Masters in Business Administration – MBA Semester IV

MF0006 – International Financial Management – 2 Credits

Assignment Set-1 (30 Marks)

Note : Each question carries 10 Marks. Answer all the questions.

Q. 1 Give possible reasons by which the companies are encouraged to be an

MNC? [10 Marks]

Answer:

There is an enormous influence of global brands like “Coca-Cola,” “Canon,” or “BMW” across
the world. These are multinational brands. A Multinational Corporation (MNC) is a company
that has been incorporated in one country and has production and sales operations in other
countries. Often 30% or more of sales and profits of multinationals are generated outside
national borders. A typical multinational company consists of a parent company located in the
home country and at least five or six foreign subsidiaries, with a high degree of strategic
interaction among them.

Firms can be defined as “multinational” on many dimensions, including the following:

• The degree of foreign sales

• The degree of foreign assets

• Source of labour and production

• Source of capital funding

An MNC is a corporation with substantial direct investments in foreign countries (it is not just
an export business) and is engaged in the active management of these off-shore assets (it is not
just holding a passive financial portfolio).

MNCs are a recent phenomenon (mainly after World War II) and they affect all the sectors of
activity (even the service sector). There are about 60,000 MNCs in the world. While not all
MNCs are large, most large companies are MNCs. Multinationals now account for about 10%
of world GDP.

Why do companies expand into other countries and become multinationals? Some of the
possible reasons are:
• To broaden markets: Saturated home markets ask for market development abroad (Coca
Cola, Mac Donald’s etc.). Multinationals seek new markets to fill product gaps in foreign
markets where excess returns can be earned.

• To seek raw materials: Multinationals secure the necessary raw materials required to sustain
primary business line (Exxon; Wal Mart). Multinationals also seek to obtain easy access to oil
exploration, mining, and manufacturing in many developing nations.

• To seek new technologies: Multinationals seek leading scientific and design ideas.

• To seek production efficiencies by shifting to low cost regions (GE).

• To avoid political hurdles such as import quota, regulatory measures of governments, trade
barriers, etc.

• To diversify i.e. to cushion the impact of adverse economic events.

• To postpone payment of domestic taxes.

• To counter foreign investments by competitors.

What is special about multinational management?

Multiple operating environments: Multinationals operate under a diverse pattern of consumer

preferences, distribution channels, legal frameworks and financial infrastructures.

Political demands; political risks: Multinationals have to mesh corporate strategy with host
country industrial development policies; thus there is a potential for conflict.

Global competitive game: Multiple market access and various global scale economies allow
companies new competitive strategic options.

Currency fluctuations (foreign exchange risk): The economic performance of a multinational

is measured in multiple currencies which result in accounting.

Q. 2 What do you mean by International Trade Flows? Also explain various factors
affecting international trade flows.

Factors Affecting International Trade Flows

• Impact of Inflation: A relative increase in a country’s inflation rate will decrease its current
account, as imports increase and exports decrease.
• Impact of National Income: A relative increase in a country’s income level will decrease its
current account, as imports increase.

• Impact of Government Restrictions: A government may reduce its country’s imports by

imposing a tariff on imported goods, or by enforcing a quota. Some trade restrictions may be
imposed on certain products for health and safety reasons.

• Impact of Exchange Rates: If a country’s currency begins to rise in value, its current account
balance will decrease as imports increase and exports decrease.

The factors interact, such that their simultaneous influence on the balance of trade is complex.

International Capital Flows

Large amounts of capital flows across international borders to take advantage of higher rates of
return and the benefits of risk diversification. The surge in capital flows is because of advances
in financial technology, information processing, and communications and dismantling of capital
controls and other barriers to financial transactions in countries across the world.

International capital flows consist of Foreign Direct Investment (FDI) and Foreign Portfolio
Investment (FPI). Foreign Direct Investment (FDI) involves ownership and control: it is the
purchase of physical assets or significant amount of ownership (shares) of a company in another
country to gain some measure of management control. Generally, ownership of 10% or more of a
company’s outstanding shares is considered FDI. By contrast, FPI does not involve obtaining a
degree of control in a company. It is the investment in the stocks and bonds of the companies of
a country by the residents of another country.

