Financial Market Alternatives for Hedging Economic Exposure - Assignment Example

Finance and accounting Lecturer Finance and Accounting Question a. financial market alternatives for hedging economicexposure The more standards method for hedging economic exposures includes: Forward contract- when a firm agrees to pay or receive a fixed amount of foreign currency at some time in the future, in most of the currencies, it can obtain a contract today that specifies a price at which it can be able to purchase or sell the foreign currency at the specific time in future. This helps in converting the uncertain future of the home currency value of the asset of liability into certain home currency value, which is to be received on a date specified, independent of the changes in the rate of exchange over the time remaining on the contract. Future contracts- they are equivalent to forward contracts in regard to how it functions despite differing in various features that are important. These exchanges are traded and therefore having contract sizes, date of maturity, collaterals among other features that are limited and standardized. Future contracts are available in specific sizes, currencies and maturity; it is therefore not possible to get an offsetting position to eliminate the exposure. Unlike the forward contracts, the future contracts are traded on an exchange and do have a secondary market that is liquid. This makes it easier to unwind or close out in any case the time of the contract does not match the timing of exposure. Money market hedge- it makes use of the fact from covered interest parity, which the forward price must always be equal to the current spot on exchange rate times the ratio of both currencies returns that are riskless. Options- foreign currency options have front fee and presents the owner with the right and not the obligation to trade domestic currency for foreign currency over a certain period. b. Alternative-Operating strategies for hedging economic exposure Economic exposures can be managed by the adoption of various operational strategies that do have the virtue of upsetting any foreign currency exposure that is in existence. These techniques are vital when functioning forward, and the derivate market does not exist for the foreign currency that is contracted. Strategies include Risk shifting- one of the best way of reducing an exposure is not having the exposure. By invoicing everything in home currency, an organization is able to avoid any economic exposure. Sharing of currency risk- to avoid the risk in currency then two parties must be involved in the transaction so that the risk cam be shared. This strategy does not eliminate the exposure but rather splits the risk. Leading and lagging- it involves playing with the timing of foreign currency flow of cash. When the nominal contract of the foreign currency appreciates then, the liabilities should be paid early. c. Financial market instruments with operating strategies for hedging economic exposure. Financial instruments and the operating strategies are more complementary than being substitutive. Financial instruments can be used in the reduction if common components of variability in profits whereas the operating strategies can be used in the reduction of the specific risks exposures of a firm. Question 2 Compare and contrast currency swaps and parallel loans. Currency swap is a foreign exchange agreement that is made between two existing institutions to exchange certain aspects especially the principal or the interest payment of a loan using one single currency for an equivalent aspect that is equal to the net present value loan using another currency. They are highly motivated by the comparative advantage. In currency swap, both the interest and the principal of loans are exchanged with both parties involved benefits mutually. Most laws do not require currency swap to be shown as part of an organization balance sheet since it is considered as part of a foreign exchange transaction. For example using the china Renminbi case, supposing a company based in United States needs to acquire the Renminbi, and the China-based company needs to acquire the US dollar. The two companies can arrange for a swap of currencies through the establishment of an interest rate, amount agreed upon and a common date of maturity for the exchange. Currency swap is a flexible method of conducting foreign exchange since its maturities can be negotiated for approximately ten years. Parallel loans are also referred to as back-to-back loans. These loans are practiced by different companies in different countries borrowing each other’s currency for some time and repay the currency at an agreed time of maturity. These companies lend each other their foreign currencies in an effort to try to hedge against the risk of currency. Companies are able to trade their currencies in the currency market. Nonetheless, the use of parallel loans is more convenient because the companies involved tend to get the currencies that they need. However, the use of currency swaps have emerged to replace parallel loans largely in the currency market since they promote the aspect of international trading compared to the use of parallel loans. The use of parallel loans is mostly involved in currencies that are unstable due to its high rate of volatility thus creating a more need for companies to try and mitigate the risk of currency. Question 3 Importance of corporate governance in international finance Corporate governance has a strong influence on the efficiency of a company’s production at a corporate level so that the nation’s effectiveness in the corporate system of governance shapes the country’s economic performance. Diffuse shareholders exert corporate governance through the rights to voting and the election of the board of directors and diffuse debt holders limiting the discretion of managers through the bond covenants. However, these mechanisms fail to work well around the globe. Several small investors have difficulties in exercising corporate governance because of the asymmetry of information and poor legal, regulatory and bankruptcy system. Small investors paly very little role in trying to exert the control of corporate outside the United States. Instead, the large investors act as the main sources of the corporate governance. If the entire world was to rely on banks and other financial intermediaries to exert corporate governance that is effective, then the managers of the institutions of finance must face sound governance of