International

Financial Management

24-1

Some Background
Types of Exchange-Rate Risk
Exposure
Management of Exchange-Rate
Risk Exposure
Structuring International Trade
Transactions

Some Background
What is a companys motivation to
invest capital abroad?

24-2

Fill product gaps in foreign markets where

excess returns can be earned.

To produce products in foreign markets

more efficiently than domestically.

To secure the necessary raw materials

required for product production.

International
Capital Budgeting
How does a firm make an international
capital budgeting decision?

24-3

1.

Estimate expected cash flows in the foreign

currency.

2.

Compute their U.S.-dollar equivalents at the

expected exchange rate.

3.

Determine the NPV of the project using the U.S.

required rate of return, with the rate adjusted
upward or downward for any risk premium effect
associated with the foreign investment.

International
Capital Budgeting

Only consider those cash flows that can

be repatriated (returned) to the homecountry parent.

The exchange rate is the number of units

of one currency that may be purchased
with one unit of another currency.
For

example, the current exchange rate

might be 2.50 Freedonian marks per one
U.S. dollar.

24-4

International
Capital Budgeting
Related issues of concern:

International diversification and risk

reduction
U.S. Government taxation

24-5

Taxable income derived from non-domestic

operations through a branch or division is taxed
under U.S. code.
Foreign subsidiaries are taxed under foreign tax
codes until dividends are received by the U.S.
parent from the foreign subsidiary.

International
Capital Budgeting

24-6

Foreign Taxation

Tax codes and policies differ from country to

country, but all countries impose income taxes
on foreign companies.

The U.S. government provides a tax credit to

companies to avoid the double taxation problem.

A credit is provided up to the amount of the

foreign tax, but not to exceed the same
proportion of taxable earnings from the foreign
country.

Excess tax credits can be carried forward.

International
Capital Budgeting

24-7

Political Risk

Expropriation is the ultimate political risk.

Developing countries may provide financial

incentives to enhance foreign investment.

Bottom line: Forecasting political instability.

instability

Protect the firm by hiring local nationals, acting

responsibly in the eyes of the host government,
entering joint ventures, making the subsidiary
reliant on the parent company, and/or
purchasing political risk insurance.
insurance

Important
Exchange-Rate Terms
Spot Exchange Rate -- The rate today for
exchanging one currency for another for
immediate delivery.
delivery
Forward Exchange Rate -- The rate today
for exchanging one currency for another at
a specific future date.
date

24-8

Currency risk can be thought of as the volatility

of the exchange rate of one currency for
another (say British pounds per U.S. dollar).

Types of ExchangeRate Risk Exposure

Translation Exposure -- Relates to the change in

accounting income and balance sheet statements
caused by changes in exchange rates.

Transactions Exposure -- Relates to settling a

particular transaction at one exchange rate when
the obligation was originally recorded at another.

Economic Exposure -- Involves changes in

expected future cash flows, and hence economic
value, caused by a change in exchange rates.

24-9

Management of ExchangeRate Risk Exposure

24-10

Natural hedges
Cash management
Adjusting of intracompany
accounts
International financing hedges
Currency market hedges

Natural Hedges
Globally
Determined
Scenario 1
Pricing
Cost
Scenario 2
Pricing
Cost

24-11

Domestically
Determined

X
X
X
X

Both scenarios are natural hedges as any gain

(loss) from exchange rate fluctuations in pricing is
reduced by an offsetting loss (gain) in costs in
similar global markets.

Natural Hedges -- Not!

Globally
Determined
Scenario 3
Pricing
Cost
Scenario 4
Pricing
Cost

24-12

Domestically
Determined

X
X
X
X

Both of these scenarios are not natural hedges and

thus create a possible firm exposure to events that
impact one market and not the other market.

Cash Management
What should a firm do if it knew that a local foreign
currency was going to fall in value (e.g., drop from
$.70 per peso to $.60 per peso)?

