International Financial Markets By- Rahul Jain

Foreign Exchange Rate Determination Determined by Demand and Supply Determined by Demand and Supply This also depends on the relative economic performance of the two countries This also depends on the relative economic performance of the two countries

Three Types of Exchange Rate Exposure Transaction Exposure Transaction Exposure Economic Exposure Economic Exposure Translation (accounting) Exposure Translation (accounting) Exposure

Transaction Exposure Transaction exposure arises whenever a company is committed to a foreign-currency- denominated transaction. Since the transaction will result in a future foreign currency cash inflow or outflow, any change in the exchange rate between the time the transaction is entered into and the time it is settled in cash will lead to a change in the dollar (HC) amount of the cash inflow or outflow.

Transaction Exposure Affects exposure to net cash flow Affects exposure to net cash flow consolidates subsidiaries’ cash in/outflows consolidates subsidiaries’ cash in/outflows e.g., minimal exposure in Mexican peso if e.g., minimal exposure in Mexican peso if Subsidiary A has net inflow of PS9,000,000 Subsidiary A has net inflow of PS9,000,000 Subsidiary B has net outflow of PS8,700,000 Subsidiary B has net outflow of PS8,700,000 MNC net flow = PS300,000 Measures how greatly exchange rate fluctuations may affect cash transactions

Transaction Exposure Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely o Purchasing or selling on credit goods or services when prices are stated in foreign currencies o Purchasing or selling on credit goods or services when prices are stated in foreign currencies o Borrowing or lending funds when repayment is to be made in a foreign currency o Borrowing or lending funds when repayment is to be made in a foreign currency o Being a party to an unperformed forward contract and o Being a party to an unperformed forward contract and o Otherwise acquiring assets or incurring liabilities denominated in foreign currencies o Otherwise acquiring assets or incurring liabilities denominated in foreign currencies h08.ppthttp:// h08.ppt. h08.ppt

Transaction Exposure Steps to assess transaction exposure Steps to assess transaction exposure assess MNC’s position in each currency assess MNC’s position in each currency estimate how an exposure in a currency affects the MNC estimate how an exposure in a currency affects the MNC use standard deviations and correlations use standard deviations and correlations assess the “net” effect of currency exposures assess the “net” effect of currency exposures

Economic Exposure Transaction is a subset of economic exposure Transaction is a subset of economic exposure Currency fluctuations affect more than currency transactions Currency fluctuations affect more than currency transactions -- e.g., an increase in inflation in France may: 1. lower value of outflow from France (transaction exposure) 1. lower value of outflow from France (transaction exposure) 2. increase subsidiary’s French sales 2. increase subsidiary’s French sales 3. raise financing cost in France 3. raise financing cost in France Measures how greatly an MNC’s present value of future cash flows is affected by unexpected exchange rate fluctuations

Economic exposure It measures how greatly a firm’s present value of future cash flows is affected by unexpected exchange rate fluctuations.

Economic Exposure Indirect exposure Indirect exposure implies even domestic firms have foreign exchange risk implies even domestic firms have foreign exchange risk

Economic Exposure Exposure of domestic firms Exposure of domestic firms impacted by foreign competition and financial markets impacted by foreign competition and financial markets

Economic Exposure Exposure of MNCs Exposure of MNCs face exposure on domestic and foreign operations face exposure on domestic and foreign operations Jan-May 1993:13% appreciation of Japanese yen against $US Jan-May 1993:13% appreciation of Japanese yen against $US many US firms increase US market share many US firms increase US market share Japanese firms often priced out of the US market Japanese firms often priced out of the US market

Economic Exposure: Measurement Assess sensitivity of earnings to exchange rate fluctuations Assess sensitivity of earnings to exchange rate fluctuations A firm is relatively insulated from exchange rate movements if costs and revenues are affected by similar magnitudes.

Translation (Accounting) exposure The change in the value of a firm’s foreign currency denominated accounts due to a change in exchange rates.

Translation Exposure Affects value of assets, liabilities and earnings Affects value of assets, liabilities and earnings Argument for relevance to MNC Argument for relevance to MNC affects financial statements (MNC performance) affects financial statements (MNC performance) Measures impact that exchange rate fluctuations have upon an MNC’s consolidated financial statement Ledger

Translation Exposure Determinants Level of foreign involvement by foreign subsidiaries Level of foreign involvement by foreign subsidiaries a greater exposure exists when: a greater exposure exists when: a larger contribution is made offshore a larger contribution is made offshore

Translation Exposure Determinants Locations of foreign subsidiaries Locations of foreign subsidiaries affects currencies used in initial measurements affects currencies used in initial measurements

Translation Exposure Determinants Accounting methods Accounting methods affect how and what financial numbers are reported affect how and what financial numbers are reported Accounting

Summary Exchange rate exposure may affect financing costs Exchange rate exposure may affect financing costs volatile cash flow from exchange rate changes increases risk volatile cash flow from exchange rate changes increases risk Transaction exposure Transaction exposure reflects the exposure of an MNC’s future cash transactions to exchange rate movements reflects the exposure of an MNC’s future cash transactions to exchange rate movements

Summary Economic exposure Economic exposure measures the direct and indirect risks to cash flows from exchange rate movements measures the direct and indirect risks to cash flows from exchange rate movements Translation exposure Translation exposure focuses on consolidated financial statements focuses on consolidated financial statements

Characterstics of Foreign Bond The bond is issued by a foreign entity (such as a government, municipality or corporation) The bond is traded on a foreign financial market The bond is denominated in a foreign currency “

Euro Bond “Eurobond is a bond issued and traded in a country other than the one in which its currency is denominated. A Eurobond does not necessarily have to originate or end up in Europe although most debt instruments of this type are issued by non-European entities to European investors.”

Foreign Currency Convertible Bond - FCCB A type of convertible bond issued in a currency different than the issuer's domestic currency. In other words, the money being raised by the issuing company is in the form of a foreign currency. A convertible bond is a mix between a debt and equity instrument. It acts like a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock. A type of convertible bond issued in a currency different than the issuer's domestic currency. In other words, the money being raised by the issuing company is in the form of a foreign currency. A convertible bond is a mix between a debt and equity instrument. It acts like a bond by making regular coupon and principal payments, but these bonds also give the bondholder the option to convert the bond into stock.

Features Sweetening Debt Sweetening Debt Deferred Equity Financing Deferred Equity Financing Cash Inflow in Future Cash Inflow in Future May keep the share prices high. May keep the share prices high. Investor enabled to have access to shares without investing now. Investor enabled to have access to shares without investing now. Risks Risks