International Financial Management - Literature review Example

INTERNATIONAL FINANCIAL MANAGEMENT By Analysis of method In this case, there would be use of the spot contract where Medco Company will make a trade date on the currency of the same amount with a bank and use the exchange rate of £1 for €1.2834. In this case, there would be a settlement and delivery of the amount in two working days. This amount however is subjective to currency risks in the market in which case the currency will be highly exposed. The exchange rates are not bound to remain the same but the amount payable at the end of the six months based on the current figures and exchange rates will be; Amount=500,000(1.04)0.5 =€509,901 or £399,766.33 This applies to a case where the company decides to take loan from a UK bank. With an exchange rate of £1 for €1.2834, the company will be supposed to pay back €513,060. This is bound to be the amount if the current exchange rate remains the same over the six months. Exposure to exchange rate risks will render the company bearing higher payment costs to the bank. If the amount was to be taken from a French bank on a spot contract, the payment period remaining the same and exposure risks remaining the same, the compound value would be: Amount= 500,000(1+0.02)0.5 €504,975 or £395,903 Analysis of method 2 This is a case of a forward contract. The price is agreed upon today and then settled in six months. The customer in France assumes the long position while Medco Ltd assumes the short position. Because of the differences in exchange rates in the UK and France, the forward price will be different in the two countries but on individual country basis, it will be the same. This case will require the agreed upon exchange rates between Medco Ltd and the bank to remain £1 for €1.2755 between the two periods. The company will choose borrow the euros from either a UK bank (rates 4%) or a French bank (rates 2%). If taken from a UK bank, the amount payable in the six months, compounded semi-annually will be; Amount=500,000(1+0.04)0.5 =€505,901 or £399,766.33 If taken from a French bank, Amount= 500,000(1+0.02)0.5 =€504,937 or £395,907 This means that the company will use the notional amounts at the moment and when the customer pays the €500,000 in six months, the company will have used the amount borrowed to generate some income. The leverage created when the customer pays lies in the company paying the bank €9,901 in UK or €4,975 in France. The use of the constant rate shields the company from exchange rate fluctuations in the market over the period of six months (Ephraim, 2002, p. 601). Advice on the Best method and analysis As can be seen, speculation of the market risks in exchange of currencies is hard. Therefore, use of safe methods of dealing with financial matters is a sound issue that could be used in minimizing losses. Of the two methods used, it is necessary to note that the second method; the forward contract is the right method to use for a collection of reasons. First, the method offers a complete hedge for the amounts and parties involved. Secondly, they have been seen to provide price protection to the amount that will be paid by the customer. This protection is against the market risks in the economies involved (Söhnke, 2008, p. 320). International Risks Faced by the Company and management Transactional risk This is an international contractual risk in trade. The risk is associated with the delay in time between entry into a contract and settlement of the same (Wojcik, 2013, p. 111). The longer the contract period between the two concerned parties, the greater the risks involved before settlement. This is because there long time allows for fluctuation of the exchange rates in the market. This type of risk causes a lot of difficulties when individuals and corporations that deal in different currencies experience a fluctuation in these currencies over a relatively short period of time (Chong, Chang, & Tan, 2014, p. 651). Companies have transactional risks when there are contractual cash flows that have their values subjective to the anticipated and unanticipated changes in the rates of exchange. This affects accompanies that transact by use of foreign currencies (Kim, 2013). To be able to realize the equivalence of the foreign currency to the domestic currency as well as that of the denominated cash flows, practical exchange must take place between the different currencies. Firms negotiate contracts at times different from that of settlement of the same (Madura, 2014, p. 335). These contracts are negotiated with set process, in volatile international markets, their operations therefore become very subjective with the fluctuating rates. The risks are as a result of the differences between domestic and foreign currency not being the same. A transactional risk exposure therefore is affected by two aspects; the time of entering into a contract and the date it is executed. Kelley (2001:32) denotes two non-hedging ways of minimizing exposure to transactional risk. The first is the transfer of the exposure to another company. For example, a French company would quote the price of a product to be imported from the UK in Francs. Then the British exporter would face the exposure as a result of the uncertainty deduced from the uncertain exchange rates. The second method of transferring is to demand payment immediately. In this case, the current spot rate will determine the value of the dollar during export. The second non-hedging method is by netting it out. There are also hedging methods of reducing transactional risk. The first method is by forward contracts (Bengt & Niclas, 2004, p. 221). For instance, if a UK exporter sells 600 bales of cotton to an Italian company with a sales contract stating that 2 million lire has to be paid within 30 days, the UK company can eliminate the risk by selling the bales to its bank. Whatever happens during the payment period does not concern the company because it is sure of converting the 2 million lire to UK pound. If the UK company faced an account payable instead of facing an account receivable, it will eliminate the exposure by buying the lire at a forward rate (Kelley, 2001, p. 33). The second method is to hedge using the existing money market. If forward contracts are not available or are too expensive to use, this is an alternative method to use. One of the specified methods here is to use options. In this case, one party is given the right to sell/buy a specified amount of currency by use of a specified amount of exchange rate. If the rate later moves in favor of him, this option can be exercised and leading