24-13

Exchange cash for real assets (inventories) whose

value is in their use rather than tied to a currency.
Reduce or avoid the amount of trade credit that will
be extended as the dollar value that the firm will
receive is reduced and reduce any cash that does
arrive as quickly as possible.
Obtain trade credit or borrow in the local currency
so that the money is repaid with fewer dollars.

Cash Management

24-14

Generally, one cannot predict the future

exchange rates, and the best policy would be
to balance monetary assets against monetary
liabilities to neutralize the effect of exchangerate fluctuations.
A reinvoicing center is a company-owned
financial subsidiary that purchases exported
goods from company affiliates and resells
(reinvoices) them to other affiliates or
independent customers.

Cash Management
Netting -- A system in which cross-border
purchases among participating subsidiaries of
the same company are netted so that each
participant pays or receives only the net amount
of its intracompany purchases and sales.

24-15

Generally, the reinvoicing center is billed in the

selling units home currency and bills the purchasing
unit in that units home currency.
Allows better management of intracompany
transactions.

International
Financing Hedges
4. Currency-Option and Multiple-Currency bonds

Currency-option bonds provide the holder with the

option to choose the currency in which payment is
received. For example, a bond might allow you to
choose between yen and U.S. dollars.
Currency cocktail bonds provide a degree of exchangerate stability by having principal and interest payments
being a weighted average of a basket of currencies.
Dual-currency bonds have their purchase price and
coupon payments denominated in one currency, while a
different currency is used to make principal payments.

24-16

Currencies and the Euro

Euro The name given to the single European
currency. Symbol is (much like the dollar, $).

24-17

Each country has a representative currency like

the $ (dollar) in the United States or the (pound)
in Britain.
On January 1, 1999, the euro started trading.
The euro is the common currency of the European
Monetary Union (EMU), which currently includes
the following 12 European Union (EU) countries:
Austria, Belgium, Finland, France, Germany,
Greece, Ireland, Italy, Luxembourg, the
Netherlands, Portugal, and Spain.

Currency Market Hedges

1. Forward Exchange Market

A forward contract is a contract for the delivery of a

commodity, foreign currency, or financial instrument at a
price specified now, with delivery and settlement at a
specified future date.
Spot rate
$.168 per EFr
90-day forward rate
.166 per EFr
As shown, the Elbonian franc (EFr) is said to sell at a
forward discount as the forward price is less than the
spot rate.
If the forward rate is $.171, the EFr is said to sell at a
forward premium.
premium

24-18

Currency Market Hedges

Fillups Electronics has just sold equipment worth
1 million Elbonian francs with credit terms of net
90. How can the firm hedge the currency risk?

24-19

The firm has the option of selling 1 million Elbonian

francs forward 90 days. The firm will receive
$166,000 in 90 days (1 million Elbonian francs x
$.166).
Therefore, if the actual spot price in 90 days is less
than .166, the firm benefited from entering into this
transaction.
If the rate is greater than .166, the firm would have
benefited from not entering into the transaction.

Currency Market Hedges

How much does this insurance cost?
Annualized cost of protection
= ( $.002 )/( $.168 ) X ( 365 days / 90 days)
= .011905 X 4.0556
= .0483 or 4.83%

24-20

Typical discount or premium ranges for

stable currencies are from 0 to 8%, but may
be as high as 20% for unstable currencies.

Currency Market Hedges

2. Currency Futures

A futures contract is a contract for the delivery of a

commodity, foreign currency, or financial instrument at a
specified price on a stipulated future date.

A currency futures market exists for the major currencies

of the world.

Futures contracts are traded on organized exchanges.

The clearinghouse of the exchange interposes itself

between the buyer and the seller. Therefore,
transactions are not made directly between two parties.

Very few contracts involve actual delivery at expiration.

