1. Welcome to class of International Financial Forces & Finance Management Dr. Satyendra Singh Professor, Marketing and International Business University of Winnipeg Canada

2. Outline Purchasing Power Parity Factors affecting Foreign currency
Fisher’s Effect
Arbitrage
Hedge (Forward, Currency option, Money Market)
Transfer Pricing
Swap (Parallel loan, Bank, Currency)
Debt vs. Equity
Impact of Culture on Accounting
Accounting Standards

3. Purchasing Power Parity (PPP)…
The number of units of a currency required to buy the same amount of goods and services in a domestic market that $1.00 would buy in the U.S.
Helps to make comparisons possible across economies
CIA Fact Book

4. Purchasing Power Parity (PPP)
If,
1 Lt. Milk US $1.00
1 Lt. Milk India Rs
Then, PPP: US $1 = Rs. 20
Reality: US $1 = Rs. 40
ie Rs. Is 50% undervalued –artificially?!

5. Factors affecting Foreign Currency
Three factors:
Inflation
Interest rate
Speculation
Fisher’s Effect
Diff. in interest rate may determine strength of FOREX
€ 1 = $1.5,
Interest rate: € (3%) and $(5%)
Speculation: Which currency becomes weaker/stronger?

6. Inflation and the International Company..
High inflation rates
Make capital expenditure planning more difficult
Cause the cost of goods and services to rise
Tend to cause BOP deficits
Could lead to more restrictive fiscal or monetary policies, currency controls, export incentives, and import obstacles
Encourage borrowing because the loan will be repaid with cheaper money
Bring high interest rates
Discourage lending

7. Atlas Conversion Factor
It is used for speculation
Average of FOREX for the last 2 years adjusted by the ratio of domestic inflation and combined inflation of US, UK, EU and Japan

8. Weak Foreign Currency…

9. Weak Foreign Currency…

10. Weak Foreign Currency… (thousand)

11. Weak Foreign Currency… (million)

12. Weak Foreign Currency (billion)

13. Weak Foreign Currency (trillion)

14. No Foreign Currency

16. Border: Rwanda and Burundi

17. Foreign Exchange Office in Africa

18. Arbitrage: The process of buying and selling instantaneously to make profit at no risk
Brazil
Riel
1:3
1:2
5 dinar
Chile
Peso
Algeria
Dinar
5:1

19. Movement of $, Transfer Pricing
Customer
$10
Profit $9
Local business
Say, 30% tax
$6.30 Net profit
$2.70 tax $1
Supplier

20. Movement of $, Transfer Pricing
Customer
$10 $9 $8
Local business
Foreign $1
Now profit $1
Say, 30% tax
33 Cents tax!
Supplier

21. Movement of $, Transfer Pricing – 3 countriesUK
OFC: Jamaica
USA
$100 to produce
Sells at $ Sells at $ Sells at $220
Profit $ Profit $ Profit $10
Tax 50% Tax 5% Tax 30%
Tax paid $ Tax paid $ Tax paid $3.33

22. OFC: Offshore Ffinancial Centres
Offshore financial center specializes in financing nonresidents, low taxes and few banking regulations
Too small to exist on its own
Boosts economy
Employment
Switzerland
Cayman Island
Hong Kong
Bahamas
Bermuda
Gibraltar
Luxemburg …

23. Transaction Exposure: Hedging
process to reduce or eliminate financial risk
Forward market hedge
Foreign currency contract sold or bought forward in order to protect against foreign currency movement
Currency option hedge
Option to buy or sell specific amount of foreign currency at specific time to protect against foreign currency risk
Money market hedge
Method to hedge foreign currency exposure by borrowing and lending in domestic and foreign money markets

24. Forward Hedge Hedge is a process to reduce risk
€ 1 = $1.5 (now/spot) $ is expected to be weak
€ 1 = $1.6 (speculate/forward)
Interest rate: € (5%) and $(3%)
Suppose you have accounts receivables for €20,000
If quoted in €, supplier may not have problem
But strong currency is desirable by both seller and buyer
If you quoted in € (ie € 20,000 x 1.5 = $30,000),
You now get $ (ie € 20,000 x 1.6 = $32,000)
You gained: $2000, because $ became weak
You lose, if $ became stronger (say 1.4) = $2,000

25. Currency Option Hedge
So you have accounts receivables in a currency that works best for your company
Firms may have bank accounts in multiple currencies such as Dollar, Euro, Yen… to avoid conversion charges.

