Chapter 37 INTERNATIONAL FINANCIAL MANAGEMENT

1. Chapter 37 INTERNATIONAL FINANCIAL MANAGEMENT  Centre for Financial Management , Bangalore

2. OUTLINE • World monetary system • Foreign exchange markets and rates • International parity relationships • International capital budgeting • Financing foreign operations • Raising foreign currency finance • Financing exports • Insuring exports • Documents in international trade • Foreign exchange exposure • Management of foreign exchange exposure  Centre for Financial Management , Bangalore

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

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

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

6. MULTINATIONAL CORPORATIONS • Companies go global for the following reasons: • Trade barriers • Imperfect labour markets • Intangible assets • Vertical integration • Product life cycle • Diversification • Shareholder diversification  Centre for Financial Management , Bangalore

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

8. CURRENCIES AND THEIR SYMBOLS Country Currency Symbol Australia Dollar A$ Canada Dollar Can $ Denmark Krone Dkr EMU Euro € Finland Markka FM India Rupee Rs Iran Rial Rl Japan Yen ¥ Kuwait Dinar KD Mexico Peso Ps Norway Krone NKr Saudi Arabia Riyal SR Singapore Dollar S$ South Africa Rand R Sweden Krona Skr Switzerland Franc SF United Kingdom Pound £ United States Dollar $  Centre for Financial Management , Bangalore

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

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

11. CROSS-CURRENCY RATES  Centre for Financial Management , Bangalore

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

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

14. BID-ASK SPREAD The bid-ask spread - the difference between bid and ask prices – reflects the breadth, depth, and volatility of the currency market. The spread in normally expressed in percentage terms as follows: For example, the percentage spread for the dollar quote Rs. 45,5000 – 45,5400 works out to 0.088 percent.  Centre for Financial Management , Bangalore

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

16. CROSS-EXCHANGE RATE QUOTATIONS Given the above rates you can calculate the exchange rate between INR and CHF. S (INR/CHF) = S (INR/USD) x S (USD/CHF) = 0.0226 x 1.2381 = 0.0280 Most commonly, cross-rate calculations are done to establish the exchange rates between two currencies that are quoted against the US dollar but are not quoted against each other.  Centre for Financial Management , Bangalore

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

18. SWAP POINTS In the interbank market, however, forward quotes are given as a pair of “swap points” to be added to or subtracted from the spot quotation. A typical swap quotation is as follows: USD/INR Spot 46.5015 / 46.5020 1 month swap : 12 / 9 The swap quotation is expressed in such a way that the last digit coincides with the same place as the last digit of the spot price. Thus in the USD/INR quote give above, the number “12/9” mean INR 0.0012 / INR 0.0009.  Centre for Financial Management , Bangalore

19. CONVERSION OF SWAP RATE INTO OUTRIGHT RATE You can convert a swap rate into an outright rate by adding the premium to, or subtracting the discount from, the spot rate. The swap rates do not carry plus or minus signs but you can easily determine whether the forward rate is at a premium or discount, in relation to the spot rate, using the following rule. If the forward bid rate in points is less (more) than the offer rate in points, the forward rate is at a premium (discount). So add (subtract) the points to the respective spot rate to get the outright quote. Let us apply this rule to the USD/INR example given above. In that example the bid rate in points (12) is more than the offer rate in points (9). So the forward rate is at a discount in relation to the spot rate. Hence we subtract the points from the respective spot quotation to get the outright forward quotation. Thus, the outright forward quotation is: USD/INR One-Month Forward : 46.5003 / 46.5120  Centre for Financial Management , Bangalore

20. FORWARD PREMIUMS AND DISCOUNTS Consider the following spot and forward quotes USD/INR Spot : 46.5020 / 46.5120 USD/INR 1-month forward : 46.5420 / 56.5620 The US dollar is costlier in the forward market than in the spot market. Put differently, it is at a forward premium in relation to the Indian rupee. With two-way quotations, you cannot quantify the premium or discount in a unique way. One way to quantify the annual percentage premium or discount is as follows.  Centre for Financial Management , Bangalore

21. FORWARD PREMIUMS AND DISCOUNTS In this formula, the mid rate is simply the arithmetic average of the bid and ask rates. Note that multiplication by 12 converts the monthly premium (or discount) to annual premium (or discount) and multiplication by 100 translates it into percentage terms. Applying this formula to the USD/INR spot and forward quotes given above, we get: This means that the annual forward premium on US dollar in relation to Indian rupee is 1.16 percent.  Centre for Financial Management , Bangalore

22. FORWARD PREMIUM OR DISCOUNT Forward rate – Spot rate 12 x Spot rate Forward contract length in months For example if the spot rate of the U.S dollar is Rs.43.26 and the three month forward rate is Rs.43.80, the annualised forward premium works out to : 43.80 - 43.26 12 Forward premium = x 43.26 3 = 0.0499 or 4.99 percent Forward premium or discount =  Centre for Financial Management , Bangalore

23. CURRENCY FUTURES Instead of using the forward market, you can use the futures market. Currency futures contracts are standardised currency forward contracts. Such contracts are standardised in terms of the size of the contract and delivery dates and exist only for major currencies. They trade on organised futures exchanges.  Centre for Financial Management , Bangalore

