Financial Markets and International Risk

Management
Objectives:
Describe the nature and role of capital
markets
Explain the types of risk associated with
multinational firms
Discuss the strategies for managing risk
Further Reading: Shapiro Alan. Multinational Financial Management, 9
th

edition: chapter 6: Country risk
Professor. A. Boateng
Financial markets
Financial Markets
are structures through which funds flow
Dimensions of Financial Markets:
Primary versus Secondary Markets
Money versus Capital Markets
Primary Market
are markets in which companies raise funds
through new issues of securities such as
stocks and bonds
Financial markets
Secondary markets
Are markets for existing securities, that is,
Securities are re-bought and resold
Secondary markets offer buyers and sellers
Liquidity- the ability to turn assets into cash
quickly
Provides information about the prices of their
instruments

Financial markets
Capital Markets
markets that trade debt (bond) and equity
(shares) instruments with maturities of more
than one year.
Money markets
markets that trade debt securities with
maturities of less than one year. For
example, Treasury bills and Commercial
papers
Stock Markets
Stock Exchange:
is a market where securities can be bought
and sold,
market where government and industry can
raise long-term capital
Principal functions:
enables companies to raise new capital the
primary market); and
Stock Markets
to facilitate the trading of existing shares the
secondary market) between investors
Dominant financial centres
form the golden triangle in three different
time zones:
USA
London, and
Tokyo
Stock Markets
America :
largest source of equity capital
over one-third of the Worlds total capital
Global Total Capitalisation stands around 20,000
bn
split into three competing stock exchanges: NYSE,
NASDAQ and AMEX
NYSE:
largest in terms of market capitalisation
Stock Markets
NASDAQ-
National Association of Securities Dealers
Automated Quotations
Twice as many companies listed compared to
NYSE
London stock exchange
largest in non-domestic shares last year with 501
firms but now overtaken by New York
Stock Markets
Stock Exchange Capitalisation Firms Int. Firms
NYSE 7660 2308 (433)
NASDAQ 2395 3294 (343)
London 1812 2692 (381)
Tokyo 2113 2206 (32)
Hong Kong 417 1037 (10)
Brazil 100 389 (2)
India 155 5644
South Africa 137 390 (21)
Financial Markets and the Economy
Information Role
Central role in the capital allocation
Investors in stock markets decide which
companies should live or die depending on
information that goes to the market
Consumption Timing
Helps shift your consumption from now to
future
Allocation of Risk
Financial markets allows investors to allocate
their risks according to their tastes
International Risk Management



Foreign Exchange Risk
Foreign Exchange 1
The Foreign Exchange Market:
Is a market where one countrys currency can be
exchanged for another countrys.
It is not a geographical location - it is an informal
network of telephone, telex satellite, fax, and
computer communication between banks, foreign
exchange dealers and speculators.
Function
transfer purchasing power dominated in one currency
to another.
Foreign Exchange Risk
Foreign exchange risk
is the risk of loss due to changes in the international
exchange value of national currencies
Why Exchange risk management important?
Daily currency fluctuations
Increasing integration of the world economy
FOREX Exposure
possibility that a firm will gain or lose due to changes
in the exchange rate
Finance Managers role
compare potential losses with the cost of avoiding
these losses.
Share of Forex Market April
2010
Country Daily Av. T/o US$ bn Overall Share %
United Kingdom 1,853,594 36.66
United States 904,357 17.88
Japan 312,326 6.18
Singapore 265,977 5.26
Switzerland 262,582 5.19
Hong Kong 237,568 4.50
Australia 192,052 3.80
France 151,621 3.00
Denmark 120,463 2.38
Germany 108,598 2.15
Others 647,144 5.38
Source: Bank for International Settlements, 2010

