mf0006 -interantion finance

8/8/2019 MF0006 -Interantion Finance

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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 acrossthe 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 othercountries. Often 30% or more of sales and profits of multinationals are generated outsidenational borders. A typical multinational company consists of a parent company located in thehome country and at least five or six foreign subsidiaries, with a high degree of strategicinteraction 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 justan export business) and is engaged in the active management of these off-shore assets (it is notjust holding a passive financial portfolio).

MNCs are a recent phenomenon (mainly after World War II) and they affect all the sectors ofactivity (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 thepossible reasons are:


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To broaden markets: Saturated home markets ask for market development abroad (CocaCola, Mac Donalds etc.). Multinationals seek new markets to fill product gaps in foreignmarkets 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 alsoseekto obtain easy access to oilexploration, mining, and manufacturing in many developing nations.

To seek new technologies: Multinationalsseek leading scientific and design ideas.

To seek production efficienciesby shifting to low cost regions (GE).

To avoid political hurdles such as import quota, regulatory measures of governments, tradebarriers, etc.

To diversify i.e. tocushion 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 undera diverse pattern of consumerpreferences, 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 allowcompanies new competitive strategic options.

Currency fluctuations (foreign exchange risk): Theeconomic performance of a multinationalis 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 countrys inflation rate will decrease its currentaccount, as imports increase and exports decrease.


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Impact of National Income: A relative increase in a countrys income level will decrease itscurrent account, as imports increase.

Impact of Government Restrictions: A government may reduce its countrys imports byimposing 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 countrys currency begins to rise in value, its current accountbalance 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 ofreturn 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 capitalcontrols and other barriers to financial transactions in countries across the world.

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

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

Changes in Restrictions: New opportunities may arise from the removal of governmentbarriers.

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

Potential Economic Growth: Countries that have higher potential for economic growth aremore attractive.

Tax Rates: Countries that impose relatively low tax rates on corporate earnings are more likelyto attract FDI.


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Exchange Rates: Firms typically prefer to invest in countries where the local currency isexpected to strengthen against their own.

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

Tax Rates on Interest or Dividends: Investors will normally prefer countries where the taxrates 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 tostrengthen.

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 estimatedworldwide turnover of this market is at around $1 trillion a day, which is several times thelevel of turnover in the U.S. Government securities market, which is the worlds second largestfinancial market. The turnover in the foreign exchange market is equivalent to more than $200 inforeign 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 $200million to $500 million can take place. The quoted prices change as often as 20 times a minutefor active currencies. It has been estimated that the worlds most active exchange rates canchange up to 18,000 times during a single day.

Almost two-third of the $1 trillion per day trade represents transactions among the dealersthemselves 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 marketoften leads to multiple further transactions, sometimes over an extended period, as the dealerinstitutions 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 exchangetrading takes place in the United Kingdom, even though that nations currency the poundsterling is less widely traded in the market than several other currencies. The United Kingdomaccounts for about 32 percent of the global total of the foreign exchange transactions; the UnitedStates is second with about 18 percent, Japan is third with 8 percent and Singapore is fourth with7 percent of the worldwide foreign exchange transactions.


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In foreign exchange trading, London benefits from its geographical location and time zone. Inaddition to being open when the numerous other financial centers in Europe are open, Londonsmorning hours overlap with the late hours in a number of Asian and Middle East markets;Londons afternoon sessions correspond to the morning periods in the large North Americanmarket.

The foreign exchange market is a twenty four hour market. Each business day arrives first in thefinancial centers of Asia-Pacific first Wellington, then Sydney followed by Tokyo, HongKong, 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 thebusiness day in Tokyo, markets open for business in Europe. When it is early afternoon inEurope, trading in New York and other U.S. centers begin. Finally, completing the circle, whenit 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 andother market participants therefore, must be alert to the possibility that a sharp move in anexchange rate can occur during an off hour, elsewhere in the world. The large dealing institutionshave thus introduced various arrangements for monitoring markets and trading on a twenty-fourhour 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 anexchange-tradedsegment of the market. The OTCmarket is an international OTC network ofmajor dealers mainly but not exclusively banks operating in financial centers around theworld, trading with each other and with customers, via computers, telephones, and other means.