corporate themselves. The corporate governance of banks and other financial intermediaries are very crucial in the shaping of the capital allocation at the organization level and the countries level. Nonetheless, the attention of the financial sector in the corporate governance has been less than what it seems warranted by their central role in the nations system of corporate governance. Countries whose governments are offering support to the ability of the private sector entities to bank monitoring, permitting banks to engage in wide range of activities, minimizes state ownership and encourages diversification, enjoy a good and well developed system of finance that has lower chances of serious financial crisis. The role of the government can be seen to be fostering the ability and incentive of all various potential monitors of banks to do their jobs well. It is evidenced that the governance problem in finance is severe but not hopeless. The recognition of the difficulties in the process of corporate governance in the financial sector and the need to get governments focused on their role as a facilitator and not a pseudo owner will be a fundamental step in achieving success. Question 4 Evidence for international determinants of capital structure The capital structure of a company consists of a certain combination of equity issues and debt issues to relieve probable pressures on the long-term financing. Several theories are in place to help in focusing on the determinants that are likely to have an influence on the leverage decisions of the firms. The empirical information suggests several factors influencing the financial structure of firms. Firm leverage tends to be affected by fixed costs, expenditures on advertisements, profitability, opportunities for investments, product uniqueness and the possibility of going bankrupt. It is also revealed that the major factors affecting the capital structure of banks include issues of tax, profitability, opportunity and growth, issuing costs and control of management. The nature of a firm’s asset has a great impact on the capital structure. The assets that are tangible are less subject to the asymmetries of information, and usually they have tremendous value compared to the assets that are intangible in the event of bankruptcy. Thus, the trade-off theory tends to make a prediction on a positive relationship between leverage measures and the tangible assets proportions. Nonetheless, the empirical evidence that are relating to this mixed. The tangibility and the leverage relationship highly depend on the debt applied measures. Further, those managers of highly levered firms will not be able to excessively consume perquisites because the bondholders do monitor such kind of firms more closely. Compare and contrast the determinants of capital structure for a purely domestic firm with multinational firms Multinationals firms and cooperation operate in an international environment, encountering forces of economy and opportunities that are not faced by their purely domestic counterparts. Therefore, it is more likely these multinationals have to make a consideration of other additional factors in the determination of their target capital structures. However, the empirical evidence existing either ignores the international factors completely or assumes implicitly that they are proxied adequately by the risk measures of standard business. There are several systematic differences existing between multinationals and domestic firms in the traditional factors that do determine capital structure, and these factors play a role in determining the decision of international capital structure. Specific international factors are important and relevant to the decisions of the multinational capital structure. Multinational capital firms have agency cost of debt that is higher than the purely domestic firms. In addition, the international diversification does not result in earnings that are low in volatility for the international cooperation’s compared to the domestic firms. Question 5 In capital budgeting, describe the two methods for discounting foreign currency cash flows Spot rate method- this method projects foreign cash flows in the foreign currency, and then discounts them at the foreign cost of capital. Then convert the present value of the cash flow of the local, domestic currency, making use of the spot exchange rate. Forward rate method- this method of discounting foreign currency projects foreign cash flows in another countries currency and then converts these currencies into domestic currencies using the relevant forward exchange rates. This method discounts the cash flows that has been converted at the cost of capital in the domestic currency. A company valuation should always result in the same intrinsic value regardless of the currency or the mix currencies in which the projection of the cash flow is made. In order to achieve such consistent outcome, a company needs to use consistent monetary assumptions and one of the methods of forecasting and discounting foreign currency cash flows. Conditions under which the two methods are equivalent Several market data comparisons across countries show differences in the premiums realized. However, this is mainly as a result of the differences in the composition of the industries compared. The returns realized do vary greatly across the markets depending on the time over which they are measured. Most important things are that these indices in the markets do not represent large and a diversified portfolio. Therefore, such premiums need to be based on the market index globally. It is very unfortunate that the global indices rarely go far back in time. Therefore, long-term estimates from the local market indices do not represent the contribution of risk necessarily. Thus, the two methods of discounting foreign currency cash flows are equivalent in situations where risks are involved. In cases of risks, they are handled by the adjustment of cash flows expected and weighting by the probability of several scenarios. Question 6 a. present the case for international diversification to a skeptical client Explain that international diversification is important and effective in this era of globalization. These are the investments of individual portfolios in securities that are traded in several countries to reduce the risks that are involved. Individual investors do this too often avoid or reduce the risk of politics that is often experienced in the countries of investment. Even though it may be