arbitrage inflow in India.
Suppose, investment = $1000 by taking a
loan @ 8% in US. Invest in India at spot rate
of Rs 42.0010 @ 12 % for six months and
cover the principal + interest in the six month
forward rate.
Principal= $ 1000 = Rs 42001
52. Solution to Illustration1
Interest on investment for six months
= Rs 42,001 * 12/ 100* 6/12
= Rs 2520.06
Amount at the end of six months = Interest +
Principal
= Rs 42001+ 2520.06
= Rs 44,521.06
53. Solution to Illustration1
Converting the above in dollars at the
forward rate = $ 44,521.06 / 42.8020
= $ 1,040.16
The arbitrageur will have to pay at the end of
six months = $1,000+ ($1000* 8/100 *6 /12)
Hence, the arbitrageur gains ($1040.16 $1040) = $ 0.16 on borrowing $1000 for six
months.
55. Solution to Illustration 2
The rule is that if the interest rate differential is
greater than the premium or discount, place the
money in the currency that has a higher rate if
interest or vice –versa.
Given the above data:
Negative interest rate differential= (12-8)= 4%
Forward premia (annualised) =
Forward rate-Spot rate * 100 * 12
Spot rate
6
= 45.0010 – 44.0030 * 100 * 12 = 4.5361%
42.0030
6
56. Solution to Illustration 2
Negative interest rate differential< forward
premia, therefore, there is a possibility of
arbitrage inflow in US.
Suppose, investment = Rs 10,000 by taking a
loan @ 12% in India.
Invest in US at spot rate of Rs 44.0030 @ 8
% for six months (US $ 227.257) and cover
the principal + interest in the six month
forward rate.
57. Solution to Illustration 2
Amount at the end of six months = Interest +
Principal
= $227.257* 8/ 100* 6/12
= $ 236.3473
Sell US $ at 6 month forward to receive
236.3473* 45.0010= Rs 10635.865
Return the rupee debt borrowed at 12%. The
amount to be refunded is Rs 10,600
Profit= Rs 10635.865 - 10600= 35.865
59. Illustration 4
An American firm purchases $4,000 worth of
perfume (FF 20,000) from a French firm. The
American distributor must make the payment
in 90 days in French francs. Given that:
Spot rate $ 0.2000 = 1 FF
90 day forward rate 0.2200 = 1 FF
US interest rate 15%
French interest rate 10%
60. Purchasing Power Parity (PPP)
It focuses on inflation and exchange rate relationships.
There are 2 forms of PPP theory:
1.
Absolute Purchasing Power Parity
It states that price levels should be equal worldwide when
expressed in a common currency. i.e. A unit of home
currency should have the same purchasing power all around
the world.
61. Absolute Purchasing Power
Parity
Also, the exchange rate between currencies of two countries is equal to the
ratio of the price levels in the two nations.
i.e. Rab = Pa /Pb
Where,
Pa – General price level in Nation A
Pb- General price level in nation B
Rab – Exchange rate between currencies of Nation A & B
62. Absolute Purchasing Power
Parity
It does not consider:
a) Transportation cost, tariffs, quotas. Product differentiation.
b) Existence of non- traded goods and services eg Cement,
bricks, doctors etc.
63. Relative Purchasing Power Parity
The change in the exchange rate over a period of time should
be proportional to the relative change in the price levels in the
2 nations over the same time period.
et/e0= (1+IA)t / (1+IB)t
Ia and Ib are inflation rates, e0 is the value of a’s currency in
terms of unit of b’s currency in the beginning of the period and
et is the spot exchange rate in period t
64. Shortcomings of the PPP theory
Shortcomings of the PPP Theory
The theory predicts well in the long run but not the short run
Limits to the PPP Theory
Not all goods and services are traded internationally
The greater the share of non-traded goods, the less precise the PPP
theory
For example, the market for haircuts is very local
Not all internationally traded goods and services are perfectly
standardized commodities
65. Problems in Relative PPP
Ratio of prices of non- traded goods to the
prices of traded goods & services is
consistently higher in developed nations than
in developing nations.
Various factors other than relative price levels
can influence exchange rates in the short run.
66. International Fisher Effect
(IFE)
IFE uses interest rates rather than inflation rates
It states that interest rate differential shall equal the inflation
rate differential.
An investor will hold assets denominated in currencies likely
to depreciate only when the interest rate on those assets is high
enough to compensate loss on account of depreciating.
