Question No. 5 - IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 5
a) Discuss the merits of foreign direct investment, portfolio investment and short term investment.

Foreign Direct Investment 

Foreign Direct Investment (FDI) is the investment of funds by an organisation from one country into another, with the intent of establishing ’lasting interest’. According to OECD (Organisation for Economic Co-operation and Development), lasting interest is determined when the organisation acquires a minimum of 10% of voting power in another organisation. For instance: the act of an Indian company such as Ola opening another headquarters in Sydney, Australia will be considered as bringing FDI into Australia. 

Reinvestment of profits from overseas operations, as well as intra - organisational loans and borrowings to overseas subsidiaries are also categorised as FDI.

The meaning of FDI is not restricted only to international movement of capital. Its definition also encompasses the international movement of elements that are complementary to capital - such as skills, processes, management, technology etc.

There is a difference between FDI and FPI (Foreign Portfolio Investments), wherein the investor purchases equity of foreign companies. FPI means only equity infusion, and does not imply the establishment of a lasting interest.

FDI can be Greenfield, wherein an organisation creates a subsidiary concern in another country and builds its business operations there from the ground up. Greenfield investments provide the highest degree of control to the organisation. It can construct the production plant as per its specifications, employ and train human resources as per company standards, as well as design and monitor its operational processes.  

Alternatively, FDI can be brownfield - wherein an organisation expands by way of cross-border mergers, acquisitions and joint ventures - by either leasing or purchasing existing facilities for its production. The clear advantage of brownfield investments is the savings in cost and time for starting up, as well as engaging in construction activities. Addition of equipment to an existing facility also qualifies as brownfield investment.

It is difficult to overstate the global and macroeconomic significance of FDI. As per UNCTAD (United Nations Conference on Trade and Development), global FDI amounted to around $ 1.8 tn in 2015. 

There are many ways in which FDI benefits the recipient nation:

1. Increased Employment and Economic Growth

Creation of jobs is the most obvious advantage of FDI. It is also one of the most important reasons why a nation, especially a developing one, looks to attract FDI. Increased FDI boosts the manufacturing as well as the services sector. This in turn creates jobs, and helps reduce unemployment among the educated youth - as well as skilled and unskilled labour - in the country. Increased employment translates to increased incomes, and equips the population with enhanced buying power. This boosts the economy of the country.

2. Human Resource Development

This is one of the less obvious advantages of FDI. Hence, it is often understated. Human Capital refers to the knowledge and competence of the workforce. Skills gained and enhanced through training and experience boost the education and human capital quotient of the country. Once developed, human capital is mobile. It can train human resources in other companies, thereby creating a ripple effect.  

3. Development of Backward Areas

This is one of the most crucial benefits of FDI for a developing country. FDI enables the transformation of backward areas in a country into industrial centres. This in turn provides a boost to the social economy of the area. The Hyundai unit at Sriperumbudur, Tamil Nadu in India exemplifies this process. 

4. Provision of Finance & Technology

Recipient businesses get access to latest financing tools, technologies and operational practices from across the world. Over time, the introduction of newer, enhanced technologies and processes results in their diffusion into the local economy, resulting in enhanced efficiency and effectiveness of the industry.

5. Increase in Exports

Not all goods produced through FDI are meant for domestic consumption. Many of these products have global markets. The creation of 100% Export Oriented Units and Economic Zones have further assisted FDI investors in boosting their exports from other countries.

6. Exchange Rate Stability

The constant flow of FDI into a country translates into a continuous flow of foreign exchange. This helps the country’s Central Bank maintain a comfortable reserve of foreign exchange. This in turn ensures stable exchange rates.

7. Stimulation of Economic Development

This is another very important advantage of FDI. FDI is a source of external capital and higher revenues for a country. When factories are constructed, at least some local labour, materials and equipment are utilised. Once the construction is complete, the factory will employ some local employees and further use local materials and services. The people who are employed by such factories thus have more money to spend. This creates more jobs. 

These factories will also create additional tax revenue for the Government, that can be infused into creating and improving physical and financial infrastructure. 

8. Improved Capital Flow

Inflow of capital is particularly beneficial for countries with limited domestic resources, as well as for nations with restricted opportunities to raise funds in global capital markets.

9. Creation of a Competitive Market

By facilitating the entry of foreign organisations into the domestic marketplace, FDI helps create a competitive environment, as well as break domestic monopolies. A healthy competitive environment pushes firms to continuously enhance their processes and product offerings, thereby fostering innovation. Consumers also gain access to a wider range of competitively priced products.

For a multinational corporation, FDI in India is a means to access new consumption and production markets, and thereby expand its influence and business operations. It can gain access not only to limited resources such as fossil fuels and precious metals, but also skilled and unskilled labour, management expertise and technologies. FDI also enables an organisation to lower its cost of production- by accessing cheaper resources, or going directly to the source of raw materials rather than buying them from third parties. Often, there are various tax advantages that accrue to a company undertaking FDI. This can occur when the home country allows tax deduction on foreign income, or when the recipient country allows tax deductions and benefits for organisations incurring FDI in that country. Additionally, this can happen when the recipient country has a more beneficial tax code than the home country.