The exchange-tradedmarket covers trade in a limited number of foreign exchange products onthe 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, andFX swaps) as wellas the more recently introduced (post-1970) OTC products (currency options and currencyswaps). On the organized exchanges, foreign exchange products traded are currency futuresand certain currency options.

OTC Market and Exchanges: Main Instruments

Spot: A spot transaction is a straightforward (or outright) exchange of one currency foranother. The spot rate is the current market price. Spot transactions do not require immediatesettlement, or payment on the spot. By convention, the settlement date, or value date, is thesecondbusiness day after the deal date (or trade date) on which the transaction is agreedupon by the two traders.

Forward: An outright forward transaction, like a spot transaction, is a straightforward singlepurchase/ sale of one currency for another. The only difference between the two is that the spot is


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settled, or delivered, on a value date not later than two business days after the deal date, whereasoutright forwardis 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 afuture 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 thenswapped back, creating an exchange and a re-exchange. An FX swap has two separate legswhere settlement is made on two different value dates, even though it is arranged as a singletransaction and is recorded in the turnover statistics as a single transaction. The twocounterparties 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 (thefar date). Effectively, it is a spot transaction and an outright forward transaction going inopposite directions, or else two outright forwards with different settlement dates, and going inopposite directions.

Currency Swap: A currency swapis different from the FX swap described above. In a typicalcurrency 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 forthe 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 specifiedprice on (in some cases, on or before) a specified date. Options are exercised only if it is in theholders interest to do so.

Foreign Currency Futures: Like the forward market, in the futures market, foreign exchangecan be bought or sold for future delivery. It serves the same general purpose, but there are manydifferences between forward and futures markets. Unlike the forwards which are traded on OTCmarkets, futures contracts are traded on an organized securities exchange. Also, unlike theforward contract, the quantity and the maturity date of the future contracts are standardized.


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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 internationalmonetary system. It encourages internationalization of businesses through surveillance, andfinancial and technical assistance. The purpose of surveillance is to prevent or manage financialcrises. Its financing facility attempts to reduce the impact of export instability on economies. Theresponsibilities 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 fromperiodic increases in this quota. The quotas determine a countrys voting power and the amountof 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 decreasein the value of one currency relative to another currency is known as depreciation (for a flexibleexchange rate system) or devaluation (for a fixed exchange rate system). An increase in the valueof one currency relative to another currency is known as appreciation (for a flexible exchangerate system) or revaluation (for a fixed exchange rate system).

Flexible Exchange Rate System


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Multinationals use forecasting models to forecast exchange rates. There are two types offorecast: market-based and model-based (Fundamental and Technical Analysis). Multinationalsalso 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 asforward rates, spot rates, and interest rates. It is based on the concept that these market indicatorsefficiently incorporate expected future currency changes. Multinationals often track changes inthe spot rate and then use these changes to estimate the future spot rate. It is often assumed thatthe current forward rate is a consensus forecast of the spot rate in the future. The forecasting offorward rates is limited to about one year since forward contracts for maturities beyond one yearhave low trading volumes and are not widely quoted. Multinationals use interest rate differentialto predict exchange rates beyond one year. The interest rates on risk-free instruments can be usedto determine what the forward rates should be according to Interest Rate Parity for long-termforecasting. 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. Thepolitical 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) orother corporations that might act in a political way. Political action has a direct bearing whenpolitical 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 politicalaction occurs when the political actors change the economic environment, the attitudes of thepopulation, or some other factor that then indirectly affects specific businesses. An example ofsuch indirect effect is when the local business lobbies the government against the entry offoreign companies.

