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International Finance. FIN45 Michael Dimond. The Balance of Payments. The measurement of all international economic transactions between the residents of a country and foreign residents is called the Balance of Payments (BOP) The IMF is the primary source of similar statistics worldwide

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International finance

International Finance

FIN45Michael Dimond


The balance of payments
The Balance of Payments

The measurement of all international economic transactions between the residents of a country and foreign residents is called the Balance of Payments (BOP)

The IMF is the primary source of similar statistics worldwide

Multinational businesses use various BOP measures to gauge the growth and health of specific types of trade or financial transactions by country and regions of the world against the home country


The balance of payments1
The Balance of Payments

Monetary and fiscal policy must take the BOP into account at the national level

Businesses need BOP data to anticipate changes in host country’s economic policies driven by BOP events

BOP data may be important for the following reasons

BOP is important indicator of pressure on a country’s exchange rate, thus potential to either gain or lose if firm is trading with that country or currency

Changes in a country’s BOP may signal imposition (or removal) of controls over payments, dividends, interest, etc

BOP helps to forecast a country’s market potential, especially in the short run

Rule of thumb to understand the BOP: follow the cash flow


Fundamentals of bop accounting
Fundamentals of BOP Accounting

The BOP must balance

Elements in measuring international economic activity:

Identifying what is/is not an international economic transaction

Understanding how the flow of goods, services, assets, money create debits and credits

Understanding the bookkeeping procedures for BOP accounting


Typical bop transactions
Typical BOP Transactions

Examples of BOP transactions from US perspective

Honda US is the distributor of cars manufactured in Japan by its parent, Honda of Japan

US based firm, Fluor Corp., manages the construction of a major water treatment facility in Bangkok, Thailand

US subsidiary of French firm, Saint Gobain, pays profits (dividends) back to parent firm in Paris

An American tourist purchases a small Lapponia necklace in Finland

A Mexican lawyer purchases a US corporate bond through an investment broker in Cleveland


Defining international economic transactions
Defining International Economic Transactions

Current Account Transactions

The export of merchandise, goods such as trucks, machinery, computers is an international transaction

Imports such as French wine, Japanese cameras and German automobiles are international transactions

The purchase of a glass figure in Venice by an American tourist is a US merchandise import

Financial Account Transactions

The purchase of a US Treasury bill by a foreign resident


Bop as a flow statement
BOP as a Flow Statement

Exchange of Real Assets – exchange of goods and services for other goods and services or for monetary payment

Exchange of Financial Assets – Exchange of financial claims for other financial claims


The current account
The Current Account

Goods Trade – export/import of goods.

Services Trade – export/import of services; common services are financial services provided by banks to foreign investors, construction services and tourism services

Income – predominately current income associated with investments which were made in previous periods. Additionally the wages & salaries paid to non-resident workers

Current Transfers – financial settlements associated with change in ownership of real resources or financial items. Any transfer between countries which is one-way, a gift or a grant,is termed a current transfer

Typically dominated by the export/import of goods, for this reason the Balance of Trade (BOT) is widely quoted



U s balances 1985 2009 bn
U.S. Balances, 1985-2009 ($Bn)

U.S. Trade Balance and Balance on Services and Income


The capital and financial accounts
The Capital and Financial Accounts

Capital account measures transfers of fixed assets such as real estate and acquisitions/disposal of non-produced/non-financial assets

Financial account components:

Direct Investment: Net balance of capital which is dispersed from and into a country for the purpose of exerting control over assets. This category includes foreign direct investment

Portfolio Investment: Net balance of capital which flows in and out of the country but does not reach the 10% ownership threshold of direct investment. The purchase and sale of debt or equity securities is included in this category

Other Investment Assets/Liabilities: Consists of various short and long-term trade credits, cross-border loans, currency and bank deposits and other accounts receivable and payable related to cross-border trade



The other accounts
The Other Accounts

Net Errors and Omissions – Account is used to account for statistical errors and/or untraceable monies within a country

Official Reserves – total reserves held by official monetary authorities within a country.

These reserves are typically comprised of major currencies that are used in international trade and financial transactions and reserve accounts (SDRs) held at the IMF

Under a fixed rate regime official reserves are more important as the government assumes the responsibility to maintain parity among currencies by buying or selling its currency on the open market

Under a floating rate regime the government does not assume such a responsibility and the importance of official reserves is reduced


Global finance in practice china s twin surpluses
Global Finance in Practice: China’s Twin Surpluses

China’s twin surpluses aka “double surplus” in the current and financial accounts is highly unusual

Typically, these relationships are inverses of one another

The reason for the twin surpluses is due to the exceptional growth of the Chinese economy




Official foreign exchange reserves
Official Foreign Exchange Reserves

Between 2001 – 2010 China increased foreign exchange reserves from $200 billion to $2,500 billion, more than a 10-fold increase

China is now able to manage its currency to maintain competitiveness worldwide

China can also maintain a relatively stable fixed exchange rate against other major currencies




Balance of payments interactions
Balance of Payments Interactions

A nation’s balance of payments interacts with nearly all of its key macroeconomic variables:

Gross domestic product (GDP)

The exchange rate

Interest rates

Inflation rates




Balance of payments interactions1
Balance of Payments Interactions

In a static (accounting) sense, a nation’s GDP can be represented by the following equation:

GDP = C + I + G + X – M

C = consumption spending

I = capital investment spending

G = government spending

X = exports of goods and services

M = imports of goods and services

X – M =

Current accountbalance


The balance of payments and exchange rates
The Balance of Payments and Exchange Rates

A country’s BOP can have a significant impact on the level of its exchange rate and vice versa depending on that country’s exchange rate regime

The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system

Under a fixed exchange rate system the government bears the responsibility to assure a BOP near zero

Under a floating exchange rate system, the government of a country has no responsibility to peg its foreign exchange rate


The balance of payments and exchange rates1

The relationship between BOP and exchange rates can be illustrated by use of a simplified equation:

CI = capital inflows

CO = capital outflows

FI = financial inflows

FO = financial outflows

FXB = official monetary reserves

The Balance of Payments and Exchange Rates

Current

Account

Balance

(X-M)

Capital

Account

Balance

(CI - CO)

Financial

Account

Balance

(FI - FO)

Reserve

Balance

(FXB)

Balance

of

Payments

BOP

+

+

+

=


The balance of payments and interest rates
The Balance of Payments and Interest Rates illustrated by use of a simplified equation:

Apart from the use of interest rates to intervene in the foreign exchange market, the overall level of a country’s interest rates compared to other countries does have an impact on the financial account of the balance of payments

Relatively low interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country-currencies

In the U.S. however, the opposite has occurred as a result of attractive growth rate prospects, high levels of productive innovation, and perceived political stability


The balance of payments and inflation rates
The Balance of Payments and Inflation Rates illustrated by use of a simplified equation:

Imports have the potential to lower a country’s inflation rate

In particular, imports of lower priced goods and services places a limit on what domestic competitors charge for comparable goods and services


Trade balances and exchange rates
Trade Balances and Exchange Rates illustrated by use of a simplified equation:

A simple concept in principle: Changes in exchange rates changes the relative prices of imports and exports which in turn result in changes in quantities demanded

In reality the process is less straight-forward


The j curve adjustment path
The J-Curve Adjustment Path illustrated by use of a simplified equation:

Trade balance adjustment occurs in three stages over a varying and often lengthy period of time

The currency contract period

Adjustment is uncertain due to existing contracts that must be fulfilled

The pass-through period

Importers and exporters must eventually pass along the cost changes

Quantity adjustment period

The expected balance of trade is eventually realized

U.S. trade balance = (P$xQx) – (S$/fc PfcM QM)


The j curve
The J-Curve illustrated by use of a simplified equation:

Trade Balance Adjustment to Exchange Rate Changes


Mncs are exposed to risk from exchange rates
MNCs are exposed to risk from exchange rates illustrated by use of a simplified equation:

Resulting from Market Forces

Resulting from Accounting

EconomicExposure

Purely Accounting Based


Foreign exchange exposure
Foreign Exchange Exposure illustrated by use of a simplified equation:

Foreign exchange exposure is a measure of the potential for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates

These three components (profits, cash flow and market value) are the key financial elements of how we view the relative success or failure of a firm

While finance theories tell us that cash flows matter and accounting does not, we know that currency-related gains and losses can have destructive impacts on reported earnings – which are fundamental to the markets opinion of that company


Types of foreign exchange exposure
Types of Foreign Exchange Exposure illustrated by use of a simplified equation:

Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes

Translation Exposure – the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements

Operating Exposure – measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates


Why hedge
Why Hedge? illustrated by use of a simplified equation:

Hedging protects the owner of an asset (future stream of cash flows) from loss

However, it also eliminates any gain from an increase in the value of the asset hedged against

Since the value of a firm is the net present value of all expected future cash flows, it is important to realize that variances in these future cash flows will affect the value of the firm and that at least some components of risk (currency risk) can be hedged against

Companies must first decide what they are trying to accomplish through their hedging program.


Why hedge the pros cons
Why Hedge - the Pros & Cons illustrated by use of a simplified equation:

Proponents of hedging give the following reasons:

Reduction in risk in future cash flows improves the planning capability of the firm

Reduction of risk in future cash flows reduces the likelihood that the firm’s cash flows will fall below a necessary minimum

Management has a comparative advantage over the individual investor in knowing the actual currency risk of the firm

Markets are usually in disequilibirum because of structural and institutional imperfections


Why hedge the pros cons1
Why Hedge - the Pros & Cons illustrated by use of a simplified equation:

Opponents of hedging give the following reasons:

Shareholders are more capable of diversifying risk than the management of a firm; if stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage that risk, investors have already factored the foreign exchange effect into a firm’s market valuation

Currency risk management does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow

The expected NPV of hedging is zero (Managers cannot outguess the market; markets are in equilibrium with respect to parity conditions)

Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss

Management often conducts hedging activities that benefit management at the expense of shareholders


International finance

Hedging’s Impact on Expected Cash Flows of the Firm illustrated by use of a simplified equation:


Measurement of transaction exposure
Measurement of Transaction Exposure illustrated by use of a simplified equation:

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely

Purchasing or selling on credit goods or services when prices are stated in foreign currencies

