international finance fin456 ♦ summer 2013 michael dimond

International FinanceFIN456 ♦ Summer 2013

Michael Dimond

Michael DimondSchool of Business Administration

The Balance of Payments• The measurement of all international economic transactions

between the residents of a country and foreign residents is called the Balance of Payments (BOP)– The IMF is the primary source of similar statistics worldwide– Multinational businesses use various BOP measures to gauge the

growth and health of specific types of trade or financial transactions by country and regions of the world against the home country


The Balance of Payments– Monetary and fiscal policy must take the BOP into account at the

national level – Businesses need BOP data to anticipate changes in host country’s

economic policies driven by BOP events– BOP data may be important for the following reasons

• BOP is important indicator of pressure on a country’s exchange rate, thus potential to either gain or lose if firm is trading with that country or currency

• Changes in a country’s BOP may signal imposition (or removal) of controls over payments, dividends, interest, etc

• BOP helps to forecast a country’s market potential, especially in the short run

– Rule of thumb to understand the BOP: follow the cash flow


Fundamentals of BOP Accounting

• The BOP must balance• Elements in measuring international economic activity:

– Identifying what is/is not an international economic transaction– Understanding how the flow of goods, services, assets, money create

debits and credits– Understanding the bookkeeping procedures for BOP accounting


Typical BOP Transactions• Examples of BOP transactions from US perspective

– Honda US is the distributor of cars manufactured in Japan by its parent, Honda of Japan

– US based firm, Fluor Corp., manages the construction of a major water treatment facility in Bangkok, Thailand

– US subsidiary of French firm, Saint Gobain, pays profits (dividends) back to parent firm in Paris

– An American tourist purchases a small Lapponia necklace in Finland– A Mexican lawyer purchases a US corporate bond through an investment

broker in Cleveland


Defining International Economic Transactions• Current Account Transactions

– The export of merchandise, goods such as trucks, machinery, computers is an international transaction

– Imports such as French wine, Japanese cameras and German automobiles are international transactions

– The purchase of a glass figure in Venice by an American tourist is a US merchandise import

• Financial Account Transactions– The purchase of a US Treasury bill by a foreign resident


BOP as a Flow Statement• Exchange of Real Assets – exchange of goods and services

for other goods and services or for monetary payment• Exchange of Financial Assets – Exchange of financial claims

for other financial claims


The Current Account• Goods Trade – export/import of goods. • Services Trade – export/import of services; common services are

financial services provided by banks to foreign investors, construction services and tourism services

• Income – predominately current income associated with investments which were made in previous periods. Additionally the wages & salaries paid to non-resident workers

• Current Transfers – financial settlements associated with change in ownership of real resources or financial items. Any transfer between countries which is one-way, a gift or a grant,is termed a current transfer

• Typically dominated by the export/import of goods, for this reason the Balance of Trade (BOT) is widely quoted


U.S. Current Account, 2002-2009 ($ Bn)


U.S. Balances, 1985-2009 ($Bn)U.S. Trade Balance and Balance on Services and Income


The Capital and Financial Accounts• Capital account measures transfers of fixed assets such as

real estate and acquisitions/disposal of non-produced/non-financial assets

• Financial account components:– Direct Investment: Net balance of capital which is dispersed from and

into a country for the purpose of exerting control over assets. This category includes foreign direct investment

– Portfolio Investment: Net balance of capital which flows in and out of the country but does not reach the 10% ownership threshold of direct investment. The purchase and sale of debt or equity securities is included in this category

– Other Investment Assets/Liabilities: Consists of various short and long-term trade credits, cross-border loans, currency and bank deposits and other accounts receivable and payable related to cross-border trade


U.S. Financial Account, 2002-2009 ($Bn)


The Other Accounts• Net Errors and Omissions – Account is used to account for statistical errors and/or

untraceable monies within a country• Official Reserves – total reserves held by official monetary authorities within a

country. – These reserves are typically comprised of major currencies that are used in

international trade and financial transactions and reserve accounts (SDRs) held at the IMF

– Under a fixed rate regime official reserves are more important as the government assumes the responsibility to maintain parity among currencies by buying or selling its currency on the open market

– Under a floating rate regime the government does not assume such a responsibility and the importance of official reserves is reduced


Global Finance in Practice: China’s Twin Surpluses• China’s twin surpluses aka “double surplus” in the current

and financial accounts is highly unusual• Typically, these relationships are inverses of one another• The reason for the twin surpluses is due to the exceptional

growth of the Chinese economy


Account Balances for the U.S., 1992-2009 ($Bn)


China’s Twin Surplus, 1998-2009


Official Foreign Exchange Reserves• Between 2001 – 2010 China increased foreign exchange

reserves from $200 billion to $2,500 billion, more than a 10-fold increase

• China is now able to manage its currency to maintain competitiveness worldwide

• China can also maintain a relatively stable fixed exchange rate against other major currencies


China’s Foreign Exchange Reserves


2009 Foreign Exchange Reserves ($Bn)


Balance of Payments Interactions• A nation’s balance of payments interacts with nearly all of its

key macroeconomic variables:– Gross domestic product (GDP)– The exchange rate– Interest rates– Inflation rates


U.S. BOP, 1995-2005 ($Bn)


India's Current Account

Use the following India balance of payments data from the IMF (all items are for the current account) to answer questions 10 through 14.