24-21

Currency Market Hedges

2. Currency Futures (continued)

Sellers (buyers) cancel a contract by purchasing

(selling) another contract. This is an offsetting position
that closes out the original contract with the
clearinghouse.

Futures contracts are marked-to-market daily. This is

different than forward contracts that are settled only at
maturity.

Contracts come in only standard-size contracts (e.g.,

12.5 million yen per contract).

24-22

Currency Market Hedges

3. Currency Options

A currency option is a contract that gives the holder the

right to buy (call) or sell (put) a specific amount of a
foreign currency at some specified price until a certain
(expiration) date.

Currency options hedge only adverse currency

movements (one-sided risk). For example, a put
option can hedge only downside movements in the
currency exchange rate.

Options exist in both the spot and futures markets.

The value depends on exchange rate volatility.

24-23

Currency Market Hedges

4. Currency Swaps

In a currency swap two parties exchange debt

obligations denominated in different currencies. Each
party agrees to pay the others interest obligation. At
maturity, principal amounts are exchanged, usually at a
rate of exchange agreed to in advance.

The exchange is notional -- only the cash flow difference

is paid.

Swaps are typically arranged through a financial

intermediary, such as a commercial bank.

A variety of (complex) arrangements are available.

24-24

Structuring International
Trade Transactions

In international trade, sellers often have

difficulty obtaining thorough and accurate
credit information on potential buyers.

Channels for legal settlement in cases of

default are more complicated and costly to
pursue.

Key documents are (1) an order to pay

(international trade draft), (2) a bill of lading,
and (3) a letter of credit.

24-25

International Trade Draft

24-26

The international trade draft (bill of exchange) is a

written statement by the exporter ordering the importer
to pay a specific amount of money at a specified time.

Sight draft is payable on presentation to the party

(drawee) to whom the draft is addressed.

Time draft is payable at a specified future date after

sight to the party (drawee) to whom the draft is
addressed.

Time Draft Features

An unconditional order in writing signed

by the drawer, the exporter.

It specifies an exact amount of money

that the drawee, the importer, must pay.

It specifies the future date when this

amount must be paid.

Upon presentation to the drawee, it is

accepted.
accepted

24-27

Time Draft Features

The acceptance can be by either the

drawee or a bank.
bank

If the drawee accepts the draft, it is

acknowledged in writing on the back of
the draft the obligation to pay the amount
so many specified days hence.

It is then known as a trade draft (bankers

acceptance if a bank accepts the draft).

24-28

Bill of Lading
Bill of Lading -- A shipping document
indicating the details of the shipment and
delivery of goods and their ownership.

24-29

It serves as a receipt from the transportation

company to the exporter, showing that specified
goods have been received.
It serves as a contract between the transportation
company and the exporter to ship goods and deliver
them to a specific party at a specific destination.
It serves as a document of title.

Letter of Credit
Letter of Credit - A promise from a third party
(usually a bank) for payment in the event that
certain conditions are met. It is frequently used
to guarantee payment of an obligation.

24-30

A letter of credit is issued by a bank on behalf of the

importer.
The bank agrees to honor a draft drawn on the importer,
provided the bill of lading and other details are in order.
The bank is essentially substituting its credit for that of
the importer.

Countertrade
Countertrade -- Generic term for barter and
other forms of trade that involve the
international sale of goods or services that are
paid for -- in whole or in part -- by the transfer
of goods or services from a foreign country.

24-31

Used effectively when exchange restrictions exist or

other difficulties prevent payment in hard currencies.
Quality, standardization of goods, and resale of goods
that are delivered are risks that arise with
countertrade.

Forfaiting
Forfaiting -- The selling without recourse of
medium- to long-term export receivables to a
financial institution, the forfaiter. A third party,
usually a bank or governmental unit,
guarantees the financing.

24-32

The forfaiter assumes the credit risk and collects

the amount owed from the importer.
Most useful when the importer is in a lessdeveloped country or in an Eastern European
nation.