1. MBSP 0354 International Finance Lecture 5 03 NOV 09

2. DEVISING A FOREIGN EXCHANGE MANAGEMENT STRATEGY

3. Objectives of Lecture Introduce the Role of the Treasurer Introduce the Role of the Treasurer Discuss: Discuss: External FX Management Strategies External FX Management Strategies Internal FX Management Strategies Internal FX Management Strategies

4. Readings: Buckley: Buckley: Chapter 10 Chapter 10 Chapter 11 Chapter 11 Chapter 32 - 32.3 to 32.5 Chapter 32 - 32.3 to 32.5

5. Centralise or Decentralise Centralise: Centralise: Take Decisions at “Group” Level Take Decisions at “Group” Level Maybe Cheaper Maybe Cheaper Maybe more Efficient Maybe more Efficient Decentralise: Decentralise: Take Decisions at “Subsidiary Company” Level Take Decisions at “Subsidiary Company” Level Maybe more in Line with Devolved Management Responsibility Maybe more in Line with Devolved Management Responsibility

6. Centralise or Decentralise Responsibility ControlAccountability

7. Enter – The Treasurer Internal BANKER: Internal BANKER: NOT Accountant NOT Accountant Job is to Make Best Use of Internal and External Banking Facilities and Techniques Job is to Make Best Use of Internal and External Banking Facilities and Techniques Profit Centre or Cost Centre Profit Centre or Cost Centre

8. The Treasurer – Job Description Identify Exposure: Identify Exposure: Transaction Exposure Transaction Exposure Translation Exposure Translation Exposure Commercial / Economic Exposure Commercial / Economic Exposure Manage Exposure Manage Exposure Manage Cash Manage Cash

9. Transaction Exposure Arises from Changes in Spot Rate Arises from Changes in Spot Rate Affects: Affects: Sales Revenue Sales Revenue Cost of Sales Cost of Sales Overhead Cost Overhead Cost A Threat to the Profit & Loss Account A Threat to the Profit & Loss Account

10. Transaction Exposure We Export Washing Machine to Switzerland: We Export Washing Machine to Switzerland: Spot Rate CHF 1.90 = GBP 1 Spot Rate CHF 1.90 = GBP 1 Sales Price = GBP 200 = CHF 380 Sales Price = GBP 200 = CHF 380 Costs Total GBP 170 Costs Total GBP 170 Profit = GBP 30 Profit = GBP 30

11. Transaction Exposure If Spot Rate Becomes CHF 2.20 = GBP 1: If Spot Rate Becomes CHF 2.20 = GBP 1: Sales Revenue = CHF 380 = GBP 172.72 Sales Revenue = CHF 380 = GBP 172.72 Costs = GBP 170.00 Costs = GBP 170.00 Profit = GBP 2.72 Profit = GBP 2.72 Profit Falls by c. 91% Profit Falls by c. 91%

12. Translation Exposure Arises from Changes in Spot Rate Arises from Changes in Spot Rate Arises from Holding: Arises from Holding: Assets Assets Liabilities Liabilities A Threat to the Balance Sheet A Threat to the Balance Sheet

13. Translation Exposure Purchase Office Block / Service Centre for CHF 2,000,000 Purchase Office Block / Service Centre for CHF 2,000,000 Spot Rate CHF 1.90 = GBP 1: Spot Rate CHF 1.90 = GBP 1: Value is GBP 1,052,630 Value is GBP 1,052,630 2 years Later: 2 years Later: Value is Still CHF 2,000,000 Value is Still CHF 2,000,000 Spot Rate is CHF 2.20 = GBP 1 Spot Rate is CHF 2.20 = GBP 1 Value is GBP 909,090 Value is GBP 909,090 Translation Loss is GBP 143,540 Translation Loss is GBP 143,540

14. Commercial / Economic Exposure Arises from Changes in Spot Rate Arises from Changes in Spot Rate Results in a Gain / Loss of Market Results in a Gain / Loss of Market Note Difference between Concept of: Note Difference between Concept of: Commercial Exposure Commercial Exposure Economic Exposure Economic Exposure “Threat to Long-Term Cash Flow” “Threat to Long-Term Cash Flow”

15. Commercial / Economic Exposure We Export Washing Machine to Switzerland: We Export Washing Machine to Switzerland: Our Price is GBP 200 Our Price is GBP 200 At CHF 1.90 = GBP 1: At CHF 1.90 = GBP 1: Our Price is CHF 380 Our Price is CHF 380 German Competitor Sells at CHF 420 German Competitor Sells at CHF 420

16. Commercial / Economic Exposure Spot Rate Changes to CHF 2.25 =GBP 1 Spot Rate Changes to CHF 2.25 =GBP 1 EUR / CHF Spot Rate Unchanged EUR / CHF Spot Rate Unchanged Our Price Changes to CHF 450 Our Price Changes to CHF 450 German Co’s Price Still CHF 420 German Co’s Price Still CHF 420

17. Internal Techniques Netting Netting Matching Matching Leading & Lagging Balances Leading & Lagging Balances Determining Currency of Invoice Determining Currency of Invoice