Portfolio Investment

Unlike the investment approach of classic security analysis that focuses on individual security selection, portfolio investment is a modern investment method that involves asset allocation and diversification to construct a collection of investments. The biggest challenge in investing is the uncertainty of an investment's future performance and thus the risk of potential investment losses. Not counting on investment results of single investments, portfolio investment can hedge investment risks by canceling out different investment returns among component investments.

1. Risk Diversification and Reduction

Portfolio investment is about reducing risk rather than increasing return. It may well be that in certain years, individual investment returns based on security analysis exceed returns from portfolio investment. However, over the long run, portfolio investment is able to deliver a steady rate of return that is on average better than individual investment returns, because of the risk diversification among various investments inside a portfolio. Portfolio investment seeks out different asset classes that are less correlated or negatively correlated, such as combining stocks and bonds to even out volatility.

2. Minimal Security Analysis

Traditional security selection requires considerable efforts in terms of time and resources to perform the so-called three-step analysis of economy, industry and company. Although portfolio investment involves assembling a collection of individual securities, the focus is less about the merits of each security standing alone but more about how they may fit with the expected overall performance of the portfolio. Some portfolio investment, once constructed, can be left unadjusted regardless of the changing economic environment. When investment results are not solely dependent on an expected above-average performance of an individual security, a simple security analysis technique like security screening can keep the work of security analysis at a minimum.

3. Systematic Investment Approach

As portfolio investment moves away from mere individual security selections, it employs a systematic investment approach that is supposed to benefit the owner of the investment portfolio in the long run. To achieve such a positive, long-term goal, a portfolio investment starts with setting portfolio objectives followed by formulating an investment strategy. The level of expected rate of return and risk tolerance are assessed so that different weights can be assigned to different asset classes and categories. The future performance of portfolio investment hinges on the overall investment policy that strives to ensure that losses from one security are compensated by gains from the other.

4. Passive Investment Style

Active investment management of constant buying and selling increases transaction costs and has tax implications that can be especially worrisome when a short-term holding period results in capital gains taxed as ordinary income. While individual security selections rely on active stock picking to influence performance, portfolio investment is designed to be passively managed, minimizing portfolio turnovers to necessary portfolio rebalancing. The set percentage of weights assigned to different assets and securities does not have to respond to every move of the market and even the economy, as long as the total risk profile of the portfolio remains unchanged.

Short Term Investment 

Short-term investments are assets that can be converted into cash or can be sold within a short period of time, typically within 1-3 years. Common instruments for short-term investing include short-term bonds, Treasury bills, and other money market funds. Short-term trading or day trading entails a significant degree of speculation and, consequently, substantial risk.

Advantages of Short-Term Investing

• Short-term investing offers flexibility to the investor as they do not need to wait for the security to mature in order to get cash. On the other hand, long-term investments can be liquidated by selling in the secondary market, but the investor earns lower profits.
• Investors can make substantial profits in a very short amount of time.
• It is less risky as money invested per transaction is substantially lower.

b) Write short notes on for forfaiting.

Forfaiting is a means of financing that enables exporters to receive immediate cash by selling their medium and long-term receivables—the amount an importer owes the exporter—at a discount through an intermediary. The exporter eliminates risk by making the sale without recourse. It has no liability regarding the importer's possible default on the receivables.

The forfaiter is the individual or entity that purchases the receivables. The importer then pays the amount of the receivables to the forfaiter. A forfaiter is typically a bank or a financial firm that specializes in export financing.

How Forfaiting Works

A forfaiter's purchase of the receivables expedites payment and cash flow for the exporter. The importer's bank typically guarantees the amount.

The purchase also eliminates the credit risk involved in a credit sale to an importer. Forfaiting facilitates the transaction for an importer that cannot afford to pay in full for goods upon delivery. 

The importer's receivables convert into a debt instrument that it can freely trade on a secondary market. The receivables are typically in the form of unconditional bills of exchange or promissory notes that are legally enforceable, thus providing security for the forfaiter or a subsequent purchaser of the debt.

These debt instruments have a range of maturities from as short as one month to as long as 10 years. Most maturities fall between one and three years from the time of sale.

Advantages and Disadvantages of Forfaiting

Advantages

Forfaiting eliminates the risk that the exporter will receive payment. The practice also protects against credit risk, transfer risk, and the risks posed by foreign exchange rate or interest rate changes. Forfaiting simplifies the transaction by transforming a credit-based sale into a cash transaction. This credit-to-cash process gives immediate cash flow for the seller and eliminates collection costs. Additionally, the exporter can remove the accounts receivable, a liability, from its balance sheet.

Forfaiting is flexible. A forfaiter can tailor its offering to suit an exporter's needs and adapt it to a variety of international transactions. Exporters can use forfaiting in place of credit or insurance coverage for a sale. Forfaiting is helpful in situations where a country or a specific bank within the country does not have access to an export credit agency (ECA). The practice allows an exporter to transact business with buyers in countries with high levels of political risk.