Borrowing or lending funds when repayment is to be made in a foreign currency

Being a party to an unperformed forward contract and

Otherwise acquiring assets or incurring liabilities denominated in foreign currencies


Purchasing or selling on open account
Purchasing or Selling on Open Account illustrated by use of a simplified equation:

Suppose Caterpillar sells merchandise on open account to a Belgian buyer for €1,800,000 payable in 60 days

Further assume that the spot rate is $1.2000/€ and Caterpillar expects to exchange the euros for €1,800,000 x $1.2000/€ = $2,160,000 when payment is received

Transaction exposure arises because of the risk that Caterpillar will something other than $2,160,000 expected

If the euro weakens to $1.1000/€, then Caterpillar will receive $1,980,000

If the euro strengthens to $1.3000/€, then Caterpillar will receive $2,340,000


Purchasing or selling on open account1
Purchasing or Selling on Open Account illustrated by use of a simplified equation:

Caterpillar might have avoided transaction exposure by invoicing the Belgian buyer in US dollars (risk shifting), but this might have lead to Caterpillar not being able to book the sale

If the Belgian buyer agrees to pay in dollars, Caterpillar has transferred the transaction exposure to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days


International finance

The Life Span of a Transaction Exposure illustrated by use of a simplified equation:


Borrowing and lending
Borrowing and Lending illustrated by use of a simplified equation:

A second example of transaction exposure arises when funds are loaned or borrowed

Example: PepsiCo’s largest bottler outside the US is located in Mexico, Grupo Embotellador de Mexico (Gemex)

On 12/94, Gemex had US dollar denominated debt of $264 million

The Mexican peso (Ps) was pegged at Ps$3.45/US$

On 12/22/94, the government allowed the peso to float due to internal pressures and it sank to Ps$4.65/US$. In January it reached Ps$5.50


Borrowing and lending1
Borrowing and Lending illustrated by use of a simplified equation:

Gemex’s peso obligation now looked like this

Dollar debt mid-December, 1994:

US$264,000,000  Ps$3.45/US$ = Ps$910,800,000

Dollar debt in mid-January, 1995:

US$264,000,000  Ps$5.50/US$ = Ps$1,452,000,000

Dollar debt increase measured in Ps

Ps$541,200,000

Gemex’s dollar obligation increased by 59% due to transaction exposure


Other causes of transaction exposure
Other Causes of Transaction Exposure illustrated by use of a simplified equation:

When a firm buys a forward exchange contract, it deliberately creates transaction exposure; this risk is incurred to hedge an existing exposure

Example: US firm wants to offset transaction exposure of ¥100 million to pay for an import from Japan in 90 days

Firm can purchase ¥100 million in forward market to cover payment in 90 days


Contractual hedges
Contractual Hedges illustrated by use of a simplified equation:

Transaction exposure can be managed by contractual, operating, or financial hedges

The main contractual hedges employ forward, money, futures and options markets

Operating and financial hedges use risk-sharing agreements, leads and lags in payment terms, swaps, and other strategies

A natural hedge refers to an offsetting operating cash flow, a payable arising from the conduct of business

A financial hedge refers to either an offsetting debt obligation or some type of financial derivative such as a swap


Risk management in practice
Risk Management in Practice illustrated by use of a simplified equation:

Which Goals?

The treasury function of most firms is usual considered a cost center; it is not expected to add to the bottom line

However, in practice some firms’ treasuries have become aggressive in currency management and act as though they were profit centers

Which Exposures?

Transaction exposures exist before they are actually booked yet some firms do not hedge this backlog exposure

However, some firms are selectively hedging these backlog exposures and anticipated exposures


Risk management in practice1
Risk Management in Practice illustrated by use of a simplified equation:

Which Contractual Hedges?

Transaction exposure management programs are generally divided along an “option-line;” those which use options and those that do not

Also, these programs vary in the amount of risk covered; these proportional hedges are policies that state which proportion and type of exposure is to be hedged by the treasury


Translation exposure
Translation Exposure illustrated by use of a simplified equation:

Translation exposure arises because the financial statements of foreign subsidiaries must be restated in the parent’s reporting currency for the firm to prepare its consolidated financial statements

Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported income caused by a change in exchange rates since the last transaction

Translation methods differ by country along two dimensions

One is a difference in the way a foreign subsidiary is characterized depending on its independence

The other is the definition of which currency is most important for the subsidiary


Subsidiary characterization
Subsidiary Characterization illustrated by use of a simplified equation:

Most countries specify the translation method to be used by a foreign subsidiary based upon its operations

A foreign subsidiary can be classified as

Integrated Foreign Entity – one which operates as an extension of the parent company, with cash flows and line items that are highly integrated with the parent

Self-sustaining Foreign Entity – one which operates in the local economy independent of its parent

The foreign subsidiary should be valued in terms of the currency that is the basis of its economic viability


Functional currency
Functional Currency illustrated by use of a simplified equation:

A foreign affiliate’s functional currency is the currency of the primary economic environment in which the subsidiary operates

The geographic location of a subsidiary and its functional currency can be different

Example: US subsidiary located in Singapore may find that its functional currency could be

US dollars (integrated subsidiary)

Singapore dollars (self-sustaining subsidiary)

British pounds (self-sustaining subsidiary)


Translation methods
Translation Methods illustrated by use of a simplified equation:

There are four principal translation methods available: the current/noncurrent method, the monetary/nonmonetary method, the temporal method, and the current‑rate method.