Foreign Direct Investment (FDI): Foreign Direct Investment often involves the establishment
of production facilities abroad. Greenfield investment involves building new facilities from the
ground up whereas cross-border acquisition involves the purchase of existing business. FDI has
grown considerably faster than world trade and is typically driven by “push factors” such as
business cycle conditions, macro-economic policy changes in industrial countries) and “pull
factors” such as changes in policy by (developing) countries, liberalization of capital accounts
and domestic stock markets, privatisation, raising equity caps on foreign investment. The factors
that affect FDI are:

• Changes in Restrictions: New opportunities may arise from the removal of government
barriers.

• Privatization: FDI has also been stimulated by the selling of government operations.

• Potential Economic Growth: Countries that have higher potential for economic growth are
more attractive.

• Tax Rates: Countries that impose relatively low tax rates on corporate earnings are more likely
to attract FDI.
• Exchange Rates: Firms typically prefer to invest in countries where the local currency is
expected to strengthen against their own.

Foreign Portfolio Investment (FPI): FPI does not involve taking a significant equity stake in a
company. The factors that affect FPI are:

• Tax Rates on Interest or Dividends: Investors will normally prefer countries where the tax
rates are relatively low.

• Interest Rates: Money tends to flow to countries with high interest rates.

• Exchange Rates: Foreign investors may be attracted if the local currency is expected to
strengthen.

Q. 3 (a) Define swaps. Also explain various types of swaps.

Foreign Exchange Markets – Foreign Exchange Trading

The foreign exchange market is the largest and most liquid market in the world. The estimated
worldwide turnover of this market is at around $1½ trillion a day, which is several times the
level of turnover in the U.S. Government securities market, which is the world’s second largest
financial market. The turnover in the foreign exchange market is equivalent to more than $200 in
foreign exchange market transactions, every business day of the year, for every man, woman,
and child on earth!

The breadth, depth, and liquidity of the market are very impressive. Individual trades of $200
million to $500 million can take place. The quoted prices change as often as 20 times a minute
for active currencies. It has been estimated that the world’s most active exchange rates can
change up to 18,000 times during a single day.

Almost two-third of the $1½ trillion per day trade represents transactions among the dealers
themselves – with only one third accounted for by their transactions with financial and non-
financial customers. An initial dealer transaction with a customer in the foreign exchange market
often leads to multiple further transactions, sometimes over an extended period, as the dealer
institutions readjust their own positions to hedge, manage, or offset the risks involved.

Among the various financial centers around the world, the largest amount of foreign exchange
trading takes place in the United Kingdom, even though that nation’s currency – the pound
sterling – is less widely traded in the market than several other currencies. The United Kingdom
accounts for about 32 percent of the global total of the foreign exchange transactions; the United
States is second with about 18 percent, Japan is third with 8 percent and Singapore is fourth with
7 percent of the worldwide foreign exchange transactions.
In foreign exchange trading, London benefits from its geographical location and time zone. In
addition to being open when the numerous other financial centers in Europe are open, London’s
morning hours overlap with the late hours in a number of Asian and Middle East markets;
London’s afternoon sessions correspond to the morning periods in the large North American
market.

The foreign exchange market is a twenty four hour market. Each business day arrives first in the
financial centers of Asia-Pacific —first Wellington, then Sydney followed by Tokyo, Hong
Kong, and Singapore. A few hours later, while markets are still active in these Asian centers,
trading begins in Bahrain and at other places in the Middle East. Later, when it is late in the
business day in Tokyo, markets open for business in Europe. When it is early afternoon in
Europe, trading in New York and other U.S. centers begin. Finally, completing the circle, when
it is mid or late afternoon in the United States, the next day has arrived in the Asia-Pacific area,
the first markets there have opened, and the process begins again.