Disadvantages

Forfaiting mitigates risks for exporters, but it is generally more expensive than commercial lender financing leading to higher export costs. These higher costs are generally pushed onto the importer as part of the standard pricing. Additionally, only transactions over $100,000 with longer terms are eligible for forfaiting, but forfaiting is not available for deferred payments.

Some discrimination exists where developing countries are concerned compared to developed countries. For example, only selected currencies are taken for forfaiting because they have international liquidity. Lastly, there is no international credit agency that can provide guarantees for forfaiting companies. This lack of guarantee affects long-term forfaiting.

Question No. 4 - IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 4
a) Discuss the factors that influence the design of world wide corporate capital structure.

Some of the major factors influencing capital structure are as follows: 1. Financial Leverage or Trading on Equity 2. Expected Cash Flows 3. Stability of Sales 4. Control over the Company 5. Flexibility of Financial Structure 6. Cost of Floating the Capital 7. Period of Financing 8. Market Conditions 9. Types of Investors 10. Legal Requirements.

1. Financial Leverage or Trading on Equity:

The word ‘equity’ denotes the ownership of the company. Trading on equity means taking advantage of equity share capital to borrowed funds on reasonable basis. It refers to the additional profits that equity shares earn because of funds raised by issuing other forms of securities, viz., preference shares and debentures. It is based on the premise that if the rate of interest on borrowed capital and the rate of dividend on preference capital are lower than the general rate of company’s earnings, the equity shareholders will get advantage in the form of additional profits. Thus, by adopting a judicious mix of long-term loans (debentures) and preference shares with equity shares, return on equity shares can be maximized.

Trading on equity is possible under the following conditions:

(i) The rate of company’s earnings is higher than the rate of interest on debentures and the rate of dividend on preference shares.

(ii) The company’s earnings are stable and regular to afford payment of interest on debentures.

(iii) The company has sufficient assets which can be used as security to raise borrowed funds.

2. Expected Cash Flows:

Debentures and preference shares are often redeemable, i.e., they are to be paid back after their maturity. The expected cash flows over the years must be sufficient to meet the interest liability on debentures every year and also to return the maturity amount at the end of the term of debentures. Thus, debentures are not suitable for those companies which are likely to have irregular cash flows in future.

3. Stability of Sales:

Stability of sales turnover enhances the company’s ability to pay interest on debentures. If sales are rising, the company can use more of debt capital as it would be in a position to pay interest. But if sales are unstable or declining, it would not be advisable to employ additional debt capital.

4. Control over the Company:

The control of a company is entrusted to the Board of Directors elected by the equity shareholders. If the board of directors and shareholders of a company wish to retain control over the company in their hands, they may not allow to issue further equity shares to the public. In such a case, more funds can be raised by issuing preference shares and debentures.

5. Flexibility of Financial Structure:

A good financial structure should be flexible enough to have scope for expansion or contraction of capitalisation whenever the need arises. In order to bring flexibility, those securities should be issued which can be paid off after a number of years. Equity shares cannot be paid off during the life time of a company. But redeemable preference shares and debentures can be paid off whenever the company feels necessary. They provide elasticity in the financial plan.

6. Cost of Floating the Capital:

Cost of raising finance by tapping various sources of finance should be estimated carefully to decide which of the alternatives is the cheapest. Prevailing rate of interest, rate of return expected by the prospective investors, and administrative expenses are the various factors which affect the cost of financing. Generally, cost of financing by issuing debentures and preference shares for a reputed company is low. It is also essential to consider the floatation costs involved in the issue of shares and debentures, such as printing of prospectus, advertisement, etc.

7. Period of Financing:

When funds are required for permanent investment in a company, equity share capital is preferred. But when funds are required to finance expansion programme and the management of the company feels that it will be able to redeem the funds within the life-time of the company, it may issue redeemable preference shares and debentures.

8. Market Conditions:

The conditions prevailing in the capital market influence the determination of the securities to be issued. For instance, during depression, people do not like to take risk and so are not interested in equity shares. But during boom, investors are ready to take risk and invest in equity shares. Therefore, debentures and preference shares which carry a fixed rate of return may be marketed more easily during the periods of low activity.

9. Types of Investors:

The capital structure is influenced by the likings of the potential investors. Therefore, securities of different kinds and varying denominations are issued to meet the requirements of the prospective investors. Equity shares are issued to attract the people who can take the risk of investment in the company. Debentures and preference shares are issued to attract those people who prefer safety of investment and certainty of return on investment.

10. Legal Requirements:

The structure of capital of a company is also influenced by the statutory requirements. For instance, banking companies have been prohibited by the Banking Regulation Act to issue any type of securities except equity shares.

b) Describe adjusted present value method?

The adjusted present value is the net present value (NPV) of a project or company if financed solely by equity plus the present value (PV) of any financing benefits, which are the additional effects of debt. By taking into account financing benefits, APV includes tax shields such as those provided by deductible interest.