10. What is India's balance on goods?11. What is India's balance on services?12. What is India's balance on goods and services?13. What is India's balance on goods, services and income?14. What is India's current account balance?

Assumptions (millions of US dollars) 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

Goods: exports 34,076 36,877 43,247 44,793 51,141 60,893 77,939 102,175 123,768 153,784 198,598 168,223Goods: imports -44,828 -45,556 -53,887 -51,212 -54,702 -68,081 -95,539 -134,692 -166,572 -208,611 -290,959 -247,040 Balance on goods -10,752 -8,679 -10,640 -6,419 -3,561 -7,188 -17,600 -32,517 -42,804 -54,827 -92,361 -78,817

Services: credit 11,691 14,509 16,684 17,337 19,478 23,902 38,281 52,527 69,730 86,929 104,215 90,598Services: debit -14,540 -17,271 -19,187 -20,099 -21,039 -24,878 -35,641 -47,287 -58,696 -70,805 -88,261 -80,996 Balance on services -2,849 -2,762 -2,503 -2,762 -1,561 -976 2,640 5,241 11,034 16,124 15,954 9,603

Income: credit 1,806 1,919 2,521 3,524 3,188 3,491 4,690 5,646 8,199 12,650 15,593 13,734Income: debit -5,443 -5,629 -7,414 -7,666 -7,097 -8,386 -8,742 -12,296 -14,445 -19,166 -18,891 -20,248 Balance on income -3,636 -3,710 -4,893 -4,142 -3,909 -4,895 -4,052 -6,650 -6,245 -6,516 -3,298 -6,514

Current transfers: credit 10,402 11,958 13,548 15,140 16,789 22,401 20,615 24,512 30,015 38,885 52,065 51,197Current transfers: debit -67 -35 -114 -407 -698 -570 -822 -869 -1,299 -1,742 -3,313 -2,095 Balance on current transfers 10,334 11,923 13,434 14,733 16,091 21,831 19,793 23,643 28,716 37,144 48,752 49,102

Questions 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

10. What is India's balance on goods? -10,752 -8,679 -10,640 -6,419 -3,561 -7,188 -17,600 -32,517 -42,804 -54,827 -92,361 -78,817

11. What is India's balance on services? -2,849 -2,762 -2,503 -2,762 -1,561 -976 2,640 5,241 11,034 16,124 15,954 9,603

12. What is India's balance on goods and services? -13,601 -11,441 -13,143 -9,181 -5,122 -8,164 -14,960 -27,276 -31,770 -38,703 -76,407 -69,215

13. What is India's balance on goods, services and income? -17,238 -15,151 -18,036 -13,323 -9,031 -13,059 -19,012 -33,926 -38,015 -45,219 -79,705 -75,728

14. What is India's current account balance? -6,903 -3,228 -4,601 1,410 7,060 8,772 780 -10,283 -9,299 -8,075 -30,952 -26,626


Balance of Payments Interactions

• In a static (accounting) sense, a nation’s GDP can be represented by the following equation:

GDP = C + I + G + X – M

C = consumption spendingI = capital investment spendingG = government spendingX = exports of goods and servicesM = imports of goods and services

X – M = Current account balance


The Balance of Payments and Exchange Rates• A country’s BOP can have a significant impact on the level of

its exchange rate and vice versa depending on that country’s exchange rate regime

• The effect of an imbalance in the BOP of a country works somewhat differently depending on whether that country has fixed exchange rates, floating exchange rates, or a managed exchange rate system– Under a fixed exchange rate system the government bears the

responsibility to assure a BOP near zero– Under a floating exchange rate system, the government of a country

has no responsibility to peg its foreign exchange rate


• The relationship between BOP and exchange rates can be illustrated by use of a simplified equation:

CI = capital inflowsCO = capital outflowsFI = financial inflowsFO = financial outflowsFXB = official monetary reserves

The Balance of Payments and Exchange Rates

Current Account Balance (X-M)

Capital Account Balance (CI - CO)

FinancialAccount Balance (FI - FO)

ReserveBalance

(FXB)

Balance ofPaymentsBOP++ + =


The Balance of Payments and Interest Rates• Apart from the use of interest rates to intervene in the foreign

exchange market, the overall level of a country’s interest rates compared to other countries does have an impact on the financial account of the balance of payments

• Relatively low interest rates should normally stimulate an outflow of capital seeking higher interest rates in other country-currencies

• In the U.S. however, the opposite has occurred as a result of attractive growth rate prospects, high levels of productive innovation, and perceived political stability


The Balance of Payments and Inflation Rates• Imports have the potential to lower a country’s inflation rate• In particular, imports of lower priced goods and services

places a limit on what domestic competitors charge for comparable goods and services


Trade Balances and Exchange Rates• A simple concept in principle: Changes in exchange rates

changes the relative prices of imports and exports which in turn result in changes in quantities demanded

• In reality the process is less straight-forward


The J-Curve Adjustment Path• Trade balance adjustment occurs in three stages over a

varying and often lengthy period of time1. The currency contract period

– Adjustment is uncertain due to existing contracts that must be fulfilled2. The pass-through period

– Importers and exporters must eventually pass along the cost changes3. Quantity adjustment period

