International Financial Management

Module 1 - International Financial Environment

International Financial Environment

Importance, Rewards and Risk of International finance Goals of MNCs International business methodsmethodsExposure to International risk International Monetary System Government influence on exchange rate

Importance of International Finance

Rapid Economic growth Flow of goods New and more remunerative markets Changes in the allocation of resources within and across countries.

 Developing countries like India followed an inward looking development strategy concentrating on import substitution , eventually realised that participation in International trade in terms of goods, capital and technology was vital.

Global links
Integrated and interdependent financial environment, close links between capital and money markets, trade growing faster than NI in developing countries Revolution in ICT.

International Finance Features

Foreign exchange risk Political risk Expanded opportunity sets Market imperfections

Goals of MNCs
Maximise the shareholders wealth. For this, the managers must understand: a) International Financial System b) Foreign Exchange market c) Host countrys Environment

International Business Methods

Licensing Franchising Joint Ventures Establishing New Foreign Subsidiaries Management Contracts

Licensing
A firm in one country licenses the use of some or all Intellectual property to a firm of some other country in exchange for fees or royalty payment. Licensing enables a firm to use technology in foreign markets without a substantial investment in foreign countries.

Franchising and Joint Ventures

Franchising : A firm in one country authorising a firm in another country to utilise its brand names, logos in return for royalty payment. Joint Ventures: JVs allow two or more firms to apply their respective comparative advantage in a given project.

Subsidiaries and Management Contracts

A firm can penetrate foreign markets by establishing new operations in foreign countries with huge investment. Management Contracts: A firm in one country agrees to operate or provide facilities to firms in another country for an agreed fees.

Basic Questions
Benefit to cost in the above methods and which would be the best? Can some common measure be applied to measure cost-benefit decision in the above methods?

Exposure to International Risk

Macro-Economic environmental risk: affect all firms in the economy. Core Business Risk: are specific to firm. Exposure: It is the measure of sensitivity of the measure of the variability of the value of the item attributable to the risk factor.

Example
Consider a firm whose business involved both exports to and imports from US during 1993-95 when the Rupee-Dollar exchange rate was rock steady. The firm would agree that the operating cash flows were sensitive to rupee-dollar exchange rate,i.e., it had significant exposure to this exchange rate; at the same time, it would have said that it does not perceive any risk on account of the stability of the exchange rate, as the probability of fluctuations is minimal. Thus the magnitude of risk is determined by the magnitude of exposure and the degree of variability in the relevant risk factor.

Exposure
Definition : Exposure of a firm to a risk factor is the sensitivity of the real value of a firms assets, liabilities or operating income, expressed in its functional currency, to unanticipated changes in risk factor. Note: a) Value of the assets, liabilities, or operating income to be expressed in the functional currency of the firm.

Exposure
b) Exposure is defined with respect to the real values, i.e. adjusted to inflation. c) Only unanticipated changes in the
relevant risk factor are to be considered. For expected changes, relevant forward rates are considered.

Types of Exposure
Currency Exposure
Accounting Exposure Translation Transaction Operating Exposure Contingent Competition/ Strategic Exposure

Strategic Exposure
It has significant implications for some strategic business decisions. Examples: a) In the late 70s Laker Airways started offering

cut-price, trans-Atlantic air travel to British tourists taking vacations in the U.S. The dollar was weak and tourist traffic was strong. Laker then expanded its fleet by buying airdraft financed with dollar borrowing. In late 1981, the dollar started rising and climb for nearly four years. On the other hand, the transaction exposure on servicing the dollar liabilities and operating exposure due to falling traffic created a severe cash crunch for Laker. The strong dollar meant that US vacations were expensive proposition for British tourists. Laker Airways went bankrupt eventually.

Examples
b) The relentless rise of the dollar during the first half of eighties eroded the competitive position of many American firms. Kodak found most of its costs were dollar denominated while their sales were in all parts of the world denominated in different currencies. They faced stiff competition from Fuji of Japan. Kodak could not raise prices without significant loss of sales.

Examples
Closer home, many Indian Manufacturers of cars and twowheelers with significant import content denominated in Yen have found that persistent strength of the Yen has meant cost raise which they could not pass on to the consumer because of depressed demand conditions and competitive considerations.

Summing Up..
Exposures on anticipated cash flows denominated in foreign currency and balance sheet exposures of foreign operations. translation exposure. Operating exposure is defined as the sensitivity of future operating profits to unanticipated changes in the exchange rates. Strategic exposure refers to still horizon and contemplates longer term operational flexibility such as changing product-mix, shifting location of operations, adopt new technologies etc.

Conclusion
Value based exposure is difficult to operationalise, which focuses on the impact of currency fluctuations on the market value of the firm. It must take into account both short term accounting exposures as well as operating and strategic flexibility in responding to currency movements.

International Monetary System

For the efficient operation of International trade, an efficient multilateral financial system is a prerequisite. Objectives: a) Exchange rate regimes b) International liquidity c) IMF d) Adjustment process in balancing imports and exports.

Exchange rate regimes

It refers to the mechanism, procedures and institutional framework for determining exchange rates at a point in time and changes in them over time, including factors which induce changes. Three Main Regimes: a) Gold regime lasted for first four decades of 20th century. b) Adjustable exchange rates lasted till 1973. c) Managed floats - Countries chose the exchange rate depending on its policies and circumstances.

Gold regime
The gold standard: The authorities stand ready to convert, at a fixed rate, the paper currency of another currency issued by them into paper currency of another country which is operating a gold bullion standard. Thus, if rupees are freely convertible into dollars and dollars in turn into gold, rupee can be said to be on a gold-exchange

Gold regime
The exchange rate between any pair of currencies will be determined by their respective exchange rates against gold. This is also called as mint parity rate of exchange. Three rules of the game: a) Must fix once for all rate of conversion of paper money issued into gold b) There must be free flow of gold between countries on gold standard. c) The money supply in the country must be tied to the amount of gold the monetary authorities have in reserve. If this decreases, money supply must contract and vice-versa.

Bretton Woods System

After the II World War, US and UK revamped the world monetary system, where World Bank, IMF and Bretton Woods System took birth. Features of Bretton Woods System: a) US Govt. undertook to convert the US dollar freely into gold at a fixed parity of $35 per ounce. b) Other member countries of the IMF agreed to fix parities of their currencies vis--vis the dollar with a variation within 1% on either side of the central parity being permissible.

Exchange rate regimes IMFs classification System

Exchange rate regimes
Dollarisation, Euroisation Currency board

Description
No separate legal tender (EU members) Currency fully backed by foreign exchange reserves .(countries which adopted other currency as their currency, E.g.Panama$,Monaco- Euro,) Peg to another currency or currency basket within a band of +/- 1%. Market determined exchange rate with monetary policy independent of the exchange rate policy.

Conventional fixed pegs Independent Float

Some thoughts ..
In the years to come, there will be only two types of exchange rate regimes : a) Truly fixed rate arrangements like, Currency Union b) Truly market determined , independently floating exchange rates.

Impossible Trinity
It asserts that a country can achieve any two of the three policy goals, but not all the three: a) A stable exchange rate b) A financial system integrated with global financial system c) Freedom to conduct an independent monetary policy. Of these, a) & b) can be achieved with currency Union, b) & c) within an independently floating exchange rate and a) & c) with capital controls.

Impossible Trinity

Monetary Independence

Exchange rate stability

PURE FLOAT

Integration with global financial markets

CURRENCY UNION

Assignment 1
Write a note on Government influence on exchange rate in India. Write a note on the role of IMF in the present international financial system. Write a note on SDRs and EMU (Economic and Monetary Union).