The Formula for APV Is: 

​Adjusted Present Value = Unlevered Firm Value + NE

where:

NE = Net effect of debt

​  

The net effect of debt includes tax benefits that are created when the interest on a company's debt is tax-deductible. This benefit is calculated as the interest expense times the tax rate, and it only applies to one year of interest and tax. The present value of the interest tax shield is therefore calculated as: (tax rate * debt load * interest rate) / interest rate.

How to Calculate Adjusted Present Value (APV)

To determine the adjusted present value:

• Find the value of the un-levered firm.
• Calculate the net value of debt financing.
• Sum the value of the un-levered project or company and the net value of the debt financing.

The adjusted present value helps to show an investor the benefits of tax shields resulting from one or more tax deductions of interest payments or a subsidized loan at below-market rates. For leveraged transactions, APV is preferred. In particular, leveraged buyout situations are the most effective situations in which to use the adjusted present value methodology.

The value of a debt-financed project can be higher than just an equity-financed project, as the cost of capital falls when leverage is used. Using debt can actually turn a negative NPV project into one that’s positive. NPV uses the weighted average cost of capital as the discount rate, while APV uses the cost of equity as the discount rate.

Example of How to Use Adjusted Present Value (APV)

In a financial projection where a base-case NPV is calculated, the sum of the present value of the interest tax shield is added to obtain the adjusted present value.

For example, assume a multi-year projection calculation finds that the present value of Company ABC’s free cash flow (FCF) plus terminal value is $100,000. The tax rate for the company is 30% and the interest rate is 7%. Its $50,000 debt load has an interest tax shield of $15,000, or ($50,000 * 30% * 7%) / 7%. Thus, the adjusted present value is $115,000, or $100,000 + $15,000.

The Difference Between APV and Discounted Cash Flow (DCF)

While the adjusted present value method is similar to the discounted cash flow (DCF) methodology, adjusted present cash flow does not capture taxes or other financing effects in a weighted average cost of capital (WACC) or other adjusted discount rates. Unlike WACC used in discounted cash flow, the adjusted present value seeks to value the effects of the cost of equity and cost of debt separately. The adjusted present value isn’t as prevalent as the discounted cash flow method.

Limitations of Using Adjusted Present Value (APV)

In practice, the adjusted present value is not used as much as the discounted cash flow method. It is more of an academic calculation but is often considered to result in more accurate valuations.

Question No. 3 - IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 3
a)What are the different ways of managing political risk? Discuss.

The different ways in which Political Risk can be managed are as follows:

1) Avoiding Investment:

The simplest way to manage political risks is to avoid investing in a country ranked high on such risks. Where investment has already been made, plants may be wound up or transferred to some other country which is considered to be relatively safe.

This may be a poor choice as the opportunity to do business in a country will be lost.

2) Adaptation:

Another way of managing political risk is adaptation. Adaptation means incorporating risk into business strategies. MNCs incorporate risk by means of the following three strategies: local equity and debt, development assistance, and insurance.

i) Local Equity and Debt:

This involves financing subsidiaries with the help of local firms, trade unions, financial institutions, and government. As partners in local businesses, these groups ensure that political developments do not disturb operations. Localization entails modifying operations, product mix, or any such activity to suit local tastes and culture. When McDonald’s commenced franchisee operations in India, it ensured that sandwiches did not contain any beef.

ii) Developmental Assistance:

Offering development assistance allows an international business to assist the host country in improving its quality of life. Since the firm and the nation become partners, both stand to gain. In Myanmar, for instance, the US oil company Unocal and France’s Total have invested billions of dollars to develop natural gas fields and also spent $6 million on local education, medical care, and other improvements.

iii) Insurance:

This is the last means of adaptation. Companies buy insurance against the potential effects of political risk. Some policies protect companies when host governments restrict the convertibility of their currency into parent country currency. Others insure against losses created by violent events, including war and terrorism.

3) Threat:

Political risk can also be managed by trying to prove to the host country that it cannot do without the activities of the firm. This may be done by trying to control raw materials, technology, and distribution channels in the host country. The firm may threaten the host country that the supply of materials, products, or technology would be stopped if its functioning is disrupted.

4) Lobbying:

Influencing local politics through lobbying is another way of managing political risks. Lobbying is the policy of hiring people to represent a firm’s business interests as also its views on local political matters. Lobbyists meet with local public officials and try to influence their position on issues relevant to the firm. Their ultimate goal is getting favourable legislation passed and unfavourable ones rejected.

5) Terrorism Consultants:

To manage terrorism risk, MNCs hire consultants in counterterrorism to train employees to cope with the threat of terrorism.

6) Invaluable Status:

Achieving a status of indispensability is an effective strategy for firms that have exclusive access to high technology or specific products. Such companies keep research and development out of the reach of their politically vulnerable subsidiaries and, at the same time, enhance their bargaining power with host governments by emphasizing their contributions to the economy.

When Texas Instruments wanted to open an operation in Japan more than a decade ago, the company was able to resist pressures to take on a local partner because of its unique advanced technology. This situation occurred at a time when many other foreign companies were forced to accept local partners. The appearance of being irreplaceable obviously helps reduce political risk.