The two most used the translation of foreign subsidiary financial statements are

The current rate method

The temporal method

Regardless of which is used, either method must designate

The exchange rate at which individual balance sheet and income statement items are remeasured

Where any imbalances are to be recorded

This can affect either the balance sheet or the income statement


Summary of translation methods
Summary of Translation Methods illustrated by use of a simplified equation:

Current Rate Method

Everything uses the current rate

Current/ NonCurrent Method

CA & CL at current rate

All others at Historic Rate

Monetary/ NonMonetary Method

Monetary assets at current rate

NonMonetary assets at historic rate

Temporal Method

Like Mon/NonMon, but Inventory is translated at Current rate (only if inventory is at Market Cost)


Summary of translation methods1
Summary of Translation Methods illustrated by use of a simplified equation:

A few pointers:

Cash & A/R: Current rate for all methods

Inventory (@ mkt): Current rate for all except Mon/NonMon

Fixed Assets: Historic rate for all except current rate method

Curr Liabilities: Current rate for all methods

LT Debt: Current rate for all except Curr/NonCurr

Equity: plug

Translation Gain (Loss): Difference in Equity (Historic vs Method)


Current rate method
Current Rate Method illustrated by use of a simplified equation:

Under this method all financial statement items are translated at the “current” exchange rate

Assets & liabilities – are translated at the rate of exchange in effect on the balance sheet date

Income statement items – all items are translated at either the actual exchange rate on the dates the various revenues, expenses, gains and losses were incurred or at a weighted average exchange rate for the period

Distributions – dividends paid are translated at the rate in effect on the date of payment

Equity items – common stock and paid-in capital are translated at historical rates; year end retained earnings consist of year-beginning plus or minus any income or loss on the year


Current rate method1
Current Rate Method illustrated by use of a simplified equation:

Any gain or loss from re-measurement is closed to an equity reserve account entitled the cumulative translation adjustment, rather than through the company’s consolidated income statement

These cumulative gains and losses from remeasurement are only recognized in current income under the current rate method when the foreign subsidiary giving rise to that gain or loss is liquidated


Temporal method
Temporal Method illustrated by use of a simplified equation:

Under this method, specific assets and liabilities are translated at exchange rates consistent with the timing of the item’s creation

The temporal method assumes that a number of line items such as inventories and net plant and equipment are restated to reflect market value

If these items were not restated and carried at historical costs, then the temporal method becomes the monetary/non-monetary method


Temporal method1
Temporal Method illustrated by use of a simplified equation:

Line items included in this method are

Monetary assets (primarily cash, accounts receivable, and long-term receivables) and all monetary liabilities are translated at current exchange rates

Non-monetary assets (primarily inventory and plant and equipment) are translated at historical exchange rates

Income statement items – are translated at the average exchange rate for the period except for depreciation and cost of goods sold which are associated with non-monetary items, these items are translated at their historical rate


Temporal method2
Temporal Method illustrated by use of a simplified equation:

Line items included in this method are

Distributions – dividends paid are translated at the exchange rate in effect the date of payment

Equity items – common stock and paid-in capital are translated at historical rates; year end retained earnings consist of year-beginning plus or minus any income or loss on the year plus or minus any imbalance from translation

Under the temporal method, any gains or losses from remeasurement are carried directly to current consolidated income and not to equity reserves


Us translation procedures
US Translation Procedures illustrated by use of a simplified equation:

The US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. Translation methods are mandated in FASB‑8 and FASB‑52.

Regardless of the translation method selected, measuring accounting exposure is conceptually the same. It involves determining which foreign currency‑denominated assets and liabilities will be translated at the current (postchange) exchange rate and which will be translated at the historical (prechange) exchange rate. The former items are considered to be exposed, while the latter items are regarded as not exposed. Translation exposure is just the difference between exposed assets and exposed liabilities.

By far the most important feature of the accounting definition of exposure is the exclusive focus on the balance sheet effects of currency changes. This focus is misplaced since it has led firms to ignore the more important effect that these changes may have on future cash flows.


Managing translation exposure
Managing Translation Exposure illustrated by use of a simplified equation:

Balance Sheet Hedge – this requires an equal amount of exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet

A change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities

This is termed monetary balance

The cost of this method depends on relative borrowing costs in the varying currencies


Managing translation exposure1
Managing Translation Exposure illustrated by use of a simplified equation:

When is a balance sheet hedge justified?

The foreign subsidiary is about to be liquidated so that the value of its CTA would be realized

The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be maintained within specific limits

Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains

The foreign subsidiary is operating in a hyperinflationary environment


Choosing which exposure to minimize
Choosing Which Exposure to Minimize illustrated by use of a simplified equation:

As a general matter, firms seeking to reduce both types of exposures typically reduce transaction exposure first

They then recalculate translation exposure and then decide if any residual translation exposure can be reduced without creating more transaction exposure


Operating exposure
Operating Exposure illustrated by use of a simplified equation:

The change in company value resulting from changes in future operating cash flows caused by an unexpected change in exchange rates.