to the holder being protected from any loss occurring (Clark & Ghosh, 2004, p. 331). Ways of dealing with long term risk exposures slightly differ from using the other short term exposures. In the long term, the methods that can be used are; use of back to back loans and also use of credit swaps. Translation Risk The translation exposure of a firm refers to the extent to which the financial status of the firm is affected by the movements in exchange rates (Nazarboland, 2003, p. 3). Firms have the obligation of preparing financial statements for the purposes of reporting. The process of consolidation for multinational companies involves translation of foreign assets and liabilities or those of their foreign subsidiary companies to their domestic currency. In most cases, the translation has no effect on the cash flows of a firm (Hagelin & Pramborg, 2006, p. 49). However, it has a significant impact on the reported earnings of a firm and their eventual stock price. When the proportion of the foreign assets and liabilities is high, the company is said to have a high exposure to translation risk. Most exchange rates change on quarterly basis and there are bound to be wide variances between the actual values and the reported values in the financial statements (Niclas, 2003, p. 101). Before dealing with the translation method, it has to be understood that there are several types of translation methods; Current and non-current method Monetary and non-monetary method Temporal method and Current rate method. The non-current method dictates that assets and liabilities are supposed to be translated when they mature (Pramborg & Hagelin, 2004, p. 301). Current assets are translated at spot rate while non-current assets are translated based on the historical method. The underlying principle in the monetary/non-monetary method is that monetary accounts deal with currencies whose value changes as the value of the market exchange rate changes (Clair & Randall, 2001, p. 23). In the temporal method, the underlying principle is that assets and liabilities are translated based on their positions and how they are carried in the books of accounts. In the current rate method, all items in the balance sheet are translated at the current exchange rates (Bradstreet, 2007, p. 93). The explained four methods in translation altogether define two specified methods of dealing with this risk. Since it deals with assets and liabilities more, the balance sheet hedge is the first method. Translation error usually is not entity specific but currency specific. Since the source is usually a mismatch between assets and liabilities, a balance sheet hedge works to eliminate this mismatch (Broll & Chow, 2001, p. 1002). When more assets are exposed than liabilities, a perfect balance sheet is created later on in which a change in the currency exchange rates would not have any effect on the balance sheet that is consolidated. This is because the change in the value of assets as related to liabilities would have been offset by the change in the value of the liabilities as denominated in the same currency as all assets (Ullrich, 2009, p. 87). The second solution to the translation risk is the derivative hedge. In this case, there would be use of forward contracts where maturity of the reporting period attempts to make the accounting numbers manageable. It however involves a lot of speculation about future exchange rates (Bae, Kwon, & Li, 2008, p. 329). Economic Risk (Operating Exposure) Economic risks occur when the market values of currencies held by companies are influenced by unexpected fluctuations in the exchange rates (Lee & Solt, 2001, p. 126). Such abrupt exchange rates largely affect the market position of the company in relation to its competitors, its future cash flows and ultimately the firm’s real value in whole. All transactions that expose the firm to any foreign exchange risk also expose the firm as a whole although economic exposure can be done by a collection of other reasons such as investments. A shift in exchange rates that creates demand for a good in one country may also be the reason for an economic exposure of the company (Goswami & Shrikhande, 2007, p. 21). The economy of the world is fast globalizing. Firms must therefore consider exposure to these economic risks as part of their plans in the financial domain (Marston, 2001, p. 21). The management is supposed to be a long term issue as it involves locations, sourcing, production and consideration for joint ventures. Hedging may be operational or financial. Operating hedging takes into consideration methods such as: Selection of production sites that are low-cost Sourcing policies that are flexible Market diversification Efforts in R and D as well as diversification Selection and sourcing indicates that when a domestic currency is strong, a domestic exporting company will be at a competitive disadvantage (Miller, 1998, p. 321). This will be solved by transferring the production into a country that gives a competitive production atmosphere that is favorable. When a country experiences high costs in the sourcing of its products, it can create policies that will allow shifts in markets to places where there are favorable costs. For instance, there would a be a shift in policy that allows for importation of labor from countries that have excess labor sources to allow for benefits due to operating economies (Gautam & Milind, 2001, p. 111). Diversification of the market is also important in that a company can decide to sell one of its products in to a collection of markets. This is because the exchange rates do not always perfectly move together against the dollar as a standard international exchange currency. Diversification mitigates the exposure to a single currency that would be too risky to operate with (Haller & Norpoth, 1997, p. 64). Financial hedging on the other hand involves the following methods: Currency futures swaps Forward contracts. The application all these methods hold in the same way as it was with all the other prior methods because it is a consideration of forwarding payments through an ideal organization with the bank (Greenwood & Naylor, 2008, p. 120). References Bae, S. C., Kwon, T. H., & Li, M. (2008). Foreign exchange rate exposure and risk premium in international investments. Journal of Multinational Financial Management, 18(2), 765. Bengt, P., & Niclas, H. (2004). 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Forecasting and Hedging in the Foreign Exchange Markets. London : Springer. Wojcik, J. (2013). TRANSACTIONAL RISK COVER CAN HELP BUYERS, SELLERS. Business Insurance, 47(15), 111. Read More