Economic Foreign Exchange Exposure - Essay Example

FINAL EXAM FIN645AC SPRING 15 IBNSTRUCTOR Economic foreign exchange exposure can be hedged with either operational strategy for financial market hedges. a. List several financial market alternatives for hedging economic exposure. These financial market alternatives are carried out in the capital and money market: a) Futures contact. b) Forward contract. In the Pixonix case, it is defined as a contractual agreement between two parties to purchase and sell an asset at a predetermined price at a specified time in future. c) Options d) Swaps e) Money market hedge. Pixonix can hedge foreign exchange risk using put options, call options and forward contracts. Cain first considered purchasing a forward contract worth US$7 million. b. List several alternative operating strategies for hedging economic exposure. Operational hedging strategies are internal organizational strategies that are used by exporters to deal with economic exposures. They include: a) Exposure netting b) Deal in local currency c) Leading and lagging receipts and payments In the case of FX Risk Hedging at EADS, EADS used netting to achieve a better match between dollar costs and dollar revenues. This operational strategy minimized the company’s anticipated net dollar inflows. c. Compare and contrast the use of financial market instruments with operating strategies for hedging economic exposure. Operational strategies and financial market instruments are both ways of mitigating economic exposures by transferring risk from one party to another. Money market hedge transfers risks from companies to banks while dealing in domestic currency transfers risks from the company to its customers. Operational hedges are only used by multinational firms when it faces a combination of demand uncertainty and exchange rate uncertainty. They are less important for managing or hedging against short-term exposures because demand uncertainty is always lower in the short term. In addition, operational hedging is likewise less crucial for commodity-based firms that face price rather than quantity uncertainty. Financial instruments are greatly used by forms to hedge against short-term exposures while operational hedges are used greatly to hedge against long term exposures. The foreign currency cash flows of firms that have plants both in foreign and domestic location are not independent of the exchange rate. And therefore, optimal financial hedging policy should entail forward contracts as well as foreign currency put and call options. Natural hedges helped MNCs to offset unexpected fluctuations in foreign currency exchange rates especially operational hedges that are associated with geographical diversification. Operational hedging often compliments financial hedging. For instance, MNCs use financial derivatives to mitigate risks exposures while they are operationally hedged, geographically diversified. Financial instruments are used to reduce the basic component of profit variability while geographical diversifications (operational hedges) can reduce firm-specific risk exposures. The use of both financial derivatives and operational hedges improves firm value. Operational hedges are not perfect substitutes for financial risk management. In the case of CARREFOUR S.A., Carrefour used financial market instruments, Forward contract, to hedge against their foreign currency borrowings in order to maintain total debt requirements at 97% in Euros. 2. Compare and contrast currency swaps and parallel loans. MNCs often use both parallel loans and currency swaps to achieve a similar objective. For instance, they provide a cheaper form of debt because they easily borrow in their respective countries and then swapping the debt. Both parallel loans and currency swaps helps the MNCs in reducing exchange rate fluctuations. Also, the two arrangements gives companies an opportunity of accessing capital markets in foreign nations then suing their comparative advantage, the firms borrow in different capital markets. By offering an opportunity to nations hit by liquidity crisis to obtain money from other countries with their own currencies, both the arrangements defend against financial turmoil. Currency swap is an agreement between two parties to exchange loans aspects, that is the principal and the interest payments, in one currency for the second currency in future while a parallel loan is a foreign exchange loan among four parties involving currency exchange with a guarantee of exchanging again such currencies at a specified future date at a predefined exchange rate. The parties to parallel loans are two pairs of affiliated companies that arrange it in two different countries. Parallel loans and currency swaps have many differences. For instance, initial cash movements take place in the case of parallel loans however, that is unnecessary in currency swaps. This is so because currency swaps are usually based on the existing spot rates. In addition, currency swaps have an implied right of offset, a condition that is not available to parallel loan holders. Currency swaps tend to offer greater flexibility to the parry involved a condition which is not available to parallel loan holders. Entry into parallel loans is permitted by constituting documents of the counterparty, however, this is lacking in currency swaps. For instance, currency swaps and parallel loans defended Australia against financial turmoil as banks sought more long terms loans from the offshore markets. The loans increased from $2.9 billion in September of 2007 to $18.5 billion in December. Due to the less attractiveness of the Australian dollar in terms of carry trade, investors borrowed in local currency with low rates of interest and bought another currency offering higher rates. 