Because the value of a firm is equal to the present value of future cash flows, accounting measures of exposure that are based on changes in the book values of foreign currency assets and liabilities need bear no relationship to reality.

Because currency changes are usually preceded by or accompanied by changes in relative price levels between two countries, it is impossible to determine exposure to a given currency change without considering simultaneously the offsetting effects of these price changes.


Operating exposure1
Operating Exposure illustrated by use of a simplified equation:

The primary exposure management objective of financial executives should be to arrange their firm's finances in such a way as to minimize the real effects of exchange rate changes.

The major burden of coping with exchange risk must be borne by the marketing and production people

They deal in imperfect product and factor markets where their specialized knowledge provides a real advantage.

Their role is to design marketing and production strategies to deal with exchange risks.

The appropriate marketing and production strategies are similar to those that would be suitable for any firm confronted with shifting relative output or input prices caused by any economic, political, or social factors.

Measuring the operating of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposure of all the firm’s competitors and potential competitors

This long term view is the objective of operating exposure analysis


Operating exposure2
Operating Exposure illustrated by use of a simplified equation:

Exchange rate changes do not always increase the riskiness of multinational corporations.

Purchasing Power Parity tells us devaluations (or revaluations) are usually preceded by higher (or lower) rates of inflation, therefore we should not evaluate only the devaluation phase of an inflation‑devaluation cycle.

Nominal currency changes smooth out the profit peaks and valleys caused by differing rates of inflation. Devaluations or revaluations should actually reduce earnings variability for MNCs. Only if currency changes involve real exchange rate changes does risk increase.

Domestic firms are also subject to exchange rate risk, not just MNCs

Domestic facilities that supply foreign markets normally entail much greater exchange risk than foreign facilities supplying local markets (because material and labor used in a domestic plant are paid for in the home currency while the products are sold in a foreign currency).

A purely domestic company selling locally but facing import competition may be seriously hurt (helped) by the devaluation (revaluation) of a competitor's home currency.


Managing exchange risk
Managing Exchange Risk illustrated by use of a simplified equation:

  • Since currency risk affects all facets of a firm's operations, it should not be the concern of financial managers alone.

  • Operating managers should develop marketing & production initiatives that help to ensure profitability over the long run. They should also devise anticipatory strategic alternatives in order to gain competitive leverage internationally.

  • The key to effective exposure management is to integrate currency considerations into the general management process.

  • Managers trying to cope with actual or anticipated exchange rate changes must first determine whether the exchange rate change is real or nominal. Nominal changes can be ignored. Real changes must be responded to.

  • If real, the manager must first assess the permanence of the change. In general, real exchange rate movements that narrow the gap between the current rate and the equilibrium rate are likely to be longer lasting than are those that widen the gap. Neither, however, will be permanent. Rather, there will be a sequence of equilibrium rates, each of which has its own implications for the firm's marketing and production strategies.


Integrated exchange risk program
Integrated Exchange Risk Program illustrated by use of a simplified equation:

  • The role of the financial executive in an integrated exchange risk program is fourfold

    • to provide local operating management with forecasts of inflation and exchange rates

    • to identify and highlight the risks of competitive exposure

    • to structure evaluation criteria such that operating managers are not rewarded or penalized for the effects of unanticipated real currency changes

    • to estimate and hedge whatever real operating exposure remains after the appropriate marketing and production strategies have been put in place.


Expected versus unexpected changes in cash flows
Expected Versus illustrated by use of a simplified equation:Unexpected Changes in Cash Flows

Operating exposure is far more important for the long-run health of a business than changes caused by transaction or translation exposure

Planning for operating exposure is total management responsibility since it depends on the interaction of strategies in finance, marketing, purchasing, and production

An expected change in exchange rates is not included in the definition of operating exposure because management and investors should have factored this into their analysis of anticipated operating results and market value


Measuring operating exposure
Measuring Operating Exposure illustrated by use of a simplified equation:

Short Run - The first-level impact is on expected cash flows in the 1-year operating budget. The gain or loss depends on the currency of denomination of expected cash flows. These are both existing transaction exposures and anticipated exposures. The currency of denomination cannot be changed for existing obligations

Medium Run Equilibrium - The second-level impact is on expected medium-run cash flows, such as those expressed in 2- to 5-year budgets

Medium Run: Disequilibrium. The third-level impact is on expected medium-run cash flows assuming disequilibrium conditions. In this case, the firm may not be able to adjust prices and costs to reflect the new competitive realities caused by a change in exchange rates

Long Run. The fourth-level impact is on expected long-run cash flows, meaning those beyond five years. At this strategic level, a firm’s cash flows will be influenced by the reactions of both existing and potential competitors, possible new entrants, to exchange rate changes under disequilibrium conditions


Strategic management of operating exposure
Strategic Management of Operating Exposure illustrated by use of a simplified equation:

The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows

To meet this objective, management can diversify the firm’s operating and financing base

Management can also change the firm’s operating and financing policies


Diversifying operations
Diversifying Operations illustrated by use of a simplified equation:

Diversifying operations means diversifying the firm’s sales, location of production facilities, and raw material sources

If a firm is diversified, management is prepositioned to both recognize disequilibrium when it occurs and react competitively

Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies


Diversifying financing
Diversifying Financing illustrated by use of a simplified equation:

Diversifying the financing base means raising funds in more than one capital market and in more than one currency

If a firm is diversified, management is prepositioned to take advantage of temporary deviations from the International Fisher effect


Proactive management of operating exposure
Proactive Management of Operating Exposure illustrated by use of a simplified equation:

Operating and transaction exposures can be partially managed by adopting operating or financing policies that offset anticipated currency exposures

Six of the most commonly employed proactive policies are

Matching currency cash flows

Risk-sharing agreements

Back-to-back or parallel loans

Currency swaps

Leads and lags

Reinvoicing centers


Matching currency cash flows
Matching Currency Cash Flows illustrated by use of a simplified equation:

One way to offset an anticipated continuous long exposure to a particular currency is to acquire debt denominated in that currency

This policy results in a continuous receipt of payment and a continuous outflow in the same currency

This can sometimes occur through the conduct of regular operations and is referred to as a natural hedge


International finance

Debt Financing as a Financial Hedge illustrated by use of a simplified equation:


Currency clauses risk sharing
Currency Clauses: Risk-sharing illustrated by use of a simplified equation:

Risk-sharing is a contractual arrangement in which the buyer and seller agree to “share” or split currency movement impacts on payments

Example: Ford purchases from Mazda in Japanese yen at the current spot rate as long as the spot rate is between ¥115/$ and ¥125/$.

If the spot rate falls outside of this range, Ford and Mazda will share the difference equally

If on the date of invoice, the spot rate is ¥110/$, then Mazda would agree to accept a total payment which would result from the difference of ¥115/$- ¥110/$ (i.e. ¥5)


Currency clauses risk sharing1
Currency Clauses: Risk-sharing illustrated by use of a simplified equation:

Ford’s payment to Mazda would therefore be

Note that this movement is in Ford’s favor, however if the yen depreciated to ¥130/$ Mazda would be the beneficiary of the risk-sharing agreement


Back to back loans
Back-to-Back Loans illustrated by use of a simplified equation:

A back-to-back loan, also referred to as a parallel loan or credit swap, occurs when two firms in different countries arrange to borrow each other’s currency for a specific period of time

The operation is conducted outside the FOREX markets, although spot quotes may be used

This swap creates a covered hedge against exchange loss, since each company, on its own books, borrows the same currency it repays


Cross currency swaps
Cross-Currency Swaps illustrated by use of a simplified equation:

Cross-Currency swaps resemble back-to-back loans except that it does not appear on a firm’s balance sheet

In a currency swap, a dealer and a firm agree to exchange an equivalent amount of two different currencies for a specified period of time

Currency swaps can be negotiated for a wide range of maturities

A typical currency swap requires two firms to borrow funds in the markets and currencies in which they are best known or get the best rates


Cross currency swaps1
Cross-Currency Swaps illustrated by use of a simplified equation:

For example, a Japanese firm exporting to the US wanted to construct a matching cash flow swap, it would need US dollar denominated debt

But if the costs were too great, then it could seek out a US firm who exports to Japan and wanted to construct the same swap

The US firm would borrow in dollars and the Japanese firm would borrow in yen

The swap-dealer would then construct the swap so that the US firm would end up “paying yen” and “receiving dollars” be “paying dollars” and “receiving yen”

This is also called a cross-currency swap


International finance

Using Cross Currency Swaps illustrated by use of a simplified equation:


Contractual approaches
Contractual Approaches illustrated by use of a simplified equation:

Some MNEs now attempt to hedge their operating exposure with contractual strategies

These firms have undertaken long-term currency option positions hedges designed to offset lost earnings from adverse changes in exchange rates

The ability to hedge the “unhedgeable” is dependent upon predictability

Predictability of the firm’s future cash flows

Predictability of the firm’s competitor responses to exchange rate changes

Few in practice feel capable of accurately predicting competitor response, yet some firms employ this strategy


Capital mobility
Capital Mobility illustrated by use of a simplified equation:

The degree to which capital moves freely cross-border is critically important to a country’s balance of payments

Historical patterns of capital mobility

1860-1914 – period characterized by continuously increasing capital openness as more countries adopted the gold standard and expanded international trade relations

1914-1945 – period of global economic destruction due to two world wars and a global depression

1945-1971 – Bretton Woods era, saw great expansion of international trade in goods and services

1971-2002 – period characterized by floating exchange rates, economic volatility, but rapidly expanding cross-border capital flows


The evolution of capital mobility
The Evolution of Capital Mobility illustrated by use of a simplified equation:


Capital flight
Capital Flight illustrated by use of a simplified equation:

“International flows of direct and portfolio investments under ordinary circumstances are rarely associated with the capital flight phenomenon. Rather, it is when capital transfers by residents conflict with political objectives that the term “flight” comes into general usage.”

—Ingo Walter, Capital Flight and Third World Debt


Capital flight1
Capital Flight illustrated by use of a simplified equation:

Five primary mechanisms exist by which capital may be moved from one country to another:

Transfers via the usual international payments mechanisms, regular bank transfers are easiest, cheapest and legal

Transfer of physical currency by bearer (smuggling) is more costly, and for many countries illegal

Transfer of cash into collectibles or precious metals, which are then transferred across borders

Money laundering, the cross-border purchase of assets which are then managed in a way that hide the movement of money and its owners

False invoicing on international trade transactions


Currency market intervention
Currency Market Intervention illustrated by use of a simplified equation:

Foreign currency intervention, the active management, manipulation, or intervention in the market’s valuation of a country’s currency, is a component of currency valuation and forecast that cannot be overlooked.