simple, in theory, diversification is not easy and does not just smooth returns and sometimes it increase the risks. I will explain why it is important for individuals to diversify their investment instead of localizing them in a single business or a single place. b. plan that you would use to tackle the numbers in this case Even though the world is globalized, several people are not aware that there exists an international diversification, and those who have heard of it are still skeptical on the issue. To tackle the growing number, I will give examples of international diversification cases and how it has developed with time. International seminars on accounting on diversification issues should be introduced as well as teaching diversification courses will help in highlighting to the people the existence and the importance of international diversification in business. c. how international diversification affects the efficient frontier Efficient frontier is a set of optimal portfolios that are offering the highest expected return for a defined level of risk or the lower risk for a certain level of the returns expected. Since the efficient frontier curve is curved and not straight, this is the key to the concepts of diversification. Diversification generally does not protect against any systematic risk since any drop in the market and economy affects the investments. Efficient frontier can be used in explaining the benefits of diversification because different assets behave differently under the same condition of economy. If one invests in all types of assets, there is likelihood that some of the assets are going to perform well even the rest are declining temporarily. In this case, a portfolio that is undiversified can be moved closer to the efficient frontier by diversifying it. Therefore, international diversification can help in increasing the returns without having to increase the risk or reduce the risk without having to reduce the returns that are expected. An investor who is rational will, therefore, hold portfolios that are lying somewhere on the efficient frontier. However, one cannot say which portfolio an investor would prefer because it is determined by the maximum risk level that investors are prepared to face and take. d. Why there is a home bias– why, more investors do not consider international investments Home bias is the tendency of investors to invest in a lot of domestic equities, despite the purported benefits of diversifying into foreign equities. Several goods are characterised by domestic products having a market share that s disproportionate. Taking the set of products that are available on the market as given, the candidates responsible for creating the “home bias” are preferences for the home goods or involve in trading the cost that are reflected in higher prices of imports or weaker networks of distribution for the goods imported. This bias tends to arise because of the extra difficulties that are associated with investing in foreign equities including additional cost of transactions and legal restrictions. Preferences and not the cost of trade are the main force acting behind the home bias. Several investors consider home investment to international investment. They prefer home bias because it is a principal of managing wealth that helps in diversifying their risks away as much as possible compared to the international investment. Investors all over the world feel much safer when they conduct their investments domestically. This is because holding of foreign stocks and other investments introduces risks to the currency due to currency exposure. Domestic investments also do have low costs and favorable tax treatment compared to having foreign investments. Question 7 Differences between macro and micro country risk Country risks are a collection of risks that are linked with foreign country investments. They include political risks, economic risks, risks associated with exchange rate, sovereign risks and transfer. Country risks are different depending on a country. Some countries do have greater risks just to discourage more foreign investment taking place. Whenever investing abroad, country risks must be put into consideration since it can reduce the expected return on an investment. Some of the country risks in place lack effectiveness on the hedge. In addition, other risks including the risk on the rate of exchange can be protected against with a marginal loss of profit potential. Macro country risk is a type of country risk that a foreign government or country alters significantly its regulations and other policies so that it can affect investments taking place in the country significantly. More broadly, this type of risk do apply to the risk a country refuses to comply with certain agreement to which it is a signatory, or that violence due to politics will be hurting business or investment. If some goods is exported to a foreign country and the country elects a totally new government in place that enacts tariffs of protection, this will tend to have an impact on nearly all the exports rather than impacting on just a single export business. On the other hand, Micro country risk is a type of political risks affecting corporations that do business in other countries that may be subject to internal chaos or anti-foreign sentiments. This type of country risk may take into account events such as vandalism, rioting, unrest foreign governments nationalizing corporate assets. In this risk policies and regulations that countries do alter only affects certain projects, company or industry. This risk implies that governments deliberately target something or someone, in particular. For example, the political climate of a country in which particular defense contractors operates may turn against a certain company because of its perceived excesses. The government then may decide to revoke its contract and allow other contractors to enjoy working in the country. Companies operating in countries must find ways of minimizing both types of risks. Whereas macro country risks are hard to minimize at some point because they largely depend on the governments regulations and policies, the micro risks can be minimized through insurance that will cater for cases such as vandalism in case of civil unrest . In addition, the micro risk can also be minimized through opening of more operations in the country. Reference Brown, P., Beekes, W., & Verhoeven, P. (2011). Corporate governance, accounting and finance: A review. Accounting and Finance. Read More