7) Vertical Integration:

Companies that maintain specialized plants, each dependent on the others in various countries, are expected to incur fewer political risks than firms with fully integrated and independent plants in each country. A firm practicing this form of distributed sourcing can offer economies of scale to a local operation. This strategy can become crucial for success in many industries.

If a host government were to take over such a plant, its output level would be spread over too many units, products, or components, thus, rendering the local company uncompetitive because of a cost disadvantage. Further risk can be reduced by having atleast two units engage in the same operation, thus, preventing the company itself from becoming hostage to over- specialization. Unless multiple sourcing exists, a company could be shut down almost completely if only one of its plants were affected negatively.

8) Local Borrowing:

One of the reasons why Cabot Corporation prefers local partners is that, it can then borrow locally instead of adding an additional level of risk with the investment funds being in a currency which is different from the currency of all the sales and costs of the venture. Financing local operations from indigenous banks and maintaining a high level of local accounts payable maximize the negative effect on the local economy if adverse political actions were taken.

Typically, host governments do not expropriate themselves, and they are reluctant to cause problems for their local financial institutions. Local borrowing is not always possible, however, because of restrictions placed on foreign companies, which otherwise crowd local companies out of the credit markets.

9) Minimizing Fixed Investments:

Political risk, of course, is always related to the amount of capital at risk. Given equal political risk, an alternative with comparably lower exposed capital amounts is preferable. A company can decide to lease facilities instead of buying them, or it can rely more on outside suppliers, provided they exist. In any case, companies should keep exposed assets to a minimum to limit the damage posed by political risk.

10) Political Risk Insurance:

As a final recourse, global companies can purchase insurance to cover their political risk. With the political developments in Iran and Nicaragua and the assassinations of President Park of Korea and President Sadat of Egypt all taking place between 1979 and 1981, many companies began to change their attitudes on risk insurance. Political risk insurance can offset large potential losses. For example, as a result of the UN Security Council’s worldwide embargo on Iraq until it withdrew from Kuwait, companies collected $100-$200 million from private insurers and billions from government-owned insurers.

b) What are foreign bonds and eurobonds. What are the advantages of eurobonds owner foreign bonds.

Foreign bonds: Foreign bonds are issued by foreign issuers in a foreign national market and are denominated in the currency of that market. Foreign bond issuance is regulated by the rules of the host national market. An example of a foreign bond is a bond denominated in US dollars issued by a German company in the United States. Foreign bonds bear distinct “street” names by which they are recognized as being traded in a particular country. Examples of foreign bonds are: Yankee bonds traded in the United States, Bulldog bonds traded in the United Kingdom, Samurai bonds traded in Japan, and Matador bonds traded in Spain.

A foreign bond may define as an international bond sold by a foreign borrower but denominated in the currency of the country in which it is placed. It underwrites and sells by a national underwriting syndicate in the lending country. Thus, a US company might float a bond issue in the London capital market, underwritten by a British syndicate and denominated in sterling.

The bond issue would sell to investors in the UK capital market, where it would quote and traded. Foreign bonds issued outside the USA call Yankee bonds, while foreign bonds issued in Japan are called Samurai bonds. Canadian entities are the major floaters of foreign bonds in the USA.

Euro bonds may define as an international bond underwritten by an international syndicate and sold in countries other than the country of the currency in which the issue denominates. In the Eurobond market, the investor holds a claim directly on the borrower rather than on a financial institution.

Eurobonds are generally issued by corporations and governments needing secure, long-term funds and are sold through a geographically diverse group of banks to investors around the world. Eurobonds are similar to domestic bonds in that they may issue with fixed or floating interest rates.

Advantages of Eurobonds:

The Eurobonds market possesses several advantages for borrowers and investors.

The advantages of Eurobonds to borrowers are:

• The size and depth of the market are such that it can absorb large and frequent issues.
• The Eurobond market has freedom and flexibility not found in domestic markets.
• The cost of the issue of Eurobonds, around 2.5 percent of the face value of the issue.
• Maturities in the Eurobond market are suited to long-term funding requirements.
• A key feature of the Eurobond market is the development of a sound institutional framework for underwriting, distribution, and the placing of securities.

The advantages of Eurobonds to investors are:

• Euro bonds are issued in such a form that interest can pay free of income or withholding taxes of the borrowing countries. Also, the bonds issued in bearer form and are held outside the country of the investor, enabling the investor to evade domestic income tax.
• Issuers of Eurobonds have a good reputation for creditworthiness.
• A special advantage to borrowers as well as lenders provides by convertible Eurobonds. Holders of convertible debentures give an option to exchange their bonds at a fixed price.
• The Eurobond market is active both as a primary and as a secondary market.

Bonds denominated in a particular currency that usually issues simultaneously in the capital markets of several nations. They differ from foreign bonds in that most nations do not have pre-offering registration or disclosure requirements for Eurobond issues. An Example of a Eurobond a bond issue by a Russian corporation in the European market that pays interest and principal in U.S. dollars.