67. International Fisher Effect
(IFE)
The IFE suggests that given two countries,
the currency in the country with the higher
interest rate will depreciate by the amount of
interest rate differential. That is, within a
country, the nominal interest rate tends to
approximately equal the real interest rate plus
the expected inflation rate.
Nominal= Real + Expected inflation rate
68. International Fisher Effect
(IFE)
The proportion that the nominal interest rate
varies directly with the expected inflation rate,
known as Fisher effect.
Inc. in interest rate- Inc. in exchange rate
It is often argued that an increase in a
country’s interest rate tends to increase the
exchange value of its currency by inducing
capital inflows.
69. International Fisher Effect
(IFE)
However, the IFE argues that a rise in a
country’s nominal interest rate relative to the
nominal interest rate of other countries
indicates that the exchange value of the
country’s currency is expected to fall. This is
due to the increase in the country’s expected
inflation and due to the increase in the
nominal interest rate.
70. Foreign Exchange Risk
Foreign exchange risk is the possibility of a
gain or loss to a firm that occurs due to
unanticipated changes in the exchange rate.
The primary goal is to protect corporate
profits from the negative impact of exchange
rate fluctuations.
72. 1. Translation exposure
All financial statements of a foreign
subsidiary have to be translated into the
home currency for the purpose of finalising
the accounts for any given period.
Translation exposure is the degree to which a
firm’s foreign currency denominated financial
statements are affected by the exchange rate
changes.
73. 1. Translation exposure
The changes in the asset valuation due to
fluctuations in the exchange rate will affect
the group’s assets, capital structure ratios,
profitability ratios, solvency ratios etc.
74. 1. Translation exposure
The following procedure has been followed:
Assets & Liabilities are to be translated at the
current rate, i.e. the rate prevailing at the time of
preparation of consolidated statements.
All revenues & expenses are to be translated at the
actual exchange rates prevailing on the date of
transactions.
Translation adjustments (gains or losses) are not be
charged to the net income of the reporting company.
(They are accumulated & reported in a separate
account).
77. Example
In the next period, exchange rate fluctuates
to $ 1 = Rs. 47.50
Assets
Liabilities
Rs. 15,300,000
Rs 15,300,000
$ 3,22,105
$ 3,22,105
Decrease in the Book Value of the assets is $
2736.
78. Transaction exposure
This exposure refers to the extent to which
the future value of firm’s domestic cash flow
is affected by exchange rate fluctuations. It
arises from thepossibility of incurring
exchange rate gains or losses on transaction
already entered into and denominated in a
foreign currency.
More the transactions, more the risk.
79. Transaction exposure
All transactions gains and losses should be
accounted for and included in the equity’s net
income for the reporting period.
The exposure could be interpreted either
from the standpoint of the affiliate or the
parent company.
80. Economic Exposure
It refers to the degree to which a firm’s
present value of future cash flows can be
influenced by exchange rate fluctuations.
It is a more managerial concept than an
accounting concept.
The risk is that a variation in the rate will
affect the company’s competitive position in
the market and hence its profits.
It cannot be hedged.
81. Tools & Techniques of Foreign
Exchange Risk Management
Forward contracts
Futures contracts
Option contract
Currency swap- It is an agreement where two
parties exchange a series of cash flows in
one currency for a series of cash flows in
another currency, at agreed intervals over an
agreed period.
82. Management of Translation
exposure
Accounting exposure/ translation exposure,
arises because MNCs may wish to translate
financial statements of foreign affiliates into
their home currency in order to prepare
consolidated financial statements. Or to
compare financial results.
Translation exposure = Exposed assets –
Exposed liabilities
83. Management of Translation
exposure- Example
A US parent company has a single wholly
owned subsidiary in France. This subsidiary
has monetary assets of 200 million francs &
monetary liabilities of 100 million francs. The
exchange rate declines from FFr 4 per dollar
to FFr 5 per dollar.
84. Management of Translation
exposure- solution
The potential foreign exchange loss on the
company’s exposed net monetary assets of 100
million francs would be $5 million.
Monetary assets
FFr 200 million
Monetary liabilities
FFr 100 million
Net exposure
FFr 100 million
Pre-devaluation rate
(FFr 4= $1) FFr 100 million $ 25.0 million
Post-devaluation rate
(FFr 5= $1) FFr 100 million $ 20.0 million
Potential Exchange Loss $ 5.0 million
85. Translation Methods
1. The current rate method
2.