Types of Exchange exposure
Exchange rate risk is commonly divided into three
types:
transaction risk
translation risk
economic risk
Transaction risk
occurs as a consequence of either importing or
exporting goods and services
refers to the possibility that, as a result of transaction
of overseas assets, liabilities and profits into domestic
currency, the holding company may experience a loss
or a gain due to changes in the exchange rate.
Types of Exchange exposure
Example 1:
A US parent company has a wholly owned
subsidiary in Singapore. This subsidiary has
exposed assets of 100 million Singapore
dollars and exposed liabilities of 50 million
Singapore dollars. The exchange rate
declines from S$4 per US$ to S$5 per dollar
Calculate the potential exchange loss
Types of Exchange exposure
Suggested solution 1:
Expected assets S$100 m
exposed liabilities 50 m
Net exposure 50 m
pre-devaluation rate(S$4=1) 50/4 12.5 m
post-devaluation rate (S$5=1) 50/5 10.0 m
potential loss 2.5 m

Types of Exchange exposure
Economic risk/ Operating Exposure
refers to the risk of long-term movement in
exchange rates and national economies
undermining the international competitiveness
of a company
Effect of exchange rates on cost and price
competitiveness. Affects all firms.

Types of Exchange Exposure
Translation Exposure
Exposure of consolidated financial statements
to exchange rate fluctuations.

Affected by:
Proportion of its business conducted by
foreign subsidiaries
Location of subsidiaries

Techniques for managing
Exchange risk -Internal
Leading and lagging:
leading is bringing forward from the original
due date the payment of a debt;
lagging is the postponement of a payment
beyond the due date.
The speeding up or delaying of payments is
particularly useful if the exchange rates will
shift significantly between now and the due
date
when making a lead payment, must consider
the finance cost


Traditional Strategies for Eliminating
Transaction Exposure
Currency of invoice
insist on being paid or paying in your home
currency
this shifts the risk to the other party
but may also limit trade if the other party is not
prepared to take the risk

Invoice the customer in the home currency
One easy way is to bypass exchange risk is to insist that all
foreign customers pay in your local currency and your firm
pays for all imports in your home currency

Traditional Strategies for Eliminating
Transaction Exposure
Netting
Subsidiaries in large multinationals can net off payments so that
the number of foreign exchange payments is minimised
is where the subsidiaries settle intra-organisational currency
debts for the net amount owed in a currency rather than have it
hedged
example multilateral netting
Matching
try to match receipts and payments in a particular currency
Matching Long Term Assets and Liabilities
Assets in foreign currencies can be financed by foreign currency
borrowing
this means that the revenues generated by the assets can be
used to pay the financing of the assets with no need to exchange
currencies


External Hedging Strategies:
Outline
Forward Contracts
A binding contract to buy or sell a fixed
amount of currency, on a specified future
date, at an exchange rate agreed when the
contract is taken out (the forward rate)
Forward contracts are bespoke, so they can
be for any amount on any date

Futures
A financial future is a standard (legally binding) contract
between buyer and seller, in which there is a binding
obligation to buy/sell a standard fixed quantity of one
currency in exchange for another, at a fixed price, on a
fixed date.

Futures are traded on exchanges.
Characteristics of Currency
Futures
Deals with transactions that will be made in
future;
Involves a promise to exchange a product for
cash by a set delivery date
It involves a process known as marking to
market (No paper gains or losses; money
actually moves between accounts each day).
Contracts are standardised and traded in
organised futures market for specific delivery
date
Options
Option
Is a contract that gives the holder the right to
either buy or sell security at a set price, on or
before a given date
Characteristics:
Contingent claim: payoffs depend upon
underlying value
Exercise is optional: can be avoided
Striking price: the predetermined transaction
price
Option Premium
Option premium
the amount or price you pay for the option
Option Premium has two components
Intrinsic value and Time value

Types of Option Contract
Call option
Right, but not the obligation, to BUY the
underlying asset at a predetermined price
(called exercise or strike price), within a set
period of time.
Put option
Right, but not the obligation, to SELL the
underlying asset at a predetermined price
(called exercise or strike price), within a set
period of time

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Market and Exercise Price
Relationship
In the Money - exercise of the option would
be profitable.
Call: market price>exercise price
Put: exercise price>market price
Out of the Money - exercise of the option
would not be profitable.
Call: market price<exercise price
Put: exercise price<market price
At the Money - exercise price and asset price
are equal.