Central bank’s driving consideration – inflation or unemployment?

“beggar-thy-neighbor,” policy to keep currency values low to aid in exports, may prove inflationary if some goods MUST be imported … e.g. oil


Currency market intervention1
Currency Market Intervention illustrated by use of a simplified equation:

Direct Intervention - This is the active buying and selling of the domestic currency against foreign currencies. This traditionally required a central bank to act like any other trader in the currency market

Coordinated Intervention - in which several major countries, or a collective such as the G8 of industrialized countries, agree that a specific currency’s value is out of alignment with their collective interests

Indirect Intervention - This is the alteration of economic or financial fundamentals which are thought to be drivers of capital to flow in and out of specific currencies


Currency market intervention2
Currency Market Intervention illustrated by use of a simplified equation:

Capital Controls - This is the restriction of access to foreign currency by government. This involves limiting the ability to exchange domestic currency for foreign currency

The Chinese regulation of access and trading of the Chinese yuan is a prime example over the use of capital controls over currency value.


Disequilibria exchange rates in emerging markets
Disequilibria: Exchange Rates in Emerging Markets illustrated by use of a simplified equation:

Although the three different schools of thought on exchange rate determination make understanding exchange rates appear to be straightforward, that is rarely the case

The problem lies not in the theories but in the relevance of the assumptions underlying each theory

After several years of relative global economic tranquility, the second half of the 1990s was racked by a series of currency crises which shook all emerging markets

The Asian crisis of July 1997

The Argentine crisis (1998 – 2002)


The asian crisis july 1997
The Asian Crisis – July 1997 illustrated by use of a simplified equation:

The roots of the Asian crisis extended from a fundamental change in the economies of the region, the transition of many Asian countries from being net exporters to net importers

Starting in 1990 in Thailand, the rapidly expanding economies of the Far East began importing more than they were exporting, requiring major net capital inflows to support their currencies

As long as capital kept flowing in, the currencies were stable, but if this inflow stopped then the governments would not be able to support their fixed currencies


The asian crisis july 19971
The Asian Crisis – July 1997 illustrated by use of a simplified equation:

The most visible roots of the crisis were in the excesses of capital inflows into Thailand in 1996 and 1997

Thai banks, firms and finance companies had ready access to capital and found US dollar denominated debt at cheap rates

Banks continued to extend credits and as long as the capital inflows were still coming, the banks, firms, and government was able to support these credit extensions abroad


The asian crisis july 19972
The Asian Crisis – July 1997 illustrated by use of a simplified equation:

After some time, the Thai Baht came under attack due to the country’s rising debt

The Thai government intervened in the foreign exchange markets directly to try to defend the Baht by selling foreign reserves and indirectly by raising interest rates

This caused the Thai markets to come to a halt along with massive currency losses and bank failures

On July 2, 1997 the Thai central bank allowed the Baht to float and it fell over 17% against the dollar and 12% against the Japanese Yen

By November 1997, the baht fell 38% against the US dollar


The asian crisis july 19973
The Asian Crisis – July 1997 illustrated by use of a simplified equation:

Within days, other Asian countries suffered from the contagion effect from Thailand’s devaluation

Speculators and capital markets turned towards countries with similar economic traits as Thailand and their currencies fell under attack

In late October, Taiwan caught the markets off-guard with a 15% devaluation and this only added to the momentum

The Korean Won fell from WON900/$ to WON1100/$ (18.2%)

The Malaysian ringgit fell 28.6% and the Filipino peso fell 20.6% against the dollar

The only currencies that were not severely affected were the Hong Kong dollar and the Chinese renminbi


International finance

The Thai Baht and the Asian Crisis illustrated by use of a simplified equation:


The asian crisis july 19974
The Asian Crisis – July 1997 illustrated by use of a simplified equation:

The Asian currency crisis was more than just a currency collapse

Although the varying countries were different they did have similar characteristics which allow comparison

Corporate socialism – Post WWII Asian companies believed that their governments would not allow them to fail, thus they engaged in practices, such as lifetime employment, that were no longer sustainable


The asian crisis july 19975
The Asian Crisis – July 1997 illustrated by use of a simplified equation:

Corporate governance – Most companies in the Far East were often largely controlled by either families or groups related to the governing body or party of that country

This was labeled cronyism and allowed the management to ignore the bottom line at times when this was deteriorating

Banking liquidity and management – Although bank regulatory structures and markets have been deregulated across the globe, their central role in the conduct of business has been ignored

As firms collapsed, government coffers were emptied and investments made by banks failed

The banks became illiquid and they could no longer support companies’ need for capital


The russian crisis of 1998
The Russian Crisis of 1998 illustrated by use of a simplified equation:

1995 – 1998 Russian govt and nongovt borrowing very high, servicing the debt becomes difficult