The monetary/ non- monetary method
3.
The temporal method
4. The current / non- current method
86. 1. The Current Rate Method
All balance sheet and income items are
translated at the current rate of exchange,
except for stockholders’ equity.
Income
statement
items,
including
depreciation and cost of goods sold, are
translated at either the actual exchange rate
(date of translation) or the weighted average
exchange rate for the period.
87. 1. The Current Rate Method
Dividends paid are translated at the
exchange rate prevailing on the date the
payment was made.
The common stock account and paid in
capital accounts are translated at historical
rates.
Gains & losses by translation adjustmentsseparate account – known as Cumulative
Translation Adjustment (CTA).
88. 2. The Monetary/ NonMonetary Method
Monetary items- are those that represent a
claim to receive or an obligation to pay fixed
amount of foreign currency unit, e.g. cash,
accounts receivable, current liabilities etc.
Monetary items- Current rate
89. 2. The Monetary/ NonMonetary Method
Non- Monetary items- are those that do not
represent a claim to receive or an obligation
to pay fixed amount of foreign currency items,
e.g. inventory, fixed assets, long-term
investments etc.
Monetary items- Historical rates
90. 3. Temporal Method
Modified version of monetary / non- monetary
method.
If inventory is in balance sheet at market
values, then current rate otherwise historical
rate.
Income statement items- average exchange
rate
Cost of Goods Sold (COGS) & Depreciationhistorical rates.
91. 4. The Current/ Non- Current
Method
Current assets & liabilities- Current exchange
rate
Non- Current assets & Liabilities – Historical
rates
92. Functional vs Reporting
Currency
Functional Accounting Standard’s Board (FASB
52) differentiates between a foreign affiliate’s
“functional” and “reporting” currency.
Functional currency is defined as the currency of
the primary economic environment in which the
affiliate operates and in which it generates cash
flows. Generally, this is the local currency of the
country in which the entity conducts most of the
business.
93. Functional vs Reporting
Currency
The reporting currency is the currency in
which the parent firm prepares its own
financial statements./; This currency is
normally the home country currency, i.e., the
currency of the country in which the parent is
located and conducts most of its business.
94. Conclusion
Accounting exposure is the potential for
translation losses or gains. Translation is the
measurement, in a reporting currency, of
assets, liabilities, revenues and expenses of
a foreign operation where the foreign
accounts are originally denominated and/ or
measured in functional currency.
95. Management of Economic
Exposure
Economic exposure measures the impact of
an actual conversion on the expected future
cash flows as a result of an unexpected
change in exchange rates.
96. Measuring Economic
Exposure
The degree of economic exposure to
exchange rate fluctuations is significantly
higher for a firm involved in international
business than for a purely domestic firm.
97. Measuring Economic
Exposure
One method of measuring an MNCs
economic exposure is to classify the cash
flows into different items on the income
statement and predict movement of each
item in the income statement based on a
forecast of exchange rates.
This will help in developing an alternate
exchange rate scenario and the forecasts for
the income statement items can be revised.
98. Managing Economic Exposure
The following are some of the proactive
marketing & production strategies which a
firm can pursue in response to anticipated
or actual real exchange rate changes.
1. Marketing initiatives
a) Market selection
b) Product strategy
c) Pricing strategy
d) Promotional strategy
99. Managing Economic Exposure
2. Production initiatives
a) Product sourcing
b) Input mix
c) Plant location
d) Raising productivity
100. Market selection
Market strategy considerations for an
exporter are the markets in which to sell, i.e.
market selection. It is also necessary to
consider the issue of market segmentation
with individual countries.
A firm that sells differentiated products to
more affluent customers may not be harmed
as much by a foreign currency devaluation as
will a mass marketer.
101. Product strategy
Companies can also respond to exchange
rate changes by altering their product
strategy, which deals in such areas as new
product introduction.
Product line decisions
Product innovations
102. Promotional strategy
A firm exporting its products after a domestic
devaluation may well find that the return per
home currency expenditure on advertising or
selling is increased because of the product’s
improved price positioning.
103. Pricing Strategy- Market Share
vs Profit Margin
To begin the analysis, a firm selling overseas
should follow the standard economic
proposition of setting the price that
maximizes dollar profits (by equating
marginal revenues and marginal costs). In
making this decision, however, profits should
be translated using the forward exchange
rate that reflects the true expected dollar
value of the receipts upon collection.
