Fall 2016

MBA Semester 4

MF0015: INTERNATIONAL FINANCIAL MANAGEMENT

Q1. Explain Globalization. What are the Advantages of Globalization and

Disadvantages of Globalization

Globalization can be defined as the process of international integration that arises due to
increasing human connectivity as well as the interchange of products, ideas and other
aspects of culture. It includes the spread and connectedness of communication,
technologies and production across the world and involves the interlacing of cultural and
economic activity. The term 'globalization' was used by the late professor Theodore Levitt of
Harvard Business School in an article titled 'Globalization of Markets' which appeared in
Harvard Business Review in 1983. The world turning into a global market has its own
advantages and disadvantages for various countries.

Advantages of Globalization

1. Economic growth: An open economy can have a higher GDP growth than a closed one
because of increased access to various markets and exposure to better technology. An
economy can be called a closed economy if it has no economic transactions with any other
economy. An open economy is one that has economic interactions with other economies.

2. Lower costs: Open economies can import inputs, raw materials, and technology at
cheaper rates and, thus benefit in terms lower cost structure.

3. Improved availability of goods and services: Open economies have access to many
countries. They can use the best among all that are available. India which is a labour-
intensive country has been able to use cheap Chinese goods due to open trade.

4. Global prosperity and flow of productive resources: Open economies can exchange
raw materials and other goods with other. This will benefit both the producers and the
customers.

5. Incentives for research and adoption of innovations: The countries that have human
resources can develop new products and technology and use the market of less-developed
countries to increase trade.

6. Raise cheaper loans: Open economies not only gain on the customer end, but also have
access to financial markets of the countries in which they do business with. They can raise
cheaper loans than their home country.
Disadvantages of Globalization

Open economies are interdependent that makes them prone to unavoidable risks like
trade cycles. The most recent example is that of the American recession that had
affected the whole world.
Import dependence can expose a country to undue political, economic and cultural
risks.
Large-scale increase in international capital flows has increased the problem of
heavy indebtedness of some countries and their inability to repay their debts.
Problems of foreign exchange due to different currencies of different countries.

Q2. In foreign exchange market many types of transactions take place. Discuss the
meaning and role of forward, future and options market.

Forward Market

In the forward market, contracts are made to buy and sell currencies for future delivery, say,
after a fortnight, one month, two months and so on. The rate of exchange for the transaction
is agreed upon on the very day the deal is finalized.

The rate of exchange for the transaction is agreed upon on the very day the deal is finalized.
The forward rates with varying maturity are quoted in the newspapers and those rates form
the basis of the contract. Both parties have to abide by the contract at the exchange rate
mentioned therein irrespective of whether the spot rate on the maturity date resembles the
forward rate or not. The value date in case of a forward contract lies definitely beyond the
value date applicable to a spot contract.

Futures Market

The foreign exchange market involving forward contracts has a long history but the market
for currency futures has a comparatively recent origin. It came into being in 1972 when the
Chicago Mercentile Exchange has set up its international monetary market division for
trading of currency futures. Currency futures are traded only in a limited number of
currencies. A forward contract is finalized on telephone, etc. meaning that it represents an
over-the-counter market. But in case of currency futures, brokers strike the deals sitting face
to face under a trading roof, known as pits. The brokers can trade for themselves as well as
on behalf of the customers. When they trade for themselves, they are called locals or floor
traders. On the other hand, when the brokers trade on behalf of their customers, they are
known as commission brokers or floor brokers.
Options Market

The market for currency options is the other form of the derivatives market representing
large-scale sale and purchase of currencies. This form of market possesses some
distinguishing features and also the methods of operation are different. There are three
different types of option market. They are listed currency options market, currency futures
options market and over-the-counter options market.

Listed currency options market

Listed currency options are standardized contracts. In such contracts, the clearinghouse is
essentially a party to the contract.

Currency futures options market

In this market, which is basically a listed currency options market, the contracts present a
mixture of currency futures and currency options.