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

25. INTERNATIONAL PARITY RELATIONSHIP • Interest rate parity • Purchasing power parity • Expectations theory and forward exchange rates • Fisher effect and international Fisher effect  Centre for Financial Management , Bangalore

26. INTEREST RATE PARITY (IRP) When IRP exists, the difference between the forward rate and the spot rate is just enough to offset the difference between the interest rates in the two currencies. The IRP condition implies that the home interest rate must be higher (lower) than the foreign interest rate by an amount equal to the forward discount (premium) on the home currency. Formally, IRP is stated as follows : F 1 + rh = So 1 + rf where F = direct quote forward rate So = direct quote spot rate rh = home (or domestic) interest rate rf = foreign interest rate  Centre for Financial Management , Bangalore

27. EXAMPLE OF IRP The 90-day interest rate is 1.25 percent in the U.S. and 2.00 percent in U.K and the current spot exchange rate is $1.50/£. What will be the 90-day forward rate? F (1 + 0.015) = $1.50 (1 + 0.025) F = $1.4854 In this case the U.S. dollar appreciates in value relative to the British pound. Explain why this happens.  Centre for Financial Management , Bangalore

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

29. RELATIVE PURCHASING POWER PARITY A less restrictive form of PPP is called the relative purchasing power parity. It says that the difference in the rates of inflation between two countries will be offset by a change in the exchange rate. For example, if the expected inflation rate is 6 percent in India and 2 percent in the U.S., then the Indian rupee will depreciate relative to the U.S. dollar at a rate of approximately 4 percent. More precisely, the relative PPP is expressed as follows : Se1 1 + ih = So 1 + if where Se1 = expected spot rate a year from now So = current spot rate ih = expected inflation rate in home country if = expected inflation rate in foreign country.  Centre for Financial Management , Bangalore

30. EXAMPLE The current spot rate for U.S. dollar is Rs.45. The expected inflation rate is 6 percent in India and 2 per cent in the U.S. What is the expected spot rate of dollar a year hence? Se1 1 + 0.06 = 45.0 1+ 0.02 Se1 = Rs.46.75  Centre for Financial Management , Bangalore

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

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

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

34. GENERALISED FISHER EFFECT If risk is held constant the real returns are equalised across countries due to arbitrage operation. This implies that in equilibrium the nominal interest differential will be equal to the expected inflation differential. In symbols, 1 + rh 1 + ih = 1 + rf 1 + if where rh = home interest rate in nominal terms rf = foreign interest rate in nominal terms ih = expected inflation rate in home country if = expected inflation rate in foreign country.  Centre for Financial Management , Bangalore

35. INTERNATIONAL FISHER EFFECT If we combine purchasing power parity with generalised Fisher effect, the result is the international Fisher effect. Se1 1 + ih Purchasing power parity : = So 1 + if 1 + rh 1 + ih Generalised Fisher effect : = 1 + rf 1 + if Se1 1 + rh International Fisher effect : = So 1 + rf  Centre for Financial Management , Bangalore

36. AN INTEGRATED PICTURE OF INTERNATIONAL PARITY RELATIONSHIP Forecasted future spot exchange rate - 5% rupee weakens; $ Forward Rate as an unbiased Relative purchasing appreciates estimator of the future power parity spot rate Forward premium or Difference in expected International fisher effect discount on foreign inflation rates currency (observed) (forecasted) + 5% - 5% Difference in nominal Interest rate parity Fisher effect interest rates (observed) + 5%  Centre for Financial Management , Bangalore

37. INTERNATIONAL CAPITAL BUDGTING There are two ways of analysing a foreign investment proposal: Home Currency Approach Foreign Currency Approach • Convert all the dollar cash flows • Calculate the NPV in dollars into rupees (use forecasted (use the dollar discount rate) exchange rates) • Calculate the NPV in rupees • Convert the dollar NPV into (using the rupee discount rate) rupees(use the spot exchange rate)  Centre for Financial Management , Bangalore

38. FINANCING FOREIGN OPERATIONS • Long-term financing • Parent company’s stake in equity • Optimal capital structure • Sources of long-term funds • Short-term and intermediate financing  Centre for Financial Management , Bangalore

39. RAISING FOREIGN CURRENCY FINANCE • Foreign currency term loans from financial • institutions • Export credit schemes • External currency borrowings • Euroissues • Issues in foreign domestic markets  Centre for Financial Management , Bangalore

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

41. EXPORT CREDIT SCHEMES Export credit agencies have been established by the governments of major industrialised countries for financing exports of capital goods and related services. Two kinds of export credit are provided : buyer’s credit and supplier’s credit.  Centre for Financial Management , Bangalore

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

43. EXTERNAL COMMERCIAL BORROWING Subject to certain terms and conditions, the Government of India permits Indian firms to resort to external commercial borrowings for the import of plant and machinery. Corporates are allowed to raise upto $100 million from the global markets through the automatic route. Companies wanting to raise more than $ 100 million have to get an approval of the MOF.  Centre for Financial Management , Bangalore

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

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

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

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

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

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

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