The twenty-four hour market means that the exchange rates and market conditions can change at
any time in response to developments that can take place at any time in the day. Traders and
other market participants therefore, must be alert to the possibility that a sharp move in an
exchange rate can occur during an off hour, elsewhere in the world. The large dealing institutions
have thus introduced various arrangements for monitoring markets and trading on a twenty-four
hour basis. Some keep their New York or other trading desks open twenty-four hours a day,
others shift work from one office to the next, and the others follow different approaches.

The foreign exchange market consists of both an over-the-counter (OTC) market and an
exchange-traded segment of the market. The OTC market is an international OTC network of
major dealers – mainly but not exclusively banks – operating in financial centers around the
world, trading with each other and with customers, via computers, telephones, and other means.
The exchange-traded market covers trade in a limited number of foreign exchange products on
the floors of organized exchanges.

The OTC market accounts for well over 90 percent of total foreign exchange market activity,
covering both the traditional (pre-1970) products (spot, outright forwards, and FX swaps) as well
as the more recently introduced (post-1970) OTC products (currency options and currency
swaps). On the “organized exchanges,” foreign exchange products traded are currency futures
and certain currency options.

OTC Market and Exchanges: Main Instruments

Spot: A spot transaction is a straightforward (or “outright”) exchange of one currency for
another. The spot rate is the current market price. Spot transactions do not require immediate
settlement, or payment “on the spot.” By convention, the settlement date, or “value date,” is the
second business day after the “deal date” (or “trade date”) on which the transaction is agreed
upon by the two traders.

Forward: An outright forward transaction, like a spot transaction, is a straightforward single

purchase/ sale of one currency for another. The only difference between the two is that the spot is
settled, or delivered, on a value date not later than two business days after the deal date, whereas
outright forward is settled on any pre-agreed date three or more business days after the deal date.
Dealers use the term “outright forward” to make it clear that it is a single purchase or sale on a
future date, and not part of an “FX swap”.

FX Swap: In the spot and outright forward markets, one currency is traded outright for another,
but in the FX swap market, one currency is swapped for another for a period of time, and then
swapped back, creating an exchange and a re-exchange. An FX swap has two separate legs
where settlement is made on two different value dates, even though it is arranged as a single
transaction and is recorded in the turnover statistics as a single transaction. The two
counterparties agree to exchange two currencies at a particular rate on one date (the “near date”)
and to reverse payments, almost always at a different rate, on a specified subsequent date (the
“far date”). Effectively, it is a spot transaction and an outright forward transaction going in
opposite directions, or else two outright forwards with different settlement dates, and going in
opposite directions.

Currency Swap: A currency swap is different from the FX swap described above. In a typical
currency swap, counterparties will:

a) Exchange equal initial principal amounts of two currencies at the spot exchange rate;

b) Exchange a stream of fixed or floating interest rate payments in their swapped currencies for
the agreed period of the swap; and then

c) Re-exchange the principal amount at maturity at the initial spot exchange rate.

Foreign Currency Options: A foreign currency option contract gives the buyer the right, but
not the obligation, to buy (or sell) a specified amount of one currency for another at a specified
price on (in some cases, on or before) a specified date. Options are exercised only if it is in the
holder’s interest to do so.

Foreign Currency Futures: Like the forward market, in the futures market, foreign exchange
can be bought or sold for future delivery. It serves the same general purpose, but there are many
differences between forward and futures markets. Unlike the forwards which are traded on OTC
markets, futures contracts are traded on an organized securities exchange. Also, unlike the
forward contract, the quantity and the maturity date of the future contracts are standardized.
 Masters in Business Administration – MBA Semester IV

MF0006 – International Financial Management – 2 Credits

Assignment Set-2 (30 Marks)

Note : Each question carries 10 Marks. Answer all the questions.