Russian exports are mostly commodity-based and world commodity prices drop as a result of the Asian crisis of 1997 – thus, Russian exports values decline

The Ruble was under a managed float with a band of 1.5% and most days the Russian Central Bank is forced to enter the market to buy rubles

The August Collapse – Currency reserves had fallen, Russia announces it will raise an extra $1 billion in foreign bonds to help pay for rising debt


The russian crisis of 19981
The Russian Crisis of 1998 illustrated by use of a simplified equation:

The August Collapse – Russian stocks drop by 5% on August 10 on fears that China would cut its currency value – Russia claims they will not devalue the Ruble then at RUB6.3/USD

August 17, the ruble is devalued by 34% by the 26th the Ruble is down to RUB13/USD

Exhibit 9.3 traces the fall of the Russian Ruble


International finance

The Fall of the Russian ruble illustrated by use of a simplified equation:


The argentine crisis 2002
The Argentine Crisis - 2002 illustrated by use of a simplified equation:

In 1991 the Argentine peso had been fixed to the U.S. dollar at a one-to-one rate of exchange

This policy was a radical departure from traditional methods of fixing the rate of a currency’s value

Argentina adopted a currency board, which was a structure rather than just a commitment, to limiting the growth of money in the economy

Under a currency board, the central bank of a country may increase the money supply in the banking system only with increases in its holdings of hard currency reserves


The argentine crisis 20021
The Argentine Crisis - 2002 illustrated by use of a simplified equation:

By removing the ability of government to expand the rate of growth of the money supply, Argentina believed it was eliminating the source of inflation which had devastated its standard of living

The idea was to limit the rate of growth in the country’s money supply to the rate at which the country receives net inflows of U.S. dollars as a result of trade growth and general surplus


International finance

The Collapse of the Argentine peso illustrated by use of a simplified equation:


The argentine crisis 20022
The Argentine Crisis - 2002 illustrated by use of a simplified equation:

A recession that began in 1998, as a result of a restrictive monetary policy, continued to worsen by 2001 and revealed three very important problems with Argentina’s economy:

The Argentine peso was overvalued

The currency board regime had eliminated monetary policy alternatives for macroeconomic policy

The Argentine government budget deficit – and deficit spending – was out of control


The argentine crisis 20023
The Argentine Crisis - 2002 illustrated by use of a simplified equation:

While the value of the peso had been stabilized, inflation had not been eliminated

The inability of the peso’s value to change with market forces led many to believe increasingly that it was overvalued

Argentine exports became some of the most expensive in all of South America as other countries saw their currencies slide marginally against the dollar over the past decade while the peso did not


The argentine crisis 20024
The Argentine Crisis - 2002 illustrated by use of a simplified equation:

Because the currency board eliminated expansionary monetary policy as a means to stimulate economic growth in Argentina, the Argentine government was left with only fiscal policy as a means to this end

The Argentine government continued to spend as a means to quell increasing social and political tensions and unrest, but without the benefit of increasing (or even stable) tax receipts

Continued government spending and the injection of foreign capital into the country steadily increased the debt burden


The argentine crisis 20025
The Argentine Crisis - 2002 illustrated by use of a simplified equation:

Many began to fear an impending devaluation, removing their peso denominated funds (as well as U.S. dollar funds) from Argentine banks

Capital flight as well as rampant conversion of peso holdings into U.S. dollar deposits put additional pressure on the value of the peso

On Sunday January 6, 2002, in the first act of his presidency (the fifth president in two weeks), President Eduardo Duhalde devalued the peso from Ps 1.00/$ to Ps 1.40/$

On February 3, 2002, the government announced that the peso would be floated, beginning a slow but gradual depreciation


The greek crisis 201x
The Greek Crisis – 201X? illustrated by use of a simplified equation:

  • In early 2000s, Greece was managing to a large budget deficit and relying on a healthy global economy to feed two main industries: Shipping and Tourism. In 2001, Greece transitioned away from its sovereign currency to the Euro.

  • By 2010, concerns about Greece’s national debt suggested emergency bailouts might be necessary. Germany refused to endorse the loan until a series of austerity measures were announced.

  • In May 2010, Eurozone countries and the IMF agreed to a three year €110 billion loan at 5.5% interest, conditional on the implementation of austerity measures.

  • Changes to the ruling government of Greece and rioting protestors showed evidence at the dissatisfaction of the Greek people with the circumstances.


The greek crisis 201x1
The Greek Crisis – 201X? illustrated by use of a simplified equation:

  • In 2011, Eurozone leaders changed the terms of the Greek loan package to extend the payback period and reduce the interest rate to 3.5%. Also, eurozone leaders and the IMF also came to an agreement with banks to accept a write-off of €100 billion of Greek debt, reducing the country's debt level from €340bn to €240bn or 120% of GDP by 2020.

  • In 2012, the second bailout package from July 2011 was extended from €109 billion to €130 billion

  • One current opinion is the best option for Greece (and the rest of the EU), would be to create an “orderly default” on Greece’s public debt. In this case, Greece would withdraw simultaneously from the eurozone and reintroduce its national currency the drachma at a debased rate. This might lead to a 60% devaluation of the new drachma. Critics also point to political and financial instability leading to hyperinflation, civil unrest and possibly a forcible overthrow of the current government.