Question No. 2 - IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 2
a) Explain the mechanism of money market hedge for managing transaction exposure.

The money market hedge allows the domestic company to lock in the value of its partner’s currency (in the domestic company’s currency) in advance of an anticipated transaction. This creates certainty about the cost of future transactions and ensures the domestic company will pay the price that it wants to pay.

Without a money market hedge, a domestic company would be subject to exchange rate fluctuations that could dramatically alter the transaction’s price. While changes in exchange-rate rates could cause the transaction to become less expensive, fluctuations could also make it more expensive and possibly cost-prohibitive.

A money market hedge offers flexibility in regard to the amount covered. For example, a company may only want to hedge half of the value of an upcoming transaction. The money market hedge is also useful for hedging in exotic currencies, such as the South Korean won, where there are few alternate methods for hedging exchange rate risk.

A money market hedge is a technique for hedging foreign exchange risk using the money market, the financial market in which highly liquid and short-term instruments like Treasury bills, bankers’ acceptances, and commercial paper are traded.

Since there are a number of avenues such as currency forwards, futures, and options to hedge foreign exchange risk, the money market hedge may not be the most cost-effective or convenient way for large corporations and institutions to hedge such risk. However, for retail investors or small businesses looking to hedge currency risk, the money market hedge is one way to protect against currency fluctuations without using the futures market or entering into a forward contract.

Forward Exchange Rates

Let’s begin by reviewing some basic concepts with regard to forward exchange rates, as this is essential to understand the intricacies of the money market hedge.

A forward exchange rate is merely the spot exchange (benchmark) rate adjusted for interest rate differentials. The principle of “Covered Interest Rate Parity” holds that forward exchange rates should incorporate the difference in interest rates between the underlying countries of the currency pair, otherwise an arbitrage opportunity would exist. 

For example, assume U.S. banks offer a one-year interest rate on U.S. dollar (USD) deposits of 1.5%, and Canadian banks offer an interest rate of 2.5% on Canadian-dollar (CAD) deposits. Although U.S. investors may be tempted to convert their money into Canadian dollars and place these funds in CAD deposits because of their higher deposit rates, they obviously face currency risk. If they wish to hedge this currency risk in the forward market by buying U.S. dollars one year forward, covered interest rate parity stipulates that the cost of such hedging would be equal to the 1% difference in rates between the U.S. and Canada.

We can take this example a step further to calculate the one-year forward rate for this currency pair. If the current exchange rate (spot rate) is US$1 = C$1.10, then based on covered interest rate parity, US$1 placed on deposit at 1.5% should be equivalent to C$1.10 at 2.5% after one year. Thus, it would be shown as:

US$1 (1 + 0.015) = C$1.10 (1 + 0.025), or US$1.015 = C$1.1275

And the one-year forward rate is therefore:

US$1= C$1.1275 ÷ 1.015 = C$1.110837

Note that the currency with the lower interest rate always trades at a forward premium to the currency with the higher interest rate. In this case, the U.S. dollar (the lower interest rate currency) trades at a forward premium to the Canadian dollar (the higher interest rate currency), which means that each U.S. dollar fetches more Canadian dollars (1.110837 to be precise) a year from now, compared with the spot rate of 1.10.

Money Market Hedge

The money market hedge works in a similar manner as a forward exchange, but with a few tweaks, as the examples in the next section demonstrate.

Foreign exchange risk can arise either due to transaction exposure (i.e., due to receivables expected or payments due in foreign currency) or translation exposure, which occurs because assets or liabilities are denominated in a foreign currency. Translation exposure is a much bigger issue for large corporations than it is for small business and retail investors. The money market hedge is not the optimal way to hedge translation exposure – since it is more complicated to set up than using an outright forward or option – but it can be effectively used for hedging transaction exposure.

If a foreign currency receivable is expected after a defined period of time and currency risk is desired to be hedged via the money market, this would necessitate the following steps:

Borrow the foreign currency in an amount equivalent to the present value of the receivable. Why the present value? Because the foreign currency loan plus the interest on it should be exactly equal to the amount of the receivable.

Convert the foreign currency into domestic currency at the spot exchange rate.

Place the domestic currency on deposit at the prevailing interest rate.

When the foreign currency receivable comes in, repay the foreign currency loan (from step 1) plus interest.

Similarly, if a foreign currency payment has to be made after a defined period of time, the following steps have to be taken to hedge currency risk via the money market:

Borrow the domestic currency in an amount equivalent to the present value of the payment.

Convert the domestic currency into the foreign currency at the spot rate.

Place this foreign currency amount on deposit.

When the foreign currency deposit matures, make the payment.

Note that although the entity who is devising a money market hedge may already possess the funds shown in step 1 above and may not need to borrow them, there is an opportunity cost involved in using these funds. The money market hedge takes this cost into consideration, thereby enabling an apples-to-apples comparison to be made with forward rates, which as noted earlier are based on interest rate differentials.

b) What is economic exposure and transaction exposure? How is economic exposure different from transaction exposure? 