26. Money Market Hedge
Counter balancing the risk by borrowing the same amount for FOREX (A/R) in domestic market and investing it until accounts receivables are received
Suppose the AR is €20,000 (in 90 days)
€ 1 = $1.5 (now) $ is expected to be strong!
€ 1 = $1.4 (expected)
Interest rate: € (3%) and $(5%)
Borrow €20,000  convert in $ (€ 20,000 x 1.5 = $30,000)  Invest  Income (but pay interest)
After 90 days, pay €20,000 to local bank, so no debt
So, Investment + income - interest ≥ €20,000

27. Source: Wall Street Journal, Exchange rate June 19, 2006
Fri: June 16 (LAST)
Mon: June 19 (SPOT)
Last Friday
Source: Wall Street Journal, Exchange rate June 19, 2006

28. Swaps Parallel Loans Bank Swap Currency Swap
Matched loans across currencies made to cover risk
Bank Swap
Swap made between banks to acquire temporary foreign currencies
Currency Swap
Exchange of debt service of loan or bond in one currency for debt service of loan or bond in another currency

29. Parallel Loan Swap $1m CANADA: Canada (parent) India (child)
INDIA: Canada (child) India (parent)
Rs. 40m
$1 = Rs. 40

30. Bank Swap $1m Canadian parent in Canada Canadian Bank in Canada
Rs. 40m
Indian Bank in India
Canadian child in India
Canadian Parent deposits $1m to the credit of the Indian Bank
The Correspondent Indian Bank lends Rs. 40m (spot rate) to the Child
At a later agreed date, the Child returns Rs. 40m to Indian Bank
Indian Bank instructs the Canadian Bank to pay $1m to the Parent
So, no conversion of $1 to Rs. Useful if you want hard currency only

31. Correspondent Bank

32. Currency Swap CANADA CYPRUS I am Known here Same is true for
So the interest rate is low for me the Cypriot person in Cyprus
So, I take the loan for the Cypriot guy Person does the
In Canada at low interest rate same for me in $1.5m Cyprus (€ 1m)
Then, we swap currency,
i.e., I service the loan in € for the Cypriot guy in CYPRUS
And the Cypriot guy services my loan in $ in Canada
€ 1 = $1.5

33. Capital Structure of a Firm
Debt  Borrow from Bank
Conservative, report less, ↓ tax exposure, ↑ dividend pay out  save $ to service debt  France, Germany, Japan, some Emerging Markets
Debt financing is less expensive than equity financing, because interest paid on debt is tax deductible, but dividends paid out to shareholders are not.
Equity  Shares, Bonds
Impressive (Inflated report) to attract investors
Value of Bond ↓, if interest rate ↑

34. How do Bonds perform? Suppose, now you have bonds worth
for a year
So expect $500 at the end of the year
Now, interest rate changed to 6%
Value of your bond now is: $x x.06 = $500
ie x = $8334
Drop in value = 17%!

35. Cultural Differences in Measurement and Disclosure for Accounting Systems

36. Annual Reports So we need uniform accounting system Depends
Calculation of Inventory
Depreciation
Income only when contract is complete
Valuation of assets
Goodwill …
So we need uniform accounting system

37. International Accounting Standards
Triple Bottom Line Standard (3BL)
Environmental, social, and financial impacts of the business
International Accounting Standards Board (IASB)
International Financial Reporting Standards (IFRS)
Sarbans-Oxley Act (2002, US)
Public Company Accounting Reform and Investor Protection Act (in the Senate)
Corporate and Auditing Accountability and Responsibility Act (in the House)
Heavy penalty for corporate finance fraud

38. Use of International Financial Reporting Standards (IFRS)

39. Tax System Direct Tax Indirect Tax (Withholding Tax) Income Tax
VAT – Value Added Tax
Indirect Tax (Withholding Tax)
Dividend
Interest
Royalty

40. Corporate Tax Rates