– The expected balance of trade is eventually realized

– U.S. trade balance = (P$xQx) – (S$/fc Pfc

M QM)


The J-CurveTrade Balance Adjustment to Exchange Rate Changes


MNCs are exposed to risk from exchange rates

Resulting from Market ForcesEconomic

Exposure

Purely Accounting Based

Resulting from Accounting


Foreign Exchange Exposure• Foreign exchange exposure is a measure of the potential

for a firm’s profitability, net cash flow, and market value to change because of a change in exchange rates– These three components (profits, cash flow and market value) are

the key financial elements of how we view the relative success or failure of a firm

– While finance theories tell us that cash flows matter and accounting does not, we know that currency-related gains and losses can have destructive impacts on reported earnings – which are fundamental to the markets opinion of that company


Types of Foreign Exchange Exposure

• Transaction Exposure – measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rate changes

• Translation Exposure – the potential for accounting derived changes in owner’s equity to occur because of the need to “translate” financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements

• Operating Exposure – measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates


Why Hedge?

• Hedging protects the owner of an asset (future stream of cash flows) from loss

• However, it also eliminates any gain from an increase in the value of the asset hedged against

• Since the value of a firm is the net present value of all expected future cash flows, it is important to realize that variances in these future cash flows will affect the value of the firm and that at least some components of risk (currency risk) can be hedged against

• Companies must first decide what they are trying to accomplish through their hedging program.


Why Hedge - the Pros & Cons

• Proponents of hedging give the following reasons:– Reduction in risk in future cash flows improves the planning capability of

the firm– Reduction of risk in future cash flows reduces the likelihood that the

firm’s cash flows will fall below a necessary minimum– Management has a comparative advantage over the individual investor

in knowing the actual currency risk of the firm– Markets are usually in disequilibirum because of structural and

institutional imperfections


Why Hedge - the Pros & Cons• Opponents of hedging give the following reasons:

– Shareholders are more capable of diversifying risk than the management of a firm; if stockholders do not wish to accept the currency risk of any specific firm, they can diversify their portfolios to manage that risk, investors have already factored the foreign exchange effect into a firm’s market valuation

– Currency risk management does not increase the expected cash flows of a firm; currency risk management normally consumes resources thus reducing cash flow

– The expected NPV of hedging is zero (Managers cannot outguess the market; markets are in equilibrium with respect to parity conditions)

– Management’s motivation to reduce variability is sometimes driven by accounting reasons; management may believe that it will be criticized more severely for incurring foreign exchange losses in its statements than for incurring similar or even higher cash cost in avoiding the foreign exchange loss

– Management often conducts hedging activities that benefit management at the expense of shareholders


Hedging’s Impact on Expected Cash Flows of the Firm


Measurement of Transaction Exposure• Transaction exposure measures gains or losses that arise

from the settlement of existing financial obligations, namely– Purchasing or selling on credit goods or services when prices are

stated in foreign currencies– Borrowing or lending funds when repayment is to be made in a foreign

currency– Being a party to an unperformed forward contract and – Otherwise acquiring assets or incurring liabilities denominated in

foreign currencies


Purchasing or Selling on Open Account• Suppose Caterpillar sells merchandise on open account to a

Belgian buyer for €1,800,000 payable in 60 days• Further assume that the spot rate is $1.2000/€ and

Caterpillar expects to exchange the euros for €1,800,000 x $1.2000/€ = $2,160,000 when payment is received– Transaction exposure arises because of the risk that Caterpillar will

something other than $2,160,000 expected– If the euro weakens to $1.1000/€, then Caterpillar will receive

$1,980,000– If the euro strengthens to $1.3000/€, then Caterpillar will receive

$2,340,000


Purchasing or Selling on Open Account

• Caterpillar might have avoided transaction exposure by invoicing the Belgian buyer in US dollars (risk shifting), but this might have lead to Caterpillar not being able to book the sale

• If the Belgian buyer agrees to pay in dollars, Caterpillar has transferred the transaction exposure to the Belgian buyer whose dollar account payable has an unknown euro value in 60 days


The Life Span of a Transaction Exposure


Borrowing and Lending• A second example of transaction exposure arises when funds

are loaned or borrowed• Example: PepsiCo’s largest bottler outside the US is located

in Mexico, Grupo Embotellador de Mexico (Gemex)– On 12/94, Gemex had US dollar denominated debt of $264 million– The Mexican peso (Ps) was pegged at Ps$3.45/US$– On 12/22/94, the government allowed the peso to float due to internal

pressures and it sank to Ps$4.65/US$. In January it reached Ps$5.50


Borrowing and Lending• Gemex’s peso obligation now looked like this

– Dollar debt mid-December, 1994:• US$264,000,000 Ps$3.45/US$ = Ps$910,800,000

– Dollar debt in mid-January, 1995:• US$264,000,000 Ps$5.50/US$ = Ps$1,452,000,000

– Dollar debt increase measured in Ps • Ps$541,200,000

• Gemex’s dollar obligation increased by 59% due to transaction exposure


Other Causes of Transaction Exposure• When a firm buys a forward exchange contract, it deliberately

creates transaction exposure; this risk is incurred to hedge an existing exposure– Example: US firm wants to offset transaction exposure of ¥100 million

to pay for an import from Japan in 90 days– Firm can purchase ¥100 million in forward market to cover payment in

90 days


Contractual Hedges• Transaction exposure can be managed by contractual, operating, or

financial hedges• The main contractual hedges employ forward, money, futures and

options markets• Operating and financial hedges use risk-sharing agreements, leads

and lags in payment terms, swaps, and other strategies• A natural hedge refers to an offsetting operating cash flow, a payable

arising from the conduct of business• A financial hedge refers to either an offsetting debt obligation or

some type of financial derivative such as a swap


Risk Management in Practice• Which Goals?