Q. 1 (a) Explain the responsibilities of IMF.

Answer:

International Monetary Fund (IMF): IMF is the central institution of the international
monetary system. It encourages internationalization of businesses through surveillance, and
financial and technical assistance. The purpose of surveillance is to prevent or manage financial
crises. Its financing facility attempts to reduce the impact of export instability on economies. The
responsibilities of IMF are:

· To promote international monetary co-operation: prevent or manage financial crises.

· To facilitate expansion and balanced growth of international trade.

· To promote exchange-rate stability.

· To assist in establishing multilateral system of payments.

· To lend to member countries experiencing balance of payments difficulties.

The IMF gets its resources from the quota countries’ pay when they join the IMF and from
periodic increases in this quota. The quotas determine a country’s voting power and the amount
of financing it can receive from the IMF.

(b) Describe two types of exchange rates.

An exchange rate is the price of one currency expressed in terms of another currency. A decrease
in the value of one currency relative to another currency is known as depreciation (for a flexible
exchange rate system) or devaluation (for a fixed exchange rate system). An increase in the value
of one currency relative to another currency is known as appreciation (for a flexible exchange
rate system) or revaluation (for a fixed exchange rate system).

Flexible Exchange Rate System

Multinationals use forecasting models to forecast exchange rates. There are two types of
forecast: market-based and model-based (Fundamental and Technical Analysis). Multinationals
also forecast exchange rate volatility. This enables them to specify a range (confidence interval)
and develop best-case and worst-case scenarios along with their point estimate forecasts.

Market-based forecasting involves developing forecasts from market indicators such as

forward rates, spot rates, and interest rates. It is based on the concept that these market indicators
efficiently incorporate expected future currency changes. Multinationals often track changes in
the spot rate and then use these changes to estimate the future spot rate. It is often assumed that
the current forward rate is a consensus forecast of the spot rate in the future. The forecasting of
forward rates is limited to about one year since forward contracts for maturities beyond one year
have low trading volumes and are not widely quoted. Multinationals use interest rate differential
to predict exchange rates beyond one year. The interest rates on risk-free instruments can be used
to determine what the forward rates should be according to Interest Rate Parity for long-term
forecasting. Forecasting horizons are a few days for spot rates, a few months for forward rates,
and a few years for interest rates.

Q. 2 Illustrate Political Exposure in Foreign Exchange Market?

Answer:

Management of Political Exposure

Political risk stems from political actions taken by political actors that affect business. The
political actors may be the members of the government, political parties, public interest groups
that are trying to affect the political process, supra-governmental entities (e.g. WTO, NAFTA) or
other corporations that might act in a political way. Political action has a direct bearing when
political actors change laws, regulations, etc. or take other actions that directly affect business.
An example of such direct effect is the nationalization of business. The indirect effect of political
action occurs when the political actors change the economic environment, the attitudes of the
population, or some other factor that then indirectly affects specific businesses. An example of
such indirect effect is when the local business lobbies the government against the entry of
foreign companies.

Country risk and political risk are sometimes used interchangeably. Country risk comprises all
the socio-political and economic factors which determine the degree and level of risk associated
with undertaking business transactions in a particular country; the likelihood that changes in the
business environment will occur that reduce the profitability of doing business in a country.

Examples of political risk:

1) Nationalization: Nationalization is the appropriation of private assets by a national

government.
2) Creeping Expropriation: Creeping expropriation occurs when the government changes the
rules and makes profit impossible. An example: The host government may require that the
company sell its products only to the local enterprises and that export opportunities are not
pursued. This limits the profit potential of the company.

3) Contract Repudiation: Here, the terms of operating arrangements are changed or

renegotiated once their operations are in place and have proved successful. Thus additional taxes
may be imposed. Companies with large fixed investments are vulnerable due to the “hostage”
effect. They cannot credibly threaten to withdraw. Companies with stable technologies are
vulnerable because locals could take over the operation without need for continuing foreign
technology transfer.

