International Corporate Finance as Spot Market and Forward - Case Study Example

CASE a) Evaluate whether or not the views of the sales manager regarding exchange risk are likely to be correct. I would agree with the views ofthe sales manager as indeed a through consideration of the international risk exposures and the relevant techniques for avoiding them is very important for multinational firms like the one before us. International Currency risk is one of the risks most international firms face in connection with foreign exchange rates.1The problem arises when future payments or remunerations payable in a foreign currency depreciate in value before the foreign currency payment is received and is exchanged into the local currency of the firm. It is not that an unexpected increase or decrease in the foreign currency may not be profitable and will always cause a loss.But this entire uncertainty hampers businesses and overall economic growth. There are two kinds of markets within the foreign exchange market: Spot market: this involves forex delivered with in two or three days as the rates are quoted in line with the exchange rate prevalent at the time of the transaction.2 Forward or future market concerns the delivery of exchange rate to be delivered with in 3 days or more. Here the banks will use the forex rate on which they are willing to buy or sell the currency with in a month or more after the transaction.3 It can be seen that due to the volatile and unpredictable nature of the forex markets during times of political or economic crisis both these markets carry a considerable risk for the multinational firms. The preceding discussion in the other sections will assess the types of strategies which can be used to avoid these risks and their feasibility in the short and long term. (b) Prepare a report discussing how the managers of VFM might protect the company against all of the risks of each of the foreign deals. Relevant calculations should support your report. There are a number of risks facing VFM right now in terms of the foreign exchange and political risks involved here. These can Credit risk , Liquidity risk , Solvency risk , Operational risk , Market risk and Interest rate risk. (Aharony, 1986.Risks like operational risks (which have been defined by the Basel Committee(Basel II) arise from 'inadequate or failed processes, people and systems or from external events'. ( Hsaio 2008) .Operational Risks cover a wide category of risks which pertain to human error or technical deficiencies.(Black,1972) and are related to all other types of risk such as capital needs, inflation, concentration of revenues (by customers, products, geographies, etc.) new competitive conditions and environmental remediation obligations(reinforced by the new concept of Corporate Social Responsibility).(Black,1972). However more serious risks pertain to losses which arise due to the failure of the obligator to perform(Credit Risk) and such losses are reported to be responsible for more that 50% of yearly business losses.(Black,1972).Today the current lending practices pertaining to credit risk management methodology have made considerable progress. Another type of risk is the market risk which related to the unpredictability surrounding future earnings, because of the volatile changes in the value of financial instruments (which again accounts for 25% of yearly bank losses) ( Staikouras 2000).Reporting risk is different from market risk and credit risk as its primary focus is on derivatives and other financial instruments and is related to the problem of Accounting Risks which are caused by the likelihood of wrongly perceiving or estimating the amounts of risk arising out of their accounting assumptions and methodologies( Staikouras 2000).However the tendency of financial institutions to suffer from Accounting risk, can be remedied by care in the preparation of financial statements.(like appropriate disclosures related to estimates contained in the financial statements) .(Black,1972,Chen 1983) Modern Market Risks are no longer defined by outright exposure and are currently calculated by a popular method of the Value at Risk (VaR)This method estimates the maximum amount of loss possible in a portfolio subject to certain periodic intervals and has its advantage of being comparative in nature, i.e it will allow the financial institutions in question to allocate capital more efficiently.(Chance 1979).These methods employ the risk level models of capital , which are used to estimate the profitability of capital, like the risk-adjusted capital (RORAC) or risk-adjusted return on capital (RAROC) and such models today play a pivotal rile in the management of risks inherent in the management of financial institutions. Finally VFM may also be suffering from interest rate risk in international transactions. This type of risk is related to the relative value of an interest-bearing asset diminishing due to a rise in the interest rate. (Bower 1984).High interest rates cause the prices of fixed rate bonds to fall and pivotal to the measurement of Interest Rate Risk is measurement of the duration of the interest-bearing asset. (Scholes. 1972.Officer. 1985)Here we are concerned with differing interest rate/yields basis which can erratically change the profits and liabilities.Also present is the Yield curve risk which is presented by the differentials between the short and long term interest rates and their utility for making a profit by short term selling and long term gains. (Scholes. 