3. Explain the importance of corporate governance in international finance. Corporate governance refers to the order and structure that helps in keeping communication within a large organization clear and easy to understand. It consists of numerous obligations, duties, and rights that direct and control a corporation. It aims at properly distributing responsibilities that participants of the corporation have. Such participants include stakeholders, managers, regulators, creditors and board of directors. On top of informing such people their responsibilities, it informs them about their rights as well within the company. Corporate governance has diverse importance to international corporations. First, it assists in streamlining the process and gives individuals accountability. It aims at helping the decision making process of companies. Corporate governance enables stakeholders to be held responsible for their actions. For instance, the board properly evaluates the corporation’s management to ensure good management. Secondly, corporate governance helps in mitigating or reducing amount of risk a company faces. Through corporate governance, fraud, scandals, and criminal liability of corporations can be prevented or even avoided altogether. The actions of an individual within the company do not mean the downfall of the whole company because individuals involved in the organization re aware of what they are accountable for. Proper identification of roles results in the prevention of negative effects because the offender is easily identified and punished. Therefore, corporate governance acts as a form of self-policing. Strong corporate governance increases access to capital hence leading to economic growth. Corporate governance increases public acceptance of a company. Such companies are accepted because of transparency and the idea of disclosure that comes with good corporate governance. There is a higher level of trust due to full disclosure and the ability of the general public and other employees to get information on the company. High level of corporate governance gives companies a public image to maintain. Organizations take more responsibility for their actions thus helping those in charge to be very aware of the corporation’s public image. A clean image helps companies to be successful. For instance, corporate governance necessitated Malaysian government to implement a New Economic Policy to tackle the problem of inter-racial and inter-ethnic wealth distribution. The policy was aimed at equitable distribution of wealth as well as fairness. The policy also corrected economic imbalance in the country by holding every accountable. This increases the transparency and the public image of the country. 4. List and explain the evidence for international determinants of capital structure. Compare and contrast the determinants of capital structure for a purely domestic firm with multinational firms. Capital structure is defined as the total long-term investments in business firms. Capital structure includes funds that are raised through bonds, ordinary as well as preference shares, debentures and term loans from financial institutions. Determinants of capital structure a) Flotation costs. These are costs incurred when raising funds. The cost of floating debts is less than that of floating equity issues thus discouraging companies from using equity issue hence more debt. b) Marketability, ability of firms to sell a given type of security. Small companies find it hard to raise long-term loans and hence depend on owned capital. Large firms have more dents because they are very able to market securities. c) Size of the firm. Small firms find it harder to raise long-term loans hence have more equity however, large firms are able to raise long-term loans hence have more dents. d) Flexibility, ability of forms to adapt their capital structure to the needs of ever changing conditions. Highly flexible firms have no difficulty in altering their source of funds. e) Control. Companies that desire to continue having control over the firm prefers debts. The firm that does not wants control prefers more equity. f) Cash flows or Profitability. Highly profitable firms have low dents since good profitability lowers the need for debt financing. Determinants of capital structure vary with the level of operation of the company. However, leverage of both companies is relatively similar. Both purely domestic firms and multinational forms depend on cost of capital, flotation costs, and marketability to determine their capital structure. Multinational firms depend on stability, size of the company, control, predictable cash flows, marketability, diverse investment opportunities, uniqueness and cash flow in determining their capital structure. On the contrary, purely domestic forms depend on financial leverage, collateral value assets, Growth, industry classification, volatility and profitability in determining their capital structure. The discipline resulting from debt outweighs the need for flexibility for multinational firms. Purely domestic have less debt than equity since they are faced with high uncertainty as a result of cyclical nature. For instance, in a bid to have control or autonomy from international markets, Malaysia (in the Malaysia: Capital and Control case) established a strict regulation of its international capital. Malaysian authorities strictly controlled outflows of short term capital. In addition, Carrefour, in the Carrefour S.A. case, used their profitability to obtain capital in the foreign market. In 2001 their foreign currency borrowings amounted to EUR13.5 billion which they hedged in order to maintain total debt requirements at 97% in Euros. 5. In capital budgeting, describe the two methods for discounting foreign currency cash flows. Explain the conditions under which the two methods are equivalent. Popular capital budgeting techniques net present value (NPV), Payback period, internal rate of return (IRR), and discounted cash flow (DCF). The two methods used in discounting foreign currency cash flows are IRR and NPV. The NPV method This is the difference between present future values of cash inflows and the initial investment. The NPV of foreign currency cash flows is the sum of PVs minus the initial outlay of the project. Since NPV uses cash flows, depreciation must be added back firms before the NPV is computed. The decision rule here an investment with NPV>0 is accepted and those with NPVcost of capital the investment is accepted and if IRR< cost of capital, the project is rejected. The first condition under which the two methods are equivalent regards the decision rule. The two methods lead to the same accept-reject decision for an investment. The second condition relates to the factors under consideration. Both IRR and NPV take into account the whole life of the project and the time value of money. Both IRR and NPV help in determining whether a new project is worthwhile. They both gauge the ability of an investment to generate net economic losses or profits for the firm. Both the methods are useful in investment valuation and capital budgeting. They are both based on cash flows rather than accounting profits. This results in wealth maximization of shareholders. If both the values of the techniques is equal to zero, then the managers become indifferent and other factors like availability of funds must be considered to arrive at a sound decision. Both NPV and IRR enable managers to arrive at better decisions because they offer a deep understanding of the returns of the investment. In the case of Hag’s Singapore Note Issue, Hag discounted their foreign currency cash flows from real estate in Vietnam using NPV and IRR which were more reliable as a measure of the company’s operating performance in comparison to income. 