– The treasury function of most firms is usual considered a cost center; it is not expected to add to the bottom line

– However, in practice some firms’ treasuries have become aggressive in currency management and act as though they were profit centers

• Which Exposures?– Transaction exposures exist before they are actually booked yet some

firms do not hedge this backlog exposure– However, some firms are selectively hedging these backlog

exposures and anticipated exposures


Risk Management in Practice• Which Contractual Hedges?

– Transaction exposure management programs are generally divided along an “option-line;” those which use options and those that do not

– Also, these programs vary in the amount of risk covered; these proportional hedges are policies that state which proportion and type of exposure is to be hedged by the treasury


Translation Exposure

• Translation exposure arises because the financial statements of foreign subsidiaries must be restated in the parent’s reporting currency for the firm to prepare its consolidated financial statements

• Translation exposure is the potential for an increase or decrease in the parent’s net worth and reported income caused by a change in exchange rates since the last transaction

• Translation methods differ by country along two dimensions– One is a difference in the way a foreign subsidiary is

characterized depending on its independence – The other is the definition of which currency is most important

for the subsidiary


Subsidiary Characterization• Most countries specify the translation method to be used by a

foreign subsidiary based upon its operations• A foreign subsidiary can be classified as

– Integrated Foreign Entity – one which operates as an extension of the parent company, with cash flows and line items that are highly integrated with the parent

– Self-sustaining Foreign Entity – one which operates in the local economy independent of its parent

• The foreign subsidiary should be valued in terms of the currency that is the basis of its economic viability


Functional Currency• A foreign affiliate’s functional currency is the currency of

the primary economic environment in which the subsidiary operates

• The geographic location of a subsidiary and its functional currency can be different– Example: US subsidiary located in Singapore may find that its

functional currency could be• US dollars (integrated subsidiary)• Singapore dollars (self-sustaining subsidiary)• British pounds (self-sustaining subsidiary)


Translation Methods

• There are four principal translation methods available: the current/noncurrent method, the monetary/nonmonetary method, the temporal method, and the current‑rate method.

• The two most used the translation of foreign subsidiary financial statements are– The current rate method – The temporal method

• Regardless of which is used, either method must designate– The exchange rate at which individual balance sheet and income

statement items are remeasured– Where any imbalances are to be recorded

• This can affect either the balance sheet or the income statement


Summary of Translation Methods

• Current Rate Method – Everything uses the current rate

• Current/ NonCurrent Method – CA & CL at current rate – All others at Historic Rate

• Monetary/ NonMonetary Method – Monetary assets at current rate – NonMonetary assets at historic rate

• Temporal Method – Like Mon/NonMon, but Inventory is translated at Current rate

(only if inventory is at Market Cost)


Summary of Translation Methods

• A few pointers:– Cash & A/R: Current rate for all methods – Inventory (@ mkt): Current rate for all except Mon/NonMon – Fixed Assets: Historic rate for all except current rate method – Curr Liabilities: Current rate for all methods – LT Debt: Current rate for all except Curr/NonCurr– Equity: plug – Translation Gain (Loss): Difference in Equity (Historic vs Method)


Current Rate Method

• Under this method all financial statement items are translated at the “current” exchange rate

• Assets & liabilities – are translated at the rate of exchange in effect on the balance sheet date

• Income statement items – all items are translated at either the actual exchange rate on the dates the various revenues, expenses, gains and losses were incurred or at a weighted average exchange rate for the period

• Distributions – dividends paid are translated at the rate in effect on the date of payment

• Equity items – common stock and paid-in capital are translated at historical rates; year end retained earnings consist of year-beginning plus or minus any income or loss on the year


Current Rate Method

• Any gain or loss from re-measurement is closed to an equity reserve account entitled the cumulative translation adjustment, rather than through the company’s consolidated income statement

• These cumulative gains and losses from remeasurement are only recognized in current income under the current rate method when the foreign subsidiary giving rise to that gain or loss is liquidated


Temporal Method• Under this method, specific assets and liabilities are

translated at exchange rates consistent with the timing of the item’s creation

• The temporal method assumes that a number of line items such as inventories and net plant and equipment are restated to reflect market value

• If these items were not restated and carried at historical costs, then the temporal method becomes the monetary/non-monetary method


Temporal Method• Line items included in this method are

– Monetary assets (primarily cash, accounts receivable, and long-term receivables) and all monetary liabilities are translated at current exchange rates

– Non-monetary assets (primarily inventory and plant and equipment) are translated at historical exchange rates

– Income statement items – are translated at the average exchange rate for the period except for depreciation and cost of goods sold which are associated with non-monetary items, these items are translated at their historical rate


Temporal Method• Line items included in this method are

– Distributions – dividends paid are translated at the exchange rate in effect the date of payment

– Equity items – common stock and paid-in capital are translated at historical rates; year end retained earnings consist of year-beginning plus or minus any income or loss on the year plus or minus any imbalance from translation

• Under the temporal method, any gains or losses from remeasurement are carried directly to current consolidated income and not to equity reserves


US Translation Procedures

• The US differentiates foreign subsidiaries on the basis of functional currency, not subsidiary characterization. Translation methods are mandated in FASB‑8 and FASB‑52.