18. Netting Netting End of Period Balances: Netting End of Period Balances: Same Currency Same Currency Parallel Currency Parallel Currency Simple Example: Simple Example: A Owes B USD 10,000,000 A Owes B USD 10,000,000 B owes A USD 8,000,000 B owes A USD 8,000,000 Net Debt is from A to B Net Debt is from A to B Net Debt is USD 2,000,000 Net Debt is USD 2,000,000 Real Life Examples much more Complicated Real Life Examples much more Complicated

19. Parallel Currency Currencies Closely Linked in their Market Performance Currencies Closely Linked in their Market Performance 2 year Chart - Spot Rate Euro (EUR) v. Danish Krone (DKK) 2 year Chart - Spot Rate Euro (EUR) v. Danish Krone (DKK)

20. Matching Matching Inflows and Outflows of Same Currency Matching Inflows and Outflows of Same Currency Dates of Individual Receipts / Payments Altered Dates of Individual Receipts / Payments Altered Simple Example: Simple Example: A is due to Receive EUR 1,000,000 on 25 JAN 10 A is due to Receive EUR 1,000,000 on 25 JAN 10 A is due to Pay EUR 1,000,000 on 05 FEB 10 A is due to Pay EUR 1,000,000 on 05 FEB 10

21. Leading and Lagging Speeding Up (Leading) Settlement of Receipt / Payment Speeding Up (Leading) Settlement of Receipt / Payment Slowing Down (Lagging) Settlement of Receipt / Payment Slowing Down (Lagging) Settlement of Receipt / Payment Normally on Inter-Company Items: Normally on Inter-Company Items: Can Also be on External Items (Risky) Can Also be on External Items (Risky)

22. Leading and Lagging Useful in Countries with Volatile Rates Useful in Countries with Volatile Rates Some Governments Often Impose Fixed Payment Dates Some Governments Often Impose Fixed Payment Dates Can also be used for Tax Planning: Can also be used for Tax Planning: Shifting Revenues / Costs Shifting Revenues / Costs

23. Leading and Lagging A (Co. in Ruritanian) has to pay 10 m. Ruritanian Pesos (RUP) in one Month A (Co. in Ruritanian) has to pay 10 m. Ruritanian Pesos (RUP) in one Month Current Spot Rate RUP 10 = GBP 1 Current Spot Rate RUP 10 = GBP 1 Current Value GBP 1,000,000 Current Value GBP 1,000,000 Exp. 10% Devaluation of RUP within Month (New Rate RUP 11 = GBP 1) Exp. 10% Devaluation of RUP within Month (New Rate RUP 11 = GBP 1) Expected Value GBP 909,090 Expected Value GBP 909,090 Pay now (Lead) and Save GBP 90,910 Pay now (Lead) and Save GBP 90,910

24. Determining Invoice Currency Do not Invoice in Weak Currency: Do not Invoice in Weak Currency: Use Strong Currency Use Strong Currency Prices in Russia Quoted in USD not Russian Roubles (RUR) Prices in Russia Quoted in USD not Russian Roubles (RUR) Could Invoice in Strong Currency to take Advantage of Currency Gains Could Invoice in Strong Currency to take Advantage of Currency Gains

25. External Techniques Forward Markets Forward Markets Currency Futures Markets Currency Futures Markets Currency Options Markets Currency Options Markets Currency Swaps Currency Swaps Factoring Foreign Debts: Factoring Foreign Debts: Selling Invoice to Factor (Bank) Selling Invoice to Factor (Bank)

26. Back to Exposure A Company only has ONE net Exposure per Currency A Company only has ONE net Exposure per Currency Treasurer’s Job to Manage this Treasurer’s Job to Manage this

27. Cost Control Use Internal Techniques Whenever Possible: Use Internal Techniques Whenever Possible: Replace External Techniques Replace External Techniques Cheaper Cheaper Offsets Cost of Treasurer Offsets Cost of Treasurer Contributes to Profit Contributes to Profit

28. Information Flows Treasurer Needs Information on: Treasurer Needs Information on: Cash Balances: Cash Balances: In ALL Currencies In ALL Currencies Cash Flows Through Trading Cash Flows Through Trading Cash Requirements for Capital Expenditure Cash Requirements for Capital Expenditure

29. Information Report Cycle Some Information Needed Daily: Some Information Needed Daily: Cash Balances Cash Balances Cash Expected Cash Expected Cash Required Cash Required Other Reporting Frequencies: Other Reporting Frequencies: Capital Expenditure Requirements Capital Expenditure Requirements

30. Behavioural Issues Responsibility ControlAccountability

31. Behavioural Issues Given Need for: Given Need for: Responsibility Responsibility Accountability Accountability Control Control How do you Exercise Central Control ? How do you Exercise Central Control ?

32. Behavioural Issues Answer - Persuasion Answer - Persuasion Treasurer’s Rates Always Best Treasurer’s Rates Always Best Treasurer’s Costs Always Lowest Treasurer’s Costs Always Lowest What is in Company’s Interest is also in Subsidiary’s Interest What is in Company’s Interest is also in Subsidiary’s Interest