1972.Officer. 1985). Then we are concerned with the option risks which are difficult control and even more difficult to measure.Repricing risks are also an incident of the banks margins fluctuating and causing interest rate irregularities. (Bower 1984)A popular way of hedging or protecting against interest rate risk with the use of fixed income instruments or interest rate swaps. Related to Interest rate Risk are the interest parity conditions which prevent the risk of arbitrage in an economy. (Scholes. 1972.Officer. 1985). According to this formula the returns from borrowing (in Currency A), exchange of that currency for Currency B if added to the investment required for this exchange and investing in interest-bearing instruments of Currency B, while at the same time purchasing futures contracts to convert that currency back when the investment period ends should be the equivalent of purchasing and holding similar interest-bearing instruments of the first currency. (Scholes. 1972.Officer. 1985) .The imbalance is actually favorable for foreign investors because when these returns are different there is a chance that investors can commit "arbitrage or make risk-free returns". (Scholes. 1972.Officer. 1985) The strategies to combat the foreign exchange risks and transaction exposure for VFM Transferring exposure This involves the transfer of the transaction exposure to another company through the technique asking them to pay for a product in your currency so that they have to bear the transaction exposure resulting from forex uncertainty on their own. Another technique would be to price the export in the local currency of the other firm and demand payment immediately in which case the current spot rate will determine the value in your own currency of the export.4 Netting transaction exposure A second way of minimising transaction risk is "netting out", and this technique is very helpful for foreign multinationals with large business concerns who do frequent and sizeable amounts of foreign currency transactions. In this way unexpected exchange rate charges will essentially "net out" over many different transactions. This is mainly because when payments and receipts are in many different currencies as this will spread the risks and there might even be a chance of profit. Although transaction exposure cannot be completely netted away ,the company is better off making a small in one area of trade that a large loss overall if it literally "puts all its eggs in one basket". Compared to hedging this may even be a safer way of avoiding forex risks. Hedging strategies (aimed at reducing short-term transaction exposures of roughly less than a year.5) Forward Contracts This is probably one of the most direct methods of handling hedging risks. The obvious advantage of this is to prevent the company from suffering any loss through a depreciating or appreciating currency because the payment has already been made to a bank. The problem however is that small businesses are often discouraged by banks in this option because of the increased risk that the banks in collecting back the money. Futures contracts Another option of hedging transaction exposure is with futures market hedge which is a lot similar to the above method .The difference begins when a short sale of a future contract puts the business in a position opposed to that of a business owning the futures contract. This happens because an increase in the value of the contract causes a loss to the company. 6When the futures contract decreases in value, it gains that amount. Another problem is that any losses in such contracts have to be made in liquidity on a daily basis and the company will have to wait for the resulting gain until the transaction actually takes place or is processed. This has been known to create severe liquidity crises with in small multinationals. There is also an added disadvantage of the sole usability of standardized amounts and maturities in these contracts. This way there is an added danger of losing profits due to a slightly mishandled timeframe.7 Hedges Using the Money Market There is an alternative way of using a money market hedge incase forward market hedging becomes too expensive.In this strategy through the short term borrowing or lending an international firm will be able to make the required exchange of currencies at the current spot rate.The cost of the money market hedge thus becomes the difference between the borrowing and the lending interest rates. Even if forward and futures contracts are available this is the least risky alternative to avoiding the problems of a forex market.8 Options Currency options give one party the right, to buy or sell a specific amount of currency at a specified exchange rate on or before an agreed-upon date. This means that if the exchange rate moves in favour of the option holder, holder will not suffer from financial loss.It is not always a great situation though,mainly because once this option is exercised the company will suffer from the burden of the option premium and commission costs. Cross Hedging9 For small developing countries cross hedging is an effective way of preventing forex loss.This entails using the local currency in conjunction with a currency