Economic exposure is a type of foreign exchange exposure caused by the effect of unexpected currency fluctuations on a company’s future cash flows, foreign investments, and earnings. Economic exposure, also known as operating exposure, can have a substantial impact on a company’s market value since it has far-reaching effects and is long-term in nature. Companies can hedge against unexpected currency fluctuations by investing in foreign exchange (FX) trading.

The degree of economic exposure is directly proportional to currency volatility. Economic exposure increases as foreign exchange volatility increases and decreases as it falls. Economic exposure is obviously greater for multinational companies that have numerous subsidiaries overseas and a huge number of transactions involving foreign currencies. However, increasing globalization has made economic exposure a source of greater risk for all companies and consumers. Economic exposure can arise for any company regardless of its size and even if it only operates in domestic markets.

Unlike transaction exposure and translation exposure (the two other types of currency exposure), economic exposure is difficult to measure precisely and hence challenging to hedge. Economic exposure is also relatively difficult to hedge because it deals with unexpected changes in foreign exchange rates, unlike expected changes in currency rates, which form the basis for corporate budgetary forecasts.

For example, small European manufacturers that sell only in their local markets and do not export their products would be adversely affected by a stronger euro, since it would make imports from other jurisdictions such as Asia and North America cheaper and increase competition in European markets.

Economic exposure can be mitigated either through operational strategies or currency risk mitigation strategies. Operational strategies involve diversification of production facilities, end-product markets, and financing sources, since currency effects may offset each other to some extent if a number of different currencies are involved. Currency risk-mitigation strategies involve matching currency flows, risk-sharing agreements, and currency swaps.

Economic exposure can be mitigated either through operational strategies or currency risk mitigation strategies. Operational strategies involve diversification of production facilities, end-product markets, and financing sources.

Currency effects may offset each other to some extent if a number of different currencies are involved. Currency risk-mitigation strategies involve matching currency flows, risk-sharing agreements, and currency swaps. Matching currency flow means matching cash outflows and inflows with the same currency, such as doing as much business as possible in one currency, including borrowings. Currency swaps allow two companies to effectively borrow each other’s currencies for a period of time. 

Assume that a large U.S. company that gets about 50% of its revenue from overseas markets has factored in a gradual decline of the U.S. dollar against major global currencies—say 2% per annum—into its operating forecasts for the next few years. If the dollar appreciates instead of weakening gradually in the years ahead, this would represent economic exposure for the company. The dollar’s strength means that the 50% of revenues and cash flows the company receives from overseas will be lower when converted back into dollars, which will have a negative effect on its profitability and valuation.

Transaction exposure is the level of uncertainty businesses involved in international trade face. Specifically, it is the risk that currency exchange rates will fluctuate after a firm has already undertaken a financial obligation. A high level of vulnerability to shifting exchange rates can lead to major capital losses for these international businesses.

Transaction exposure is also known as translation exposure or translation risk.

The danger of transaction exposure is typically one-sided. Only the business that completes a transaction in a foreign currency may feel the vulnerability. The entity that is receiving or paying a bill using its home currency is not subjected to the same risk.

Usually, the buyer agrees to buy the product using foreign money. If this is the case, the hazard comes if that foreign currency should appreciate, as this would result in the buyer needing to spend more than they had budgeted for the goods.

Question No. 1 - IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 1
a) What were the distinctive features of Breton Woods System.

The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at the United Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire. Thus, the name “Bretton Woods Agreement.

Under the Bretton Woods System, gold was the basis for the U.S. dollar and other currencies were pegged to the U.S. dollar’s value. The Bretton Woods System effectively came to an end in the early 1970s when President Richard M. Nixon announced that the U.S. would no longer exchange gold for U.S. currency.

Approximately 730 delegates representing 44 countries met in Bretton Woods in July 1944 with the principal goals of creating an efficient foreign exchange system, preventing competitive devaluations of currencies, and promoting international economic growth. The Bretton Woods Agreement and System were central to these goals. The Bretton Woods Agreement also created two important organizations—the International Monetary Fund (IMF) and the World Bank. While the Bretton Woods System was dissolved in the 1970s, both the IMF and World Bank have remained strong pillars for the exchange of international currencies.

Though the Bretton Woods conference itself took place over just three weeks, the preparations for it had been going on for several years. The primary designers of the Bretton Woods System were the famous British economist John Maynard Keynes and American Chief International Economist of the U.S. Treasury Department Harry Dexter White. Keynes’ hope was to establish a powerful global central bank to be called the Clearing Union and issue a new international reserve currency called the bancor. White’s plan envisioned a more modest lending fund and a greater role for the U.S. dollar, rather than the creation of a new currency. In the end, the adopted plan took ideas from both, leaning more toward White’s plan.

Following were the features of Bretton Woods Agreement: 

i Bretton Woods agreement was signed among the world powers in 1944. 

ii This agreement established IMF and World Bank to preserve economic stability in the world. 

iii Decision making in Bretton Woods Institutions was controlled by the Western Industrial powers. 

iv National currencies followed the fixed exchange rates. 

v It led to an era of unprecedented growth of trade and incomes.

b) Briefly discuss the various money market instruments with their purpose.  

