International Finance & Risk Diversification - Case Study Example

International finance & risk diversification Table of Content Content Page No Introduction International Cash Management, Applications of derivatives, International capital budgeting 2 2. Exchange Rate Risk 2.1 IBM 4 2.2 Coca Cola Company 4 3. Interest Rate Risk 3.1 IBM 6 3.2 Coca Cola Company 6 1. Introduction IBM In order to determine the possible results of market risk exposures on the fair values of IBM's debt and other financial instruments, it performs a sensitivity analysis which comprises of all the company's marketable securities, cash and cash equivalents, investments, long-term and short-term debt and long-term non-lease receivables. Also, foreign currency swaps, includes interest rate swaps, option contracts and forward contracts comprise of IBM's portfolio of derivative financial instruments. In order to carry out the sensitivity analysis, IBM calculates the risk of loss in fair values from the result of hypothetical changes in the foreign currency exchange rates and interest rates on market-sensitive instruments. With the help of the current value of the possible future cash flows, the market values for interest and foreign currency exchange risk are found out. However, the information according to the sensitivity analysis will not necessarily signify the real changes in fair value that IBM would face in case of normal market conditions as, due to practical confinements, all variables except for the particular market risk factor are held constant. Coca Cola Company Coca Cola Company makes the use of derivative financial instruments mostly to lessen their exposure to unfavorable fluctuations in the foreign currency exchange rates and in interest rates and commodity prices involved as market risks. The company does not go into derivative financial instruments in order to carry out trading. In fact, risk by hedging and primary economic exposure is reduced by all their derivative positions. Owing to the high connection between the underlying exposure and hedging instrument, reciprocal changes in the value of the underlying exposure is used to counterbalance fluctuations in the value of the instruments. Practically all of Coca Cola's derivatives are simple, over-the-counter instruments with liquid markets. 2. Exchange rate and Interest rate risk Kinds of risks that are involved are either interest rate risk or exchange rate risk. Interest rate uncertainty exposes a firm to the following kinds of risks: If the firm has borrowed on a floating rate basis, at very reset date, the rate for the following period would be set in line with the market rate. The firm's future interest payments are therefore uncertain. An increase in rates will adversely affect the cash flows. Consider a firm, which wants to undertake a fixed investment project. Suppose it requires foreign currency financing and is forced to borrow on a floating rate basis. Since its cost of capital is uncertain, an additional element of risk is introduced in project appraisal. On the other hand, consider a firm, which has borrowed on a fixed rate basis to finance a fixed investment project. Subsequently inflation rate in the economy slows down and the market rate of interest declines. The cash flows from the project may decline as a result of the fall in the rate of inflation but the firm is logged into high cost borrowing. 2.1 IBM As compared to an increase of $18 million on December 31, 2005, there would be reduction in the fair market value of IBM's financial instruments of $113 million, which would be a result of a 10% reduction in the levels of interest rates on December 31, 2006, keeping all other variables constant. On the other hand, as compared to a reduction of $8 million at December 31, 2005, there would be a hike in the fair value of IBM's financial instruments of $96 million, which would be a result of a 10% increase in the levels of interest rates, keeping all other variables constant. Alterations in IBM's interest rate profile and amount and debt maturities have resulted in variations in the relative sensitivity of the fair value of IBM's financial instrument portfolio for the theoretical changes in the level of interest rates. 2.2 The Coca Cola Company For interest rate risk, Coca Cola monitors a mix of variable-rate and fixed-rate debt, along with a mix of non-term debt and term debt. In order to manage their mix of variable-rate and fixed-rate debt, the company enters into interest rate swap agreements from time to time. On the other hand, exchange rate exchange gives rise to number of concerns for such a firm, example, What will be the effect on sales volumes if prices are maintained If prices are changed Should prices be changed Since a part of inputs are imported material cost will increase following a depreciation of the home currency. Even if all inputs are locally purchased, if their production requires imported inputs the firms material cost will be affected following a change in exchange rate. Labour cost may also increase if cost of living increases and the wages have to be raised. Interest cost on working capital may rise if in response to depreciation the authorities resort to monetary tightening. Exchange rate changes are usually accompanied by if not caused by difference in inflation across countries. Domestic inflation will increase the firm's material and labour cost quite independently of exchange rate changes. This will affect its competitiveness in all the markets but particularly so in markets where it is competing with firms of other countries Real exchange rate changes also alter income distribution across countries. For an American firm, which sells both at home, exports to Germany, the net impact depends upon the relative income elasticity's in addition to any effect to relative price changes. Thus, the total impact of a real exchange rate change on a firm's sales, costs and margins depends upon the response of consumers, suppliers, competitors and the government to this macroeconomic shock. In general, an exchange rate change will effect both future revenues as well as operating costs and hence exchange rates changes, relative inflation rates at home and abroad, extent of competition in the product and input markets, currency composition of the firm's costs as compared to its competitors' costs, price elasticity's of export and import demand and supply and so forth. 3.1 IBM As compared to a decrease of $257 million on December 31, 2005, there would be reduction in the fair market value of IBM's financial instruments of $348 million, which would be a result of a 10% reduction in U.S. dollar against foreign currencies on December 31, 2006, keeping all other variables constant. On the other hand, as compared to increase of $278 million on December 31, 2005, there would be a hike in the fair value of IBM's financial instruments of $330 million, which would be a result of a 10% stronger U.S. dollar against foreign currencies on December 31, 2006, keeping all other variables constant. 3.2 Coca Cola Company Coca Cola is able to net specific exposures and thus make use of any natural offsets which helps it to manage, on a consolidated basis, their foreign currency exposures. Almost 72% of their net operating revenues have been generated through operations outside of the U.S.A. in 2006. This shows that any kind of weakness in one particular currency can be counterbalanced by strengths in any other currency over a period of time. In order to further decrease their net exposure to currency fluctuations, Coca Cola uses derivative financial instruments. They have forecasted cash flows denominated in foreign currencies, and hence to hedge the same, the company purchases currency options (mostly euro and Japanese yen) and collars and enters forward exchange contracts. To counterbalance the earnings impact concerning exchange rate fluctuations on particular monetary assets and liabilities, they go into forward exchange contracts. Also, as hedges of net investments in international operations, Coca Cola enters into forward exchange contracts. Bibliography 1. Coca Cola Company Annual Report (2006) (http://www.thecoca-colacompany.com/investors/pdfs/form_10K_2006.pdf) 2. IBM Annual Report (2006) (http://www.ibm.com/annualreport/2006/md_6mr.shtml) Read More