4) Political Pressure in a Democratic System: Spread of democracy increases popular criticism

of foreign investors. Opposition parties may use attacks on foreign investors as nationalistic
position to gain voter support (but pro-business opposition can also provide protection against
government arbitrary policies, such as tariff increases). There is evidence to prove that business
grows faster under democracies even though many believe that suppressive authoritarian regimes
are more favourable to business.

5) Threats from Local Business: Local business interests use political connections to secure
favourable treatment over foreign companies or resist market liberalization. Many local business
people become wealthy during the period of protected markets and do not want to eliminate
protectionist policies. As a result of lobbying by local business, governments may require foreign
investors to have local partners or make laws that keep foreigners entirely away from some
“critical” sectors or enact licensing procedures that delay investment. When liberalization occurs,
local business still tries to create adverse political conditions. They try to prevent foreign
companies from winning government contracts, or try to slow licensing and other approvals for
foreign companies to decrease their relative efficiency.

The multinational’s interest in political risk lies in forecasting that risk so that it can be avoided
or managed. Assessment of political risk is the projection of possible losses that result from
governmental and societal sources. The goal of political risk assessment is to provide projections
that will guide the multinational in decision-making about investment, corporate strategy, and
specific business tactics.

Investors cannot always choose projects or countries where the risk is low and it is not possible
to insure against all risks. There are steps that the investor can take to reduce risk in a given
project. The prudent investor takes advantage of available information and relationships to
manage political risks in the same way in which he manages economic or financial risks.

Basic Strategies to Actively Manage Political Risk:

Low Involvement Strategy High Involvement Strategy

Work through a coalition of firms.Develop a network with economic,
No independent action. political and social groups.
Reduce asset exposure and focus on Focus on all policy levels (national,
national-level policy. local, etc.).
Targets regulatory framework of Targets political environment in
business. general.

Q. 3 Explain Trade deficits and Trade surplus in regard to Balance of Payments.

Answer:

Trade Deficits

The trade balance is the difference between a country’s output and its domestic demand-the
difference between what goods and services a country produces and how many goods and
services it buys from abroad. A trade deficit occurs when, during a certain period, a nation
imports more goods and services than it exports. A trade surplus occurs when a nation exports
more goods and services than it imports.

According to the BOP identity (Current Account + Capital Account =Change in Official Reserve
Account), any trade deficit must be offset by surpluses on other accounts. Since the official
reserves are limited, a surplus on the Official Reserve Account (which means selling of the
foreign exchange reserves by the central bank) can at best be a temporary measure. Thus the
trade deficit must be "financed" by foreign income or transfers, or by a capital account surplus. A
capital account surplus consists of capital purchases (stocks, bonds etc.) by foreign nationals. A
capital account surplus (an increase in net foreign investment) may result in an increase in the net
outflow of income (dividend, interest) to foreign nationals on these investments in the future.
Thus, such payments to foreigners could have intergenerational effects: they shift consumption
over time, and future generations have to pay for the consumption by the present generation.
However, a trade deficit can also lead to higher consumption in the future, if, for example, it is
used to finance profitable domestic investment, which generates returns in excess of what is paid
to the foreign nationals on their investments in the country. Such a situation may arise if a
country experiences a gain in productivity as a result of these investments.

A trade surplus implies an increase in the net international investment of the residents of the
country and the shifting of consumption to future rather than current generations. Even trade
surpluses can be undesirable for a country. An example where a trade surplus was not beneficial
for the country is Japan in the 1990s. The positive trade balance that Japan had was partly due to
the protectionist measures that were adopted by the Japanese government. These measures
caused the price of goods in Japan to be much higher than what they would have been, had
imports been freely allowed. The foreign currency that the Japanese companies earned overseas
were kept abroad and not converted into yen in order to keep the value of the yen low and
maintain the competitiveness of Japanese exports. However, a weak yen also prevented Japanese
consumers from importing goods from abroad and benefiting from the trade surplus. The foreign
exchange earned abroad as a result of the trade surplus was partly squandered by spending it on
real estate purchases in the United States that often proved unprofitable.