The term ‘Money Market’, according to the Reserve Bank of India, is used to define a market where short-term financial assets are traded. These assets are a near substitute for money and they aid in the money exchange carried out in the primary and secondary market. So, essentially, the money market is an apparatus which facilitates the lending and borrowing of short-term funds, which are usually for a duration of under a year. Short maturity period and high liquidity are two characteristic features of the instruments which are traded in the money market. Institutions like commercial banks, non-banking finance corporations (NBFCs) and acceptance houses are the components which make up the money market.

The money market is a part of the larger financial market and consists of numerous smaller sub-markets like bill market, acceptance market, call money market, etc. Money market deals are not carried out in money / cash, but other instruments like trade bills, government papers, promissory notes, etc. Also, money market transactions cannot be done via brokers but have to be carried out via mediums like formal documentation, oral or written communication.

Types Of Money Market Instruments

1. Treasury Bills (T-Bills)

Issued by the Central Government, Treasury Bills are known to be one of the safest money market instruments available. However, treasury bills carry zero risk. I.e. are zero risk instruments. Therefore, the returns one gets on them are not attractive. Treasury bills come with different maturity periods like 3-month, 6-month and 1 year and are circulated by primary and secondary markets. Treasury bills are issued by the Central government at a lesser price than their face value. The interest earned by the buyer will be the difference of the maturity value of the instrument and the buying price of the bill, which is decided with the help of bidding done via auctions. Currently, there are 3 types of treasury bills issued by the Government of India via auctions, which are 91-day, 182-day and 364-day treasury bills.

2. Certificate of Deposits (CDs)

A Certificate of Deposit or CD, functions as a deposit receipt for money which is deposited with a financial organization or bank. However, a Certificate of Deposit is different from a Fixed Deposit Receipt in two aspects. The first aspect of difference is that a CD is only issued for a larger sum of money. Secondly, a Certificate of Deposit is freely negotiable. First announced in 1989 by RBI, Certificate of Deposits have become a preferred investment choice for organizations in terms of short-term surplus investment as they carry low risk while providing interest rates which are higher than those provided by Treasury bills and term deposits. Certificate of Deposits are also relatively liquid, which is an added advantage, especially for issuing banks. Like treasury bills, CDs are also issued at a discounted price and their tenor ranges between a span of 7 days up to 1 year. However, banks issue Certificates of Deposits for durations ranging from 3 months, 6 months and 12 months. They can be issued to individuals (except minors), trusts, companies, corporations, associations, funds, non-resident Indians, etc.

3. Commercial Papers (CPs)

Commercial Papers are can be compared to an unsecured short-term promissory note which is issued by highly rated companies with the purpose of raising capital to meet requirements directly from the market. CPs usually feature a fixed maturity period which can range anywhere from 1 day up to 270 days. Highly popular in countries like Japan, UK, USA, Australia and many others, Commercial Papers promise higher returns as compared to treasury bills and are automatically not as secure in comparison. Commercial papers are actively traded in secondary market.

4. Repurchase Agreements (Repo)

Repurchase Agreements, also known as Reverse Repo or simply as Repo, loans of a short duration which are agreed upon by buyers and sellers for the purpose of selling and repurchasing. These transactions can only be carried out between RBI approved parties Repo / Reverse Repo transactions can be done only between the parties approved by RBI. Transactions are only permitted between securities approved by the RBI like treasury bills, central or state government securities, corporate bonds and PSU bonds.

5. Banker's Acceptance (BA)

Banker's Acceptance or BA is basically a document promising future payment which is guaranteed by a commercial bank. Similar to a treasury bill, Banker’s Acceptance is often used in money market funds and specifies the details of the repayment like the amount to be repaid, date of repayment and the details of the individual to which the repayment is due. Banker’s Acceptance features maturity periods ranging between 30 days up to 180 days.

IBO-06 - INTERNATIONAL BUSINESS FINANCE - Master of Commerce (M.Com)

Solutions to Assignments 

IBO-06 - INTERNATIONAL BUSINESS FINANCE

Master of Commerce (M.Com) - 1st Year

Question No. 1

a) What were the distinctive features of Breton Woods System.

b) Briefly discuss the various money market instruments with their purpose.     

                                                    CLICK HERE

Question No. 2

a) Explain the mechanism of money market hedge for managing transaction exposure.

b) What is economic exposure and transaction exposure? How is economic exposure different from transaction exposure?                CLICK HERE

Question No. 3

a)What are the different ways of managing political risk? Discuss.

b) What are foreign bonds and eurobonds. What are the advantages of eurobonds owner foreign bonds.

                                                    CLICK HERE

Question No. 4

a) Discuss the factors that influence the design of world wide corporate capital structure.

b) Describe adjusted present value method?

                                                        CLICK HERE

Question No. 5

a) Discuss the merits of foreign direct investment, portfolio investment and short term investment.

b) Write short notes on for forfaiting.    CLICK HERE