104. Input Mix
Outright additions to facilities overseas
accomplish a manufacturing shift. A more
flexible solution is to purchase more
components overseas. This practice is called
as outsourcing.
105. Shifting production among
plants
MNCs with world wide production systems
can allocate production among their several
plants in line with the changing home
currency cost of production, increasing
production in a nation whose currency has
devalued and decreasing production in a
country where their has been a revaluation.
Assumption- Company has a portfolio of
plants worldwide.
107. Raising Productivity
Raising productivity through closing inefficient
plants, automating heavily and negotiating
wage benefit cutbacks and work rule
concessions is another alternative to manage
economic exposure.
108. Corporate philosophy for
Exposure Management
High risk
All exposures left unhedged
Low reward
Active trading
High reward
Selective hedging
All exposures hedged
Low risk
110. Multinational Cash
Management
Objectives of cash management
How to manage & control the cash resources
of the company as quickly and efficiently as
possible.
Achieve the optimum utilization and
conservation of the funds.
111. Objective of an efficient
system:
Minimise the currency exposure risk.
Minimise the country and political risk.
Minimise the overall cash requirements of the
company.
Minimise the transaction costs.
Full benefits of economies of scale as well as
the benefit of superior knowledge.
112. Techniques to Optimise Cash
Flows
Accelerating cash inflows.
Managing blocked funds.
Leading and lagging strategy.
Using netting to reduce overall transaction
costs by eliminating a no. of unnecessary
conversions and transfer of currencies.
Minimising the tax on cash flow through
international transfer pricing.
113. Accelerating cash inflows
Quicker recovery of inflows by
# establishing lockboxes
# Pre-authorising payments- It allows an
organisation to charge a customer’s bank
account up to some limit.
114. Managing blocked funds
The host country may block funds that the
subsidiary attempts to send to the parent.
For eg. The host country may ask the
company to re-invest the funds for few years
and create jobs.
Prior to making a capital investment in a
foreign subsidiary, the parent firm should
investigate the potential of future funds
blockage.
115. Leading and Lagging
MNCs can accelerate (lead) or delay (lag) the
timing of foreign currency payments by
modifying the credit terms extended by one
unit to another.
116. Leading & Laggingadvantages
It is used for minimising foreign exchange
exposure and helps in shifting liquidity among
affiliates by changing credit terms.
It helps in taking advantage of expected
revaluations and devaluations of currency
movements.
No formal note of indebtedness is required
and credit terms can be changed by
increasing & decreasing the terms on the
account.
117. Example
An MNC faces the after tax borrowing and
lending rates in UK and the US as shown
below:
Borrowing rate
Lending rate
%
%
US
3.6
2.8
UK
3.4
2.6
+
119. Netting
Netting is a technique of optimising cash flow
movements with the joint efforts of
subsidiaries.
The process involves the reduction of
administration and transaction costs that
result from currency conversion.
Netting helps in minimising the total volume
of inter company fund flow.
120. Advantages of Netting
It reduces the no. of cross border transactions
between subsidiaries, thereby reducing the overall
costs of such cash transfers.
There is a more co-ordinated effort among all the
subsidiaries to accurately report and settle various
accounts
It reduces the need for foreign exchange conversion
and hence, reduces transaction costs
It helps improved cash flow forecasting since, only
net cash transfers are made at the end of each
period.
122. Bilateral Netting System
Example:
Suppose, The US parent and the German
Affiliate have to receive net $ 40,000 and $
30,000 from one another. Then, under a
bilateral netting system, only one payment
will be made – the German affiliate pays the
US parent an amount equal to $ 10,000.
123. Bilateral Netting System
Pay $ 30,000
US Parent
German Affiliate
Pay $ 40,000
After Bilateral Netting
German Affiliate
US Parent
Pay $ 10,000
124. Multinational Netting System
In this system, each affiliate nets all its inter
affiliate receipts against all its disbursements.
It then transfers or receives the balance,
depending upon whether it is the net receiver
or a payer.
To be really effective, it needs centralised
and effective communication system and
discipline.
127. Political Risk Indicators
It is very difficult to measure political risk
associated with a particular country or a
borrower. Assessing political risk is a
continuous problem.