• Regardless of the translation method selected, measuring accounting exposure is conceptually the same. It involves determining which foreign currency‑denominated assets and liabilities will be translated at the current (postchange) exchange rate and which will be translated at the historical (prechange) exchange rate. The former items are considered to be exposed, while the latter items are regarded as not exposed. Translation exposure is just the difference between exposed assets and exposed liabilities.

• By far the most important feature of the accounting definition of exposure is the exclusive focus on the balance sheet effects of currency changes. This focus is misplaced since it has led firms to ignore the more important effect that these changes may have on future cash flows.


Managing Translation Exposure• Balance Sheet Hedge – this requires an equal amount of

exposed foreign currency assets and liabilities on a firm’s consolidated balance sheet– A change in exchange rates will change the value of exposed assets

but offset that with an opposite change in liabilities– This is termed monetary balance– The cost of this method depends on relative borrowing costs in the

varying currencies


Managing Translation Exposure• When is a balance sheet hedge justified?

– The foreign subsidiary is about to be liquidated so that the value of its CTA would be realized

– The firm has debt covenants or bank agreements that state the firm’s debt/equity ratios will be maintained within specific limits

– Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains

– The foreign subsidiary is operating in a hyperinflationary environment


Choosing Which Exposure to Minimize• As a general matter, firms seeking to reduce both types of

exposures typically reduce transaction exposure first• They then recalculate translation exposure and then decide if

any residual translation exposure can be reduced without creating more transaction exposure


Operating Exposure

• The change in company value resulting from changes in future operating cash flows caused by an unexpected change in exchange rates.

• Because the value of a firm is equal to the present value of future cash flows, accounting measures of exposure that are based on changes in the book values of foreign currency assets and liabilities need bear no relationship to reality.

• Because currency changes are usually preceded by or accompanied by changes in relative price levels between two countries, it is impossible to determine exposure to a given currency change without considering simultaneously the offsetting effects of these price changes.


Operating Exposure

• The primary exposure management objective of financial executives should be to arrange their firm's finances in such a way as to minimize the real effects of exchange rate changes.

• The major burden of coping with exchange risk must be borne by the marketing and production people

– They deal in imperfect product and factor markets where their specialized knowledge provides a real advantage.

– Their role is to design marketing and production strategies to deal with exchange risks.

– The appropriate marketing and production strategies are similar to those that would be suitable for any firm confronted with shifting relative output or input prices caused by any economic, political, or social factors.

• Measuring the operating of a firm requires forecasting and analyzing all the firm’s future individual transaction exposures together with the future exposure of all the firm’s competitors and potential competitors

• This long term view is the objective of operating exposure analysis


Operating Exposure

• Exchange rate changes do not always increase the riskiness of multinational corporations.

– Purchasing Power Parity tells us devaluations (or revaluations) are usually preceded by higher (or lower) rates of inflation, therefore we should not evaluate only the devaluation phase of an inflation‑devaluation cycle.

– Nominal currency changes smooth out the profit peaks and valleys caused by differing rates of inflation. Devaluations or revaluations should actually reduce earnings variability for MNCs. Only if currency changes involve real exchange rate changes does risk increase.

• Domestic firms are also subject to exchange rate risk, not just MNCs

– Domestic facilities that supply foreign markets normally entail much greater exchange risk than foreign facilities supplying local markets (because material and labor used in a domestic plant are paid for in the home currency while the products are sold in a foreign currency).

– A purely domestic company selling locally but facing import competition may be seriously hurt (helped) by the devaluation (revaluation) of a competitor's home currency.


Managing Exchange Risk• Since currency risk affects all facets of a firm's operations, it should not be the

concern of financial managers alone.• Operating managers should develop marketing & production initiatives that help to

ensure profitability over the long run. They should also devise anticipatory strategic alternatives in order to gain competitive leverage internationally.

• The key to effective exposure management is to integrate currency considerations into the general management process.

• Managers trying to cope with actual or anticipated exchange rate changes must first determine whether the exchange rate change is real or nominal. Nominal changes can be ignored. Real changes must be responded to.

• If real, the manager must first assess the permanence of the change. In general, real exchange rate movements that narrow the gap between the current rate and the equilibrium rate are likely to be longer lasting than are those that widen the gap. Neither, however, will be permanent. Rather, there will be a sequence of equilibrium rates, each of which has its own implications for the firm's marketing and production strategies.


Integrated Exchange Risk Program• The role of the financial executive in an integrated exchange

risk program is fourfold• to provide local operating management with forecasts of inflation and

exchange rates• to identify and highlight the risks of competitive exposure• to structure evaluation criteria such that operating managers are not

rewarded or penalized for the effects of unanticipated real currency changes

• to estimate and hedge whatever real operating exposure remains after the appropriate marketing and production strategies have been put in place.