Political Risk
Political Risk
Is the assessment of economic opportunity against
political odds
Thus political risk assessment requires that MNCs
evaluate both economic and political indicators.
It is difficult to separate political and economic risks.
While government decisions are political by definition,
the underlying forces behind the decision may be purely
economic.
For example, funds may be blocked because of
unexpected shortage or certain types of domestic
pressures
The United Nations imposed economic sanctions on Iraq
in 1990 because of Iraqs invasion of Kuwait
Nature of Political Risk
Countrywide political risks depend on three broad groups
of variables:
Political climate
Measured by tendencies toward subversion, rebellion, or political
turmoil. Example, recent events in Thailand where Red shirt
opposition say they want the government out now.
Economic climate
Likelihood of government intervention in the economy, levels of
interest and inflation rates, persistent balance of payments
deficits, worsening monetary reserves
Foreign relations
Investors should determine the extent to which host countries
manifest hostility toward other countries.

1-32
Business risks
Foreign-exchange
risks
Governance risks
Blocked funds
Nepotism & corruption
Religious heritage
Intellectual property rights
Terrorism & War
Anti-globalization
movement
Cyberattacks
Poverty
Environmental
concerns
Protectionism
Transfer Risk
Cultural and
Institutional Risk
Ownership structure
Human resource norms
Firm-Specific
Risks
Country-Specific
Risks
Global-Specific
Risks
Classification of Political
Risks
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Assessing Political Risk
Macro level
firms attempt to assess a host countrys
political stability and attitude toward foreign
investors.
Micro level
firms analyze whether their firm-specific
activities are likely to conflict with host-country
goals as evidenced by existing regulations.
1-34
Firm-Specific Risks
The firm-specific risks that confront MNEs include:
Business risk
Foreign exchange risk
Governance risks
Governance risk
is the ability to exercise effective control over an MNEs
operations within a countrys legal and political environment
For an MNE, it must be addressed from the individual
business unit as well as for the MNE as a whole
1-35
Firm-Specific Risks
Corporate governance principles include:
Accountability (transparent ownership, appropriate
board size, defined board accountability, and
ownership neutrality)
Disclosure and transparency (broad, timely and
accurate disclosure, use of proper accounting
standards)
Independence (dispersed ownership, independent
audits and oversight, independent directors)
Shareholder equity (one share, one vote)
Pre-investment strategy to
anticipate blocked funds
Fronting loans
Creating unrelated exports
Obtaining special dispensation
Forced reinvestment
Blocked Funds
Ownership Structure
Intellectual Property
Joint venture
Legal action in host
country courts
Human Resource Norms
Understand and respect host
country religious heritage
Local management & staffing
Religious Heritage
Nepotism and Corruption
Disclose bribery policy to both
employees and clients
Retain a local legal advisor
Support worldwide treaty
to protect intellectual
property rights
Protectionism
Support government
actions to create
regional markets
Transfer Risk
Cultural and
Institutional Risk
Exhibit 1: Management Strategies for
Country-Specific Risks
Country-Specific Risks:
Transfer Risk
At least six popular strategies are used to move
blocked funds:
Providing alternative conduits for repatriating funds
Transfer pricing
Leading and lagging payments
Using fronting loans
Creating unrelated exports
Obtaining special dispensation
Support government
efforts to flight terrorism
and war
Crisis planning
Terrorism & War
Poverty
Anti-Globalization
Support government
efforts to reduce trade
barriers
Recognize that MNEs
are the targets
Provide stable, relatively
well-paying jobs
Cyber Attacks
No effective strategy
except internet security
efforts
Support government
anti-cyber attack efforts
Environmental Concerns
Show sensitivity to
environmental concerns
Support government efforts
to maintain a level playing
field for pollution controls
Establish the strictest of
occupational safety standards
MNE movement towards multiple primary objectives:
Profitability, Sustainable Development, Corporate Social Responsibility
Exhibit 2: Management Strategies for
Global-Specific Risks