The Economics of Foreign Exchange and Global Finance - Essay Example

It is critical to that the terms exposure as well as risk are used interchangeably however, there are some critical differences. Exposure actually measures the sensitivity of the value of the foreign currency’s associated risk factors. Risk on the other hand however, measures the variability of the value attributed to each factor of risk. The various risks arising as a result of Citibank’s exposure to the foreign currency can be: Translation Exposure Translation exposure is also called accounting exposure as firms operating in foreign currency has to convert or translate the same into local currency to represent these assets/liabilities in local currency. As per prevailing accounting standards, all firms must translate their foreign currency exposures in local currency in order to represent them on their balance sheets. This exposure normally arises when a parent company needs to convert the liabilities/assets of its subsidiary in its balance sheet. The risk arising as a result of this translation is termed as translation exposure. (Wang, 2009) Transaction Exposure It actually measures the sensitivity when the assets or liabilities of Citibank are actually liquidated due to fluctuations in currency exchange rate. Transaction risk and exposure arises when they are liquidated and hence may gain or lose value in the process of conversion. It is critical to note that transaction exposure do not create any impact on the cash flows of the firm whereas transaction exposure does have an impact on the cash flows of the firm. International firms therefore have to consider this aspect into account also. How to manage these risks? Translation exposure often arises due to recording of items on the balance sheet therefore Citibank can engage into standards balance sheet hedge in order to safeguard themselves against any changes in the values. Transaction exposure can also be managed by entering into foreign exchange derivatives. Citibank can actually manage its transaction exposure by entering into forward and future exchange rates with counterparties. Foreign currency swaps as well as other more sophisticated instruments may also be used to manage transaction risk. More specifically, Citibank however, need to define risk limits against each currency besides forming policy regarding counterparties. This will actually allow Citi Group to manage counterparty risk associated with the parties with whom it actually enters into foreign currency transactions. (Riad A. Ajami & Goddard, 2006) Basic Functions of International Banking System and Financial Markets The basic functions of international banking system and financial markets are: 1. International banks tend to facilitate international trade and to ensure the movement of goods and services across political borders. International banks though not deal in goods but provide the mechanism through which payments against selling and buying of such goods are securely processed. (Roy C. Smith, Walter, & DeLong, 2012) 2. International banking system helps facilitate the payments between exporters and importers by providing a sophisticated and secure payment mechanism. 3. Sharing and management of risk is also another important function observed by international banking system. International banks tend to share the risks and distribute across different banks in order to reduce and manage the risk. 4. International financial markets provide much needed liquidity to the firms and provide funds which may not be otherwise available in the domestic market. 5. International financial markets also offer opportunity to increase higher rates of return as due to market friendly regulations, capital can be moved from one country to another. Under such regulatory environment, firms can actually invest their capital in financial markets where returns are higher. Since Citigroup itself is a banking institution therefore it can use its presence in the international banking system as well as in financial markets to raise the required funds to support its operations in Nigeria. In order to effectively raise the capital required to fund its operations, Citigroup can either list itself into the domestic stock exchanges of Nigeria or it can borrow from international markets to set up its operations. In order to effectively utilize these channels, Citigroup first need to raise the capital from the local markets of Nigeria. It must list itself on the local stock exchange through initial public offering. It can also borrow from international financial markets in order to raise substantial debt capital to finance its operations in Nigeria. This could be achieved through either issuing short term notes through international money market or selling equity in international market. Citigroup can also issue bonds to raise capital to finance its operations in the region. Citigroup can also use its internally generated equity to finance its operations as it may serve as a cheaper alternative as compared to raising money through international banking channels or financial markets. Financial Strategy for Expansion Since Citigroup is in the financial services industry therefore its financial strategy will be relatively different as compared to other traditional firms. Financial institutions traditionally raise funds through their deposit taking activity. The overall long term financial strategy therefore is based upon the ability of a financial institution to continue to raise deposits to generate enough funds to lend and support its operations. It is relatively important to understand that overall purpose of the financial strategy for sustaining longer period of time should be driven by the assumption of increasing overall value for the firm. If the financial strategy fails to increase the value of the firm and wealth of shareholders, such financial strategy may fail to deliver results which can help Citigroup sustain over longer period of time. In order to expand and sustain over a longer period of time, following financial strategy needs to be implemented: 1. Citigroup must first outline its objectives for sustaining over a long period of time. By outlining its strategic objectives first, Citigroup can actually develop a focus on engaging and executing only those finance strategies which corroborate its overall financial strategy objectives. 2. Citigroup must continue to strengthen its equity base by either contributing more equity from the current shareholders or offloading extra shares through secondary issues. This will help Citigroup to continue to keep itself funded without actually referring to external sources of funding. Nigerian Stock Exchange is quite vibrant stock exchange and can offer alternatives to raising capital and strengthening the overall equity base in order to sustain over longer period of time. 3. Citigroup can also engage into issuing long term i.e. 30 years Bonds in order to raise long term finance. Citigroup however must first identify as to whether issuing bonds in Nigeria or global markets will actually serve its purpose or not. It must link its decision to raise capital through debt markets by considering the overall cost involved and whether the decision will actually result into increasing overall shareholder value or not. 4. The overall decisions to invest or divest into any project should be based upon basic finance principles of adding more value to the shareholders wealth. Management of Citigroup in Nigeria must make investment, financing and restricting decisions in a manner which have positive strategic consequences for the shareholders. Recommendations The advent of free market economies and the increasing globalization has made international finance a relatively easier option for firms to adapt. The ability to move capital across markets therefore may serve as a benefit for international firms with the ability to tap into different markets across the globe. Considering the initial assessment made, following recommendations are presented: 1. Since the financial system in Nigeria is largely regulated and is under direct control of government. Secondly, corruption is on the higher side in Nigeria therefore Citigroup must ensure that it adapts practices which can allow it to continue to act as a responsible and accountable institution. It must however, continue to work towards establishing its link with the government and develop itself as a responsible corporate citizen to contribute towards the overall well-being of Nigerian economy. 2. In order to deal with the fluctuating exchange rates, Citigroup must be able to develop products which can help it to deal in financial derivatives. Citigroup must develop and strengthen its financial derivatives unit in order to ensure that it can easily manage the risks arising out of the fluctuations in exchange rates. 3. Citigroup must focus upon developing and implementing technology and best practices to the Nigerian market. Though globalization and availability of oil rich resources has made Nigeria as one of the preferred destination for firms, however, Citigroup must be able to implement best practices and technology. Since local banks are not as sophisticated as they should be in their operations, Citigroup therefore must find ways to introduce best global banking practices in Nigerian Banking Sector. 4. Considering the global as well as local economic trends, Citigroup must look for developing products and services which cater to different segments of the market. Market segmentation strategy should be spread over different types of customers in order to reduce the risk and also cater to the wider needs of the consumers across Nigerian market. 5. Citigroup will have no control over the interest rates in the economy therefore in such controlled environment; it must continue to look for low cost sources of funds so that it can maintain its spreads and achieve its profitability targets. Bibliography Riad A. Ajami, & Goddard, G. (2006). International Business: Theory and Practice. New York: M.E. Sharpe. Roy C. Smith, Walter, I., & DeLong, G. (2012). Global Banking. Oxford: Oxford University Press. Wang, P. (2009). The Economics of Foreign Exchange and Global Finance. London: Springer. Read More