Expected Versus Unexpected Changes in Cash Flows• Operating exposure is far more important for the long-run

health of a business than changes caused by transaction or translation exposure– Planning for operating exposure is total management responsibility

since it depends on the interaction of strategies in finance, marketing, purchasing, and production

– An expected change in exchange rates is not included in the definition of operating exposure because management and investors should have factored this into their analysis of anticipated operating results and market value


Measuring Operating Exposure

• Short Run - The first-level impact is on expected cash flows in the 1-year operating budget. The gain or loss depends on the currency of denomination of expected cash flows. These are both existing transaction exposures and anticipated exposures. The currency of denomination cannot be changed for existing obligations

• Medium Run Equilibrium - The second-level impact is on expected medium-run cash flows, such as those expressed in 2- to 5-year budgets

• Medium Run: Disequilibrium. The third-level impact is on expected medium-run cash flows assuming disequilibrium conditions. In this case, the firm may not be able to adjust prices and costs to reflect the new competitive realities caused by a change in exchange rates

• Long Run. The fourth-level impact is on expected long-run cash flows, meaning those beyond five years. At this strategic level, a firm’s cash flows will be influenced by the reactions of both existing and potential competitors, possible new entrants, to exchange rate changes under disequilibrium conditions


Strategic Management of Operating Exposure

• The objective of both operating and transaction exposure management is to anticipate and influence the effect of unexpected changes in exchange rates on a firm’s future cash flows

• To meet this objective, management can diversify the firm’s operating and financing base

• Management can also change the firm’s operating and financing policies


Diversifying Operations

• Diversifying operations means diversifying the firm’s sales, location of production facilities, and raw material sources

• If a firm is diversified, management is prepositioned to both recognize disequilibrium when it occurs and react competitively

• Recognizing a temporary change in worldwide competitive conditions permits management to make changes in operating strategies


Diversifying Financing• Diversifying the financing base means raising funds in more

than one capital market and in more than one currency• If a firm is diversified, management is prepositioned to take

advantage of temporary deviations from the International Fisher effect


Proactive Management of Operating Exposure• Operating and transaction exposures can be partially

managed by adopting operating or financing policies that offset anticipated currency exposures

• Six of the most commonly employed proactive policies are– Matching currency cash flows– Risk-sharing agreements– Back-to-back or parallel loans– Currency swaps– Leads and lags– Reinvoicing centers


Matching Currency Cash Flows• One way to offset an anticipated continuous long exposure to

a particular currency is to acquire debt denominated in that currency

• This policy results in a continuous receipt of payment and a continuous outflow in the same currency

• This can sometimes occur through the conduct of regular operations and is referred to as a natural hedge


Debt Financing as a Financial Hedge


Currency Clauses: Risk-sharing• Risk-sharing is a contractual arrangement in which the buyer

and seller agree to “share” or split currency movement impacts on payments– Example: Ford purchases from Mazda in Japanese yen at the current

spot rate as long as the spot rate is between ¥115/$ and ¥125/$. – If the spot rate falls outside of this range, Ford and Mazda will share

the difference equally– If on the date of invoice, the spot rate is ¥110/$, then Mazda would

agree to accept a total payment which would result from the difference of ¥115/$- ¥110/$ (i.e. ¥5)


22.222,222$¥112.50/$

0¥25,000,00

2¥5.00/$ - ¥115.00/$

0¥25,000,00

Currency Clauses: Risk-sharing• Ford’s payment to Mazda would therefore be

• Note that this movement is in Ford’s favor, however if the yen depreciated to ¥130/$ Mazda would be the beneficiary of the risk-sharing agreement


Back-to-Back Loans• A back-to-back loan, also referred to as a parallel loan or

credit swap, occurs when two firms in different countries arrange to borrow each other’s currency for a specific period of time– The operation is conducted outside the FOREX markets, although

spot quotes may be used– This swap creates a covered hedge against exchange loss, since

each company, on its own books, borrows the same currency it repays


Cross-Currency Swaps• Cross-Currency swaps resemble back-to-back loans except

that it does not appear on a firm’s balance sheet• In a currency swap, a dealer and a firm agree to exchange an

equivalent amount of two different currencies for a specified period of time– Currency swaps can be negotiated for a wide range of maturities

• A typical currency swap requires two firms to borrow funds in the markets and currencies in which they are best known or get the best rates


Cross-Currency Swaps

• For example, a Japanese firm exporting to the US wanted to construct a matching cash flow swap, it would need US dollar denominated debt

• But if the costs were too great, then it could seek out a US firm who exports to Japan and wanted to construct the same swap

• The US firm would borrow in dollars and the Japanese firm would borrow in yen

• The swap-dealer would then construct the swap so that the US firm would end up “paying yen” and “receiving dollars” be “paying dollars” and “receiving yen”

• This is also called a cross-currency swap


Using Cross Currency Swaps


Contractual Approaches

• Some MNEs now attempt to hedge their operating exposure with contractual strategies

• These firms have undertaken long-term currency option positions hedges designed to offset lost earnings from adverse changes in exchange rates