which is highly influenced by it in the sale and purchase of business assets.However the success of this method will largely depend upon the extent to which the stronger currency changes in value along with the minor currency. Best advice for VFM based on the above We have been told that currently the exchange rate in the Spot market is (290 - 294 Werland francs/ -US$1.4640 - 90/ 220 - 228 Thodian Pesos/$US ) and the forward market which is in $US/ conversion as 3 Months forward 0.98 - 1.15 cents discount ,6 Months forward 1.70 - 1.86 cents discount .It has also been stated that No forward market exists for the Werland franc or Thodian peso. My advice based on these figures would be to maximise the usage of forward market strategies. This will help VFM to avoid any loss from the depreciation of the dollar or the pound but they will need very good relations with their bank to be able to manage this as banks are very reluctant to give in to such credit risk. Again I would advise VFM to avoid the over the counter (OTC) European currency call options for Werland francs at a premium of 25 francs/because if we look at the interest rate here with an exercise price of 300 francs/ and a three month maturity date for Werland@ 12% this is just not worth the trouble.So far the most reasonable amount of interest rate available to VFM is in pound sterling as not only is reasonable for both borrowing and investing but the currency and is stable in the face of inflationary problems. (c) Discuss what alternatives might be available to VFM Ltd to finance the two trade deals. VFM is advised to also pay attention to a host of other strategies available 10 like Back-to-Back Loans which allow Multinationals to reduce their risks by entering into bilateral arrangements which are outside the scope of the foreign exchange markets. This will essentially protect both the buying and selling company from losses . Furthermore Currency and Credit Swaps are like a series of forward contracts 11and can be successfully used to avoid the credits related to parallel borrowing.Here two parties agree to exchange specified amounts of currency at present and to reverse the exchange at some point in the future.12 The only risk inherent in this very safe method is that the forex exchange has to be carried out at a new rate in the future. In practice there are some very interesting ways in which various corporations have dealt with and suffered the burnt of foreign currency transaction risk in the past. Millman(1990,1995) gives some interesting examples in his research work. One example he gives is of Lufthansa,the German airline which when contracted with Boeing to purchase aircrafts in the 1980's ,the value of the dollar was rising. The price of the aircrafts were set in dollars. Lufthansa feared that the dollar would strengthen and the cost in . Deutsche marks would increase the cost of the planes. Therefore it entered into forward contracts for the dollars required to pay for the planes.Contray to expectations the dollar weakened. Due to its wrong speculation forward contracts cost Lufthansa $140 to $160 million more for the aircrafts that they would have if they had bought the dollars on the spot market(Millman 1990). In conclusion there is really no reliable way to counter forex risk in foreign markets. Back to Back loans definitely provide more certainty for companies like VFM rather than hedging which causes unexpected risks especially in financially volatile markets much affected by political repercussions and unpredictable events. CASE 2 This report pertains to the current credit crunch and how it will cause a problem for the MNCs like Global Plc. The current credit crunch has its source in the current regulation around the world under the Basel I and II accords which has cause the banks to be less likely to finance MNC's like Global Plc.The Credit risks that face the modern financial institutions and form the absolute nightmares of financial regulators can be fatal to the health and wealth of any institution. (Black, 1972). The globalization of financial markets as well as the constant development of innovation in the field of financial instruments has changed both the operational and structural qualities of financial institutions. Although global efforts to counter Risks encountered by Financial institutions are underway the nature and characteristics of these risks keep changing.For example the Basel Committee (under the Bank of International Settlements ) which was formed in response to the crises caused by the insolvency of Bankaus Herstatt and the problems caused by Nixon's announcement of the closure of the Golden Window ,has worked since 1974 to prevent such risks from injuring the health and wealth of such financial institutions. (Aharony, 1986) Its 1988 Basel Accord deals with credit risk and has extensively guided international banks in their risk management.Similarly the Basel II(International Convergence of Capital Measurement and Capital Standards) deals with the problem of operational ,legal and strategic as well as those arising out of the loss of goodwill. ( Hsaio 2008) ..Banks and other financial institutions perform the functions of financial intermediaries that distinguish them from other businesses. They intermediate liquidity between economic subjects and in this process face a number of risk atypical of non-financial