Country risk and political risk are sometimes used interchangeably. Country risk comprises allthe 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 thebusiness 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 nationalgovernment.


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2) Creeping Expropriation: Creeping expropriation occurs when the government changes therules and makes profit impossible. An example: The host government may require that thecompany sell its products only to the local enterprises and that export opportunities are notpursued. This limits the profit potential of the company.

3) Contract Repudiation: Here, the terms of operating arrangements are changed orrenegotiated once their operations are in place and have proved successful. Thus additional taxesmay be imposed. Companies with large fixed investments are vulnerable due to the hostageeffect. They cannot credibly threaten to withdraw. Companies with stable technologies arevulnerable because locals could take over the operation without need for continuing foreigntechnology transfer.

4) Political Pressure in a Democratic System: Spread of democracy increases popular criticismof foreign investors. Opposition parties may use attacks on foreign investors as nationalisticposition to gain voter support (but pro-business opposition can also provide protection againstgovernment arbitrary policies, such as tariff increases). There is evidence to prove that business

grows faster under democracies even though many believe that suppressive authoritarian regimesare more favourable to business.

5) Threats from Local Business: Local business interests use political connections to securefavourable treatment over foreign companies or resist market liberalization. Many local businesspeople become wealthy during the period of protected markets and do not want to eliminateprotectionist policies. As a result of lobbying by local business, governments may require foreigninvestors to have local partners or make laws that keep foreigners entirely away from somecritical sectors or enact licensing procedures that delay investment. When liberalization occurs,local business still tries to create adverse political conditions. They try to prevent foreigncompanies from winning government contracts, or try to slow licensing and other approvals for

foreign companies to decrease their relative efficiency.

The multinationals interest in political risk lies in forecasting that risk so that it can be avoidedor managed. Assessment of political risk is the projection of possible losses that result fromgovernmental and societal sources. The goal of political risk assessment is to provide projectionsthat will guide the multinational in decision-making about investment, corporate strategy, andspecific business tactics.

Investors cannot always choose projects or countries where the risk is low and it is not possibleto insure against all risks. There are steps that the investor can take to reduce risk in a givenproject. The prudent investor takes advantage of available information and relationships tomanage 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.No independent action.

Develop a network with economic,political and social groups.

Reduce asset exposure and focus on Focus on all policy levels (national,


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national-level policy. local, etc.).Targets regulatory framework ofbusiness.

Targets political environment ingeneral.

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 countrys output and its domestic demand-thedifference between what goods and services a country produces and how many goods andservices it buys from abroad. A trade deficit occurs when, during a certain period, a nationimports 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 ReserveAccount), any trade deficit must be offset by surpluses on other accounts. Since the officialreserves are limited, a surplus on the Official Reserve Account (which means selling of theforeign exchange reserves by the central bank) can at best be a temporary measure. Thus thetrade deficit must be "financed" by foreign income or transfers, or by a capital account surplus. Acapital account surplus consists of capital purchases (stocks, bonds etc.) by foreign nationals. Acapital account surplus (an increase in net foreign investment) may result in an increase in the netoutflow 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 isused to finance profitable domestic investment, which generates returns in excess of what is paidto the foreign nationals on their investments in the country. Such a situation may arise if acountry 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 thecountry and the shifting of consumption to future rather than current generations. Even tradesurpluses can be undesirable for a country. An example where a trade surplus was not beneficialfor the country is Japan in the 1990s. The positive trade balance that Japan had was partly due tothe 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, hadimports been freely allowed. The foreign currency that the Japanese companies earned overseaswere kept abroad and not converted into yen in order to keep the value of the yen low andmaintain the competitiveness of Japanese exports. However, a weak yen also prevented Japaneseconsumers from importing goods from abroad and benefiting from the trade surplus. The foreignexchange earned abroad as a result of the trade surplus was partly squandered by spending it onreal estate purchases in the United States that often proved unprofitable.


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