6. The Innocents Abroad case explores international investing: a. Explain how you would present the case for international diversification to a skeptical client. A skeptical client needs substantial data in order to convince them of the importance of international investment. Therefore, carrying it a very extensive research on international market will provide me an opportunity to identify asset allocations that would actually add value to them. In addition, I would carry out extensive analysis of the foreign markets aimed at understanding the behavior of international stocks returns. For instance, In the case of Innocents Abroad: Currencies and International Stock Returns, Meyer decided to examine closely the performance of global stocks over a considerable duration to understand their behavior. This will enable me to give them a thoroughly searched data on the behavior as well as predictability of stocks. I would present to them standard deviations and returns of global markets to enable them see the real picture regarding the performance of international equities. Finally, I would show to them that, just like China, foreign stock markets results in less risk and higher returns. b. Explain the plan that you would use to tackle the numbers in this case. First, I would work out the annualized returns as well as standard deviations for the outlined equity markets. Then I would find out the correlation between different markets as presented by the tables. Further, I would examine the annual performance of foreign equalities like in the case of EM and EAFE indices. Using different asset allocation, I would compute returns of different portfolios. Then I would map the efficient frontiers to demonstrate the effect of international portfolio allocation on risk return characteristics. For instance, In the case of Innocents Abroad: Currencies and International Stock Returns, Meyer determined the annualized returns as well as standard deviations for various equity to understand how they correlate. c. Explain how international diversification affects the efficient frontier. International diversification lowers foreign exchange risk because international equities do not move in perfect tandem with local or domestic equities. It reduces volatility and increases returns of the overall portfolio. It enhances the risk-adjusted portfolio performance thereby improving the efficient frontier. A well diversified portfolio of international and domestic investment helps position businesses to make money. In the case of Innocents Abroad: Currencies and International Stock Returns, Meyer indicates that internationally diversified portfolio has a lot of financial reward. d. Explain why there are home bias–why more investors do not consider international investments. Home bias is a situation whereby investors prefer to investment in their home country at the expense of foreign countries. There are several reasons as to why that occurs. First, equities of their home country outperform those of other developed countries. Secondly, even though equities of emerging markets have stronger growth opportunities, they very volatile hence pose a lot of risk to the investments. For example, in Innocents Abroad: Currencies and International Stock Returns case, Investors have prolonged experience that US indices always outperform those abroad. International investments create currency risks instead of adding much value to the overall portfolio. Returns of home based investments compares quire favorably to international indices hence no greater returns. Foreign countries tend to have information asymmetry. For example, Meyer’s returns compares well with international indices. 7. Explain the differences between macro and micro country risk Country risk refers to a type of risk faced by governments, investors, as well as corporations in their operations. Micro country risk only affects companies that carry out businesses in nations that face internal turmoil or anti-foreign sentiment whereas macro country risk affects all foreign companies operating in a host nation. Macro country risks arise due to the foreign government altering their policies as well as other regulations in a manner that significantly impacts all investments in that country while micro country risks include circumstances such as rioting and civil unrest, nationalization of companies or corporate assets by foreign governments as well as vandalism acts. Macro country risks also incorporate risks that arise due to the refusal of a country to comply with agreements that it is a party. On the other hand, a micro country risk does not affect all businesses because it is industry-specific, for instance, in case a country passes a environmental law on factories, the regulation only affects operations in that industry and not other industries like tourism and hotels. For instance, the case of Foreign Direct Investment in the Middle East, points out that the high volatility of economic and political conditions in that region only affects businesses in the Middle East and not in the West. Macro country risks, on the other hand affects all businesses. For instance, increase in taxes by a host country, civil war outbreak and devaluation of a currency of a given country affects businesses across the board. Macro country risk is reduced through the method of diversifying businesses by expanding their operations to other foreign nations, however, micro country risks are mitigated by just shifting the investments of a company to other industries not impacted by the country’s unfavorable changes. Saudi Arabia has macro country risk because it imposes import restrictions on certain commodities because of religious and health reasons. According to the case of Foreign Direct Investment in the Middle East: Riyadh and Dubai, The countries in the region have low ranking in country risk rating due to massive political unrest experienced in the region that significantly affected firms. Read More