firms. (Aharony, 1986)This financial risk measurement and management becomes very important for banks than for other companies. Basel I and Basel II have played a seminal role in the creation of international banking standards for regulators in order to insulate them from the types of financial risk and capital management requirements to regulate banks against credit and operational risks which they are exposed to through their lending and investment practices. As one commentator has put it , "Basel II has been designed to ensure the capital adequacy of internationally active banks. A framework has been designed to measure capital adequacy and the minimum standard to be adopted by national regulatory authorities. The two objectives are soundness and stability of international banking system, and consistency among international active banks." ( Hsaio 2008) The banks are required to do this by not only ensuring that their capital allocation is more risk sensitive, but also paying sufficient attention to operational and credit risk and all these measures are aimed primarily to counter regulatory arbitrage.In Particular the Basel II employs the concept of three pillars which include the minimum capital requirements, supervisory review and market discipline for a more stabilised and healthy economic system. ( Hsaio 2008).The problem for MNC's like Global Plc start here as these international efforts to curb the damage from the risks facing financial institutions have their own shortcomings as they are not well suited to the global diversity of cultures and banking models and therefore their implementation is unlikely to be smooth. ( Hsaio 2008) Basel II's implementation is already underway in the European Union through the EU Capital Requirements Directives and many of its signatories have demonstrated the intention to implement these measures with in the next few years. ( Hsaio 2008) Global Plc is involved in massive Foreign Direct Investment. The Post World War II the position was that the US was dominating the world share of FDI by three quarters of the entire market share. The US at this point had around three-quarters of the Global FDI (1945 and 1960).However today in the age of globalisation the FDI is no longer a phenomena restricted to OECD countries. FDI growth is very important for the modern global economy with the FDI stocks now constituting over 20 percent of global GDP. Inward FDI happens when there is an investment of foreign capital within a country's own local resources and can be attracted by tax holidays and tax subsidies, low rates of interest, and more investor friendly laws. However ownership restraints or differential performance requirements are likely to discourage FDI. Feenstra (1998) has pointed out some interesting myths and fallacies which have rooted themselves deep in economic theory and can potential distort an FDI's vision. She argues that depreciation of the dollar has played a significant role in increasing the flow of FDI. "(exchange rates are important because) foreign companies purchasing a U.S. firm will be able to use the knowledge from this firm in their own home market, so that they purchase the firms in dollars but earn a return in their own currencies. It is then certainly the case that the exchange rate will enter into the calculation of whether to purchase a U.S. firm or not (but not in the decision of whether to establish a new firm). I believe this argument is especially important in such industries with high R&D expenditures, and can explain the influx of foreign firms into Silicon Valley."(Feenstra 1998) Due to the Credit Crunch and paralysed cash flows Global MNC will have to focus upon their activities in East Asia or South Asia where the banks are not signatories to the Basel accords and therefore there is less of a fuss upon the regulatory arbitrage and credit risk.These kind of locations will inevitable save money losses and beneficial in terms of being the natural resource-securing , market-securing and cost-saving type of ventures. In Asia the cost saving FDI is done by export-oriented foreign firms like Global Plc.. The aim is to set up low cost production bases.Interesting because of the low wages and the exchange rate gap much of the FDI in Asia since the mid-1980s has been the cost-saving type particularly prominent in the electric and electronics industry. It is worth looking at the example of the Japanese and Chinese FDI locations which were profitable to Western FDI investors and MNCs in the face of the Credit Crunches on the 1980's.Feenstra (1998) has discussed the case of the Japanese electronics firms who when faced with losing price competitiveness of their products (due to the drastic yen appreciation in the mid-1980s) so they decided to set up their production bases in low cost locations like Korea and Taiwan, to maintain their price competitiveness. Later on as all the FDI increased the exchange rates of Korea and Taiwan as well they too stopped being FDI favourites in the early nineties.The Japanese firms were now faced with the dilemma of shifting their FDI's back into ASEAN countries to avail the advantages of low cost labour. The same happened to the ASEAN countries eventually and their exchange rates increased as well. Now Japan chose China for its large consumer market and low wages. 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