Stability of the local political environment
Consensus regarding priorities
Attitude of the host government
War
Mechanisms for expressions of discontent
128. Economic Risk Indicators
Inflation rate
Current and potential state of the country’s
economy
Resource base
Adjustment to external shocks
Other factors include exports and imports as
a proportion of GDP etc.
129. Techniques to assess Country
Risk
1. Debt related factors:
For eg, countries with a high export growth
rate are more likely to be able to service their
debt and are expected t enjoy better credit
worthiness rating since exporters are the
main source of foreign exchange earnings for
most of the countries.
130. Techniques to assess Country
Risk
1. Debt related factors:
The debt service indicators include:
Debt / GDP (to rank countries according to
external debt)
Debt- service ratio (relates debt service
requirements to export incomes)
Short term debt/ Total exports
131. Techniques to assess Country
Risk
1. Debt related factors:
The debt service indicators include:
Imports/
GDP (Sensitivity of domestic
economy to external development)
Net interest payment / Export of goods and
services
132. Techniques to assess Country
Risk
2. Balance of Payments
The balance of payment indicators include:
%age increase in imports / %age increase in
GDP (this ratio shows the income elasticity of
demand for exports)
Current Account/ GNP (a measure of the
country’s net external borrowings relative to
country size)
133. Techniques to assess Country
Risk
2. Balance of Payments
The balance of payment indicators include:
Imports of goods and services / GDP
Effective exchange rate Index (measures the
relative movements in domestic and
international prices)
134. Techniques to assess Country
Risk
3. Economic Performance
It can be measured in terms of a country’s
rate of growth and its rate of inflation. The
inflation can be regarded as a proxy for the
quality of economic management. Thus, the
higher the inflation rate, the lower the
creditworthiness rating.
135. Techniques to assess Country
Risk
3. Economic Performance
Ratios that can be used are:
GNP per capita
Money supply (serves as an early indicator for future
inflation)
Gross Domestic Savings / Gross National Product
Gross Investment / GDP. This ratio is called
propensity to invest ratio and captures a country’s
prospects for future growth.
136. Techniques to assess Country
Risk
4. Political Instability undermines the
economic capacity of a country to service its
debt.
Political
instability
generates
adverse
consequences for economic growth, inflation,
domestic supply, level of import dependency
and creates foreign exchange shortage from
imbalance between exports and imports.
137. Techniques to assess Country
Risk
4. Political instability:
The political instability indicators which can
be considered are:
The political protest, for example, protest
demonstrations, political strikes, riots, political
assassination etc.
Successful and unsuccessful irregular
transfer.
138. Techniques to assess Country
Risk
5. Check list approach
A number of relevant indicators that
contribute to a firm’s assessment of country
risk are chosen and a weight is attached to it.
Factors having greater influence on country
risk are assigned greater weights.
It employs a combination of statistical and
judgmental factors.
139. Techniques to assess Country
Risk
5. Check list approach
Statistical factors try and assess the performance of
a country’s economy. (study past to judge the
future)
Judgmental factors – give some indication of a
country’s future ability and willingness to repay.
The weighting of the judgmental and statistical
factors could then be done to arrive at thea risk
ranking for countries.
141. Cost of capital
Cost of capital for a firm is the rate that must
be earned in order to satisfy the required rate
of return of the firm’s investors.
It has a major impact on firm’s value.
Lesser the cost of capital, the better it is.
142. Cost of capital for MNCs vs
Domestic firms
There is a difference between Cost of capital
for MNCs and Domestic firms because of the
following:
1. Size of the firm: Firms that operate
internationally are usually much bigger in size
than firms that operate only in the domestic
market. MNCs generally borrow substantial
amount of funds by virtue of their size and
are in a position to get it at cheaper rates.
143. Cost of capital for MNCs vs
Domestic firms
2. Foreign exchange risk: An exceptionally
volatile exchange rate is not much
appreciated as it leads to wide fluctuations in
in the cash flows of an MNC. It would be
difficult for the firm to meet its fixed
commitments and therefore, the shareholders
and creditors demand a higher return which,
in turn, would increase the cost of capital of
the firm.
144. Cost of capital for MNCs vs
Domestic firms
3. Access to international capital markets:
MNCs can access to international capital
markets helps them to attract funds at lower
cost than domestic companies.
4. International diversification effect: If a firm’s
cash flows come from sources all over the
world, there might be more stability in them.