• The ability to hedge the “unhedgeable” is dependent upon predictability– Predictability of the firm’s future cash flows– Predictability of the firm’s competitor responses to exchange rate

changes• Few in practice feel capable of accurately predicting competitor

response, yet some firms employ this strategy


Capital Mobility

• The degree to which capital moves freely cross-border is critically important to a country’s balance of payments

• Historical patterns of capital mobility– 1860-1914 – period characterized by continuously increasing capital

openness as more countries adopted the gold standard and expanded international trade relations

– 1914-1945 – period of global economic destruction due to two world wars and a global depression

– 1945-1971 – Bretton Woods era, saw great expansion of international trade in goods and services

– 1971-2002 – period characterized by floating exchange rates, economic volatility, but rapidly expanding cross-border capital flows


The Evolution of Capital Mobility


Capital Flight“International flows of direct and portfolio investments under ordinary circumstances are rarely associated with the capital flight phenomenon. Rather, it is when capital transfers by residents conflict with political objectives that the term “flight” comes into general usage.”

—Ingo Walter, Capital Flight and Third World Debt


Capital Flight• Five primary mechanisms exist by which capital may be

moved from one country to another:– Transfers via the usual international payments mechanisms, regular

bank transfers are easiest, cheapest and legal– Transfer of physical currency by bearer (smuggling) is more costly,

and for many countries illegal– Transfer of cash into collectibles or precious metals, which are then

transferred across borders– Money laundering, the cross-border purchase of assets which are

then managed in a way that hide the movement of money and its owners

– False invoicing on international trade transactions


Currency Market Intervention• Foreign currency intervention, the active management, manipulation, or

intervention in the market’s valuation of a country’s currency, is a component of currency valuation and forecast that cannot be overlooked.

• Central bank’s driving consideration – inflation or unemployment?• “beggar-thy-neighbor,” policy to keep currency values low to aid in

exports, may prove inflationary if some goods MUST be imported … e.g. oil


Currency Market Intervention• Direct Intervention - This is the active buying and selling of the domestic

currency against foreign currencies. This traditionally required a central bank to act like any other trader in the currency market

• Coordinated Intervention - in which several major countries, or a collective such as the G8 of industrialized countries, agree that a specific currency’s value is out of alignment with their collective interests

• Indirect Intervention - This is the alteration of economic or financial fundamentals which are thought to be drivers of capital to flow in and out of specific currencies


Currency Market Intervention• Capital Controls - This is the restriction of access to foreign

currency by government. This involves limiting the ability to exchange domestic currency for foreign currency– The Chinese regulation of access and trading of the Chinese yuan is

a prime example over the use of capital controls over currency value.


Disequilibria: Exchange Rates in Emerging Markets

• Although the three different schools of thought on exchange rate determination make understanding exchange rates appear to be straightforward, that is rarely the case

• The problem lies not in the theories but in the relevance of the assumptions underlying each theory

• After several years of relative global economic tranquility, the second half of the 1990s was racked by a series of currency crises which shook all emerging markets– The Asian crisis of July 1997– The Argentine crisis (1998 – 2002)


The Asian Crisis – July 1997• The roots of the Asian crisis extended from a fundamental

change in the economies of the region, the transition of many Asian countries from being net exporters to net importers

• Starting in 1990 in Thailand, the rapidly expanding economies of the Far East began importing more than they were exporting, requiring major net capital inflows to support their currencies– As long as capital kept flowing in, the currencies were stable, but if

this inflow stopped then the governments would not be able to support their fixed currencies


The Asian Crisis – July 1997• The most visible roots of the crisis were in the excesses of

capital inflows into Thailand in 1996 and 1997• Thai banks, firms and finance companies had ready access

to capital and found US dollar denominated debt at cheap rates

• Banks continued to extend credits and as long as the capital inflows were still coming, the banks, firms, and government was able to support these credit extensions abroad


The Asian Crisis – July 1997• After some time, the Thai Baht came under attack due to the country’s

rising debt• The Thai government intervened in the foreign exchange markets

directly to try to defend the Baht by selling foreign reserves and indirectly by raising interest rates

• This caused the Thai markets to come to a halt along with massive currency losses and bank failures

• On July 2, 1997 the Thai central bank allowed the Baht to float and it fell over 17% against the dollar and 12% against the Japanese Yen– By November 1997, the baht fell 38% against the US dollar


The Asian Crisis – July 1997• Within days, other Asian countries suffered from the contagion effect

from Thailand’s devaluation• Speculators and capital markets turned towards countries with similar

economic traits as Thailand and their currencies fell under attack• In late October, Taiwan caught the markets off-guard with a 15%

devaluation and this only added to the momentum– The Korean Won fell from WON900/$ to WON1100/$ (18.2%)– The Malaysian ringgit fell 28.6% and the Filipino peso fell 20.6%

against the dollar• The only currencies that were not severely affected were the Hong

Kong dollar and the Chinese renminbi


The Thai Baht and the Asian Crisis


The Asian Crisis – July 1997• The Asian currency crisis was more than just a currency

collapse• Although the varying countries were different they did have

similar characteristics which allow comparison– Corporate socialism – Post WWII Asian companies believed that

their governments would not allow them to fail, thus they engaged in practices, such as lifetime employment, that were no longer sustainable


The Asian Crisis – July 1997– Corporate governance – Most companies in the Far East were often

largely controlled by either families or groups related to the governing body or party of that country