Over-the-counter options market

The second type of market for currency options is known as inet-bank currency options
market or the over-the-counter options market.

Q3. Explain Swap, its features and types of Swap.

Swap

Swap is an agreement between two or more parties to exchange sets of cash flows over a
period in future. The parties that agree to swap are known as counter parties. It is a
combination of a purchase with a simultaneous sale for equal amount but different dates.
Swaps are used by corporate houses and banks as an innovating financing instrument that
decreases borrowing costs and increases control over other financial instruments. It is an
agreement to exchange payments of two different kinds in the future. Financial swap is a
funding technique that permits a borrower to access one market and then exchange the
liability for another type of liability. The first swap contract was negotiated in 1981 between
Deutsche Bank and an undisclosed counter party.

The International Swap Dealers association (ISDA) was formed in 1984 to speed up the
growth in the swap market by standardizing swap documentation. In 1985, ISDA published
the standardized swap code.

Features of swap

Swaps are contracts of exchanging the cash flows and are tailored to the needs of counter
parties. Swaps can meet the specific needs of customers.
Counter parties can select amount, currencies, maturity dates etc.
Exchange trading involves loss of some privacy but in the swap market privacy exists and
only the counter parties know the transactions.
There is no regulation in swap market.
There are some limitations like
Each party must find a counter party which wishes to take opposite position.
Determination requires to be accepted by both parties.
Since swaps are bilateral agreements the problem of potential default exists.

There are two kinds of swap, they are as follows:

1. Currency swap: It is an agreement whereby currencies are exchanged at specified

exchange rates and at specific intervals. The reason is to lock in the exchange rate. Large
commercial banks that serve as an intermediary agree to swap currencies with a firm. Two
currencies are exchanged in the beginning and again at the maturity, they are re exchanged
because one counter party is able to borrow a particular currency at a lower interest rate
than the other counter-party.

2. Interest rate swap: It is an arrangement whereby one party exchange one set of interest
rate payments for another. Most common arrangement is an exchange of Fixed Interest rate
payment for another rate of over a period of time.

Q4. Explain in detail the types of exposure and measuring economic exposure

Types of Exposure

There are different types of exposure to which a particular company-domestic or

internationalis exposed to. The types of exposure are related to two parameters:

One is related to the time of the transactions, the transactions and the flows of
money (payment and receivables) related to them and the other one to the aspect of
conducting international business in host countries.
The second one is based on the analysis of how to reconcile the balance sheet of the
subsidiary company with that of the parent companys balance sheet.

The types of exposure are broadly divided into economic and translation exposure.
Economic exposure is further divided into transaction exposure and operating exposure.
Economic Exposure

The potential changes in all future cash flows of a firm resulting from unanticipated changes
in the exchange rates are referred to as economic exposure. The monetary assets and
liabilities, in addition to the future cash flows, get influenced by the changes in foreign
exchange rates.

There are two components of economic exposure transaction.

(a) Transaction Exposure

(b) Operating Exposure

(a) Transaction exposure

Transaction exposure is concerned with the impact of change in exchange rate on present
cash flows. Transaction exposure emerges mainly on account of export and import of
commodities on open account, borrowing and lending in a foreign currency and intra-firm
flows within an international company.

(b) Operating exposure

Operating exposure has an impact on the firms future operating costs and cash flows. Since
the firm is valued as a going concern entity, its future revenues and costs are to be affected
by the exchange rate changes.

Translation Exposure

Translation exposure, which is also known as accounting exposure, emerges on account of

consolidation of financial statements of different units of a multinational firm. The parent
company is normally interested in maximizing its overall profitability and to make it possible,
it consolidates the financial statements of its subsidiaries with its own.

Measuring Economic Exposure

One method of measuring the economic exposure of an MNC is through classification of

cash flows into different items on the income statement and prediction of movement of each
item in the income statement that is based on a forecast of exchange rates. This will
facilitate the development of an alternative exchange rate scenario. It will also help in
revising the forecasts of the income statement items. Depending on the change in the
forecasts for the economic statement items, it will become possible for the firm to assess the
influence of currency movements on cash flows and earnings.
Q5. Elaborate on the tools of foreign exchange risk management and techniques of
exposure management.

Tools of Foreign Exchange Risk Management

Forward contracts: A forward contract is a non-standardized contract that takes place

between two parties for the purpose of selling or buying an asset at a specified future time at
a price that has already been agreed. The party who buys the underlying position assumes a
long position and the party who sells the asset assumes a short position.

Futures contracts: It is a standardized contract that takes place between two parties for
buying and selling a specified asset of standardized quality and quantity for a price that has
been agreed at the present date. The payment and delivery takes place at a future specified
date which is also known as the delivery date.

Option contracts: In this type of contract, the buyer of the option has the right but not the
obligation to fulfill the transaction while the seller has the responsibility of fulfilling the
conditions stated in the contract through the delivery of the shares to the appropriate party.

Currency Swap: The agreement that takes place between two parties through which they
exchange a series of cash flows in one currency for a series of cash flows in another
currency is known as currency swap. It takes place at agreed intervals and over an agreed
period of time.

Techniques of Exposure Management

Managing Transaction Exposure

Transaction exposure calculates gains or losses which occur after the current financial
compulsions according to terms of reference are resolved. Taken that the deal would lead to
a future inflow or outflow of foreign currency cash, any unprecedented alterations in rate of
exchange amid the period in which transaction is entered and the time taken for it to settle in
cash would guide to a change in worth of net flow of cash in terms of the home currency. For
example a transaction exposure of an Indian company will be the account receivable which
is associated with a sale denominated in US dollars or the compulsion of an account payable
in Euro debt.

Managing Operating Exposure

Operating exposure is alternatively known as economic exposure. It evaluates the changes

that occur in the current value of the firm. The change in the current value may be a result of
the change that takes place in predicted operating cash flows on account of fluctuations in
exchange rates.
Q6. Write short note on:
a. Adjusted present value model (APV model)
b. Forced Disinvestment

a. Adjusted present value model (APV model)

The method of adding the tax benefits of debt to the separately calculated present value of
the project using the allequity cost of capital is known as the adjusted present value (APV)
approach.

The APV model is a three step approach:

Step1: Evaluate the project as if it is financed entirely by equity to obtain the cash flows.The
rate of discount is the required rate of return on equity corresponding to the risk class of the
project.

Step2: Add the present value of any cash flows arising out of special financing featuers of
the project such as external financing. The rate of discount used should reflect the
associated risk with each of the cash flows.

Step3: Add cash flow of step 1 and step 2 to obtain APV

Accordingly, we can say that: Value of the levered firm = Value of the unlevered firm + Value
of financing effects.

b. Forced Disinvestment: Government may put pressure on firms to disinvest.

Forced disinvestment may take place for various reasons such as:
Government may believe that it may make better use of the assets.
Takeover may improve the image of the government among the people of the country.
Government wants to control these assets for strategic and developmental reasons.

An example of forced disinvestment is the takeover of oil exploration. In India, most of the oil
producing companies is nationalized though a few private players like Reliance have come
up in the market. These forced disinvestments are legal under international law as long as
they are accompanied by adequate compensation. Such takeovers do not involve the risk of
total loss of assets.

Forced disinvestments are practiced in two forms.

(i) Takeover/nationalization: These are done as a matter of political philosophy. The
government announces a policy for takeover or nationalization with a compensation
package. The company owners are asked to withdraw from the management for the
announced compensation which usually does not match with the expectation of the owners.
Takeovers and nationalizations are usually done when the ideological base of the
government changes from right or centralist to socialist or to communist ideology.
(ii) Confiscation/expropriation with or without compensation: This is another form of forced
disinvestment. In this form, the government expropriates a legal title to the property or the
stream of income the company generates. Governments may also constrain the property
owners in the way they use their property. Confiscation may be with a minimal compensation
or even without compensation. This step may be taken by governments because of political
rivalry among nations or because of idealistic shift in governments political philosophy.