• This was labeled cronyism and allowed the management to ignore the bottom line at times when this was deteriorating

– Banking liquidity and management – Although bank regulatory structures and markets have been deregulated across the globe, their central role in the conduct of business has been ignored

• As firms collapsed, government coffers were emptied and investments made by banks failed

• The banks became illiquid and they could no longer support companies’ need for capital


The Russian Crisis of 1998• 1995 – 1998 Russian govt and nongovt borrowing very high, servicing the

debt becomes difficult• Russian exports are mostly commodity-based and world commodity

prices drop as a result of the Asian crisis of 1997 – thus, Russian exports values decline

• The Ruble was under a managed float with a band of 1.5% and most days the Russian Central Bank is forced to enter the market to buy rubles

• The August Collapse – Currency reserves had fallen, Russia announces it will raise an extra $1 billion in foreign bonds to help pay for rising debt


The Russian Crisis of 1998• The August Collapse – Russian stocks drop by 5% on August 10 on

fears that China would cut its currency value – Russia claims they will not devalue the Ruble then at RUB6.3/USD

• August 17, the ruble is devalued by 34% by the 26th the Ruble is down to RUB13/USD

• Exhibit 9.3 traces the fall of the Russian Ruble


The Fall of the Russian ruble


The Argentine Crisis - 2002• In 1991 the Argentine peso had been fixed to the U.S. dollar

at a one-to-one rate of exchange• This policy was a radical departure from traditional methods

of fixing the rate of a currency’s value• Argentina adopted a currency board, which was a structure

rather than just a commitment, to limiting the growth of money in the economy

• Under a currency board, the central bank of a country may increase the money supply in the banking system only with increases in its holdings of hard currency reserves


The Argentine Crisis - 2002• By removing the ability of government to expand the rate of

growth of the money supply, Argentina believed it was eliminating the source of inflation which had devastated its standard of living

• The idea was to limit the rate of growth in the country’s money supply to the rate at which the country receives net inflows of U.S. dollars as a result of trade growth and general surplus


The Collapse of the Argentine peso


The Argentine Crisis - 2002• A recession that began in 1998, as a result of a restrictive

monetary policy, continued to worsen by 2001 and revealed three very important problems with Argentina’s economy:– The Argentine peso was overvalued– The currency board regime had eliminated monetary policy

alternatives for macroeconomic policy– The Argentine government budget deficit – and deficit spending – was

out of control


The Argentine Crisis - 2002• While the value of the peso had been stabilized, inflation had

not been eliminated• The inability of the peso’s value to change with market forces

led many to believe increasingly that it was overvalued• Argentine exports became some of the most expensive in all

of South America as other countries saw their currencies slide marginally against the dollar over the past decade while the peso did not


The Argentine Crisis - 2002• Because the currency board eliminated expansionary

monetary policy as a means to stimulate economic growth in Argentina, the Argentine government was left with only fiscal policy as a means to this end

• The Argentine government continued to spend as a means to quell increasing social and political tensions and unrest, but without the benefit of increasing (or even stable) tax receipts

• Continued government spending and the injection of foreign capital into the country steadily increased the debt burden


The Argentine Crisis - 2002• Many began to fear an impending devaluation, removing their peso

denominated funds (as well as U.S. dollar funds) from Argentine banks

• Capital flight as well as rampant conversion of peso holdings into U.S. dollar deposits put additional pressure on the value of the peso

• On Sunday January 6, 2002, in the first act of his presidency (the fifth president in two weeks), President Eduardo Duhalde devalued the peso from Ps 1.00/$ to Ps 1.40/$

• On February 3, 2002, the government announced that the peso would be floated, beginning a slow but gradual depreciation


The Greek Crisis – 201X?• In early 2000s, Greece was managing to a large budget deficit and relying on a

healthy global economy to feed two main industries: Shipping and Tourism. In 2001, Greece transitioned away from its sovereign currency to the Euro.

• By 2010, concerns about Greece’s national debt suggested emergency bailouts might be necessary. Germany refused to endorse the loan until a series of austerity measures were announced.

• In May 2010, Eurozone countries and the IMF agreed to a three year €110 billion loan at 5.5% interest, conditional on the implementation of austerity measures.

• Changes to the ruling government of Greece and rioting protestors showed evidence at the dissatisfaction of the Greek people with the circumstances.


The Greek Crisis – 201X?• In 2011, Eurozone leaders changed the terms of the Greek loan package to

extend the payback period and reduce the interest rate to 3.5%. Also, eurozone leaders and the IMF also came to an agreement with banks to accept a write-off of €100 billion of Greek debt, reducing the country's debt level from €340bn to €240bn or 120% of GDP by 2020.

• In 2012, the second bailout package from July 2011 was extended from €109 billion to €130 billion

• One current opinion is the best option for Greece (and the rest of the EU), would be to create an “orderly default” on Greece’s public debt. In this case, Greece would withdraw simultaneously from the eurozone and reintroduce its national currency the drachma at a debased rate. This might lead to a 60% devaluation of the new drachma. Critics also point to political and financial instability leading to hyperinflation, civil unrest and possibly a forcible overthrow of the current government.

international finance fin456 ♦ summer 2013 michael dimond

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