Notes of GFM

8/2/2019 Notes of GFM

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Global financial markets

Unit I

International Economic environment and International Monetary system

Various environmental factors such as economic environment, socio-cultural environment, political,

technological, demographic and international, affect the business and its working. Out of these factors

economic environment is the most important factor.

Meaning of Economic Environment:- Those Economic factors which have their affect on the working of

the business is known as economic environment. It includes system, policies and nature of an economy,

trade cycles, economic resources, level of income, distribution of income and wealth etc. Economic

environment is very dynamic and complex in nature. It does not remain the same. It keeps on changing from

time to time with the changes in an economy like change in Govt. policies, political situations.

Elements of Economic Environment:- It has mainly five main components:-

1. Economic Conditions

2. Economic System

3. Economic Policies

4. International Economic Environment

5. Economic Legislations

Economic Conditions:- Economic Policies of a business unit are largely affected by the economic

conditions of an economy. Any improvement in the economic conditions such as standard of

living, purchasing power of public, demand and supply, distribution of income etc. largely affects the size of

the market.

Business cycle is another economic condition that is very important for a business unit. Business Cycle has

5 different stages viz. (i) Prosperity, (ii) Boom, (iii) Decline, (iv) Depression, (v) Recovery.

Following are mainly included in Economic Conditions of a country:-

I. Stages of Business Cycle

II. National Income, Per Capita Income and Distribution of Income

III. Rate of Capital Formation

IV. Demand and Supply Trends

V. Inflation Rate in the Economy

VI. Industrial Growth Rate, Exports Growth Rate

VII. Interest Rate prevailing in the Economy

VIII. Trends in Industrial Sickness

IX. Efficiency of Public and Private Sectors

X. Growth of Primary and Secondary Capital Markets

XI. Size of Market


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Economic Systems:- An Economic System of a nation or a country may be defined as a framework of

rules, goals and incentives that controls economic relations among people in a society. It also helps in

providing framework for answering the basic economic questions. Different countries of a world have

different economic systems and the prevailing economic system in a country affect the business units to a

large extent. Economic conditions of a nation can be of any one of the following type:-

1. Capitalism:- The economic system in which business units or factors of production are privately owned

and governed is called Capitalism. The profit earning is the sole aim of the business units. Government of

that country does not interfere in the economic activities of the country. It is also known as free

market economy. All the decisions relating to the economic activities are privately taken. Examples of

Capitalistic Economy:- England, Japan, America etc.

2. Socialism:- Under socialism economic system, all the economic activities of the country are controlled

and regulated by the Government in the interest of the public. The first country to adopt this concept was

Soviet Russia. The two main forms of Socialism are: -

(a) Democratic Socialism:- All the economic activities are controlled and regulated by the government but

the people have the freedom of choice of occupation and consumption.

(b) Totalitarian Socialism:- This form is also known as Communism. Under this, people are obliged to work

under the directions of Government.

3. Mixed Economy:- The economic system in which both public and private sectors co-exist is known as

Mixed Economy. Some factors of production are privately owned and some are owned by Government.

There exists freedom of choice of occupation and consumption. Both private and public sectors play key

roles in the development of the country.

Economic Policies:- Government frames economic policies. Economic Policies affects the different

business units in different ways. It may or may not have favorable effect on a business unit. The

Government may grant subsidies to one business or decrease the rates of excise or custom duty or the

government may increase the rates of custom duty and excise duty, tax rates for another business. All the

business enterprises frame their policies keeping in view the prevailing economic policies. Important

economic policies of a country are as follows:-

1. Monetary Policy:- The policy formulated by the central bank of a country to control the supply and the

cost of money (rate of interest), in order to attain some specified objectives is known as Monetary Policy.

2. Fiscal Policy:- It may be termed as budgetary policy. It is related with the income and expenditure of a

country. Fiscal Policy works as an instrument in economic and social growth of a country. It is framed by the

government of a country and it deals with taxation, government expenditure, borrowings, deficit financing

and management of public debts in an economy.

3. Foreign Trade Policy:- It also affects the different business units differently. E.g. if restrictive import

policy has been adopted by the government then it will prevent the domestic business units from foreign


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competition and if the liberal import policy has been adopted by the government then it will affect the

domestic products in other way.

4. Foreign Investment Policy:- The policy related to the investment by the foreigners in a country is known

as Foreign Investment Policy. If the government has adopted liberal investment policy then it will lead to

more inflow of foreign capital in the country which ultimately results in more industrialization and growth

in the country.

5. Industrial Policy:- Industrial policy of a country promotes and regulates the industrialization in the

country. It is framed by government. The government from time to time issues principals and guidelines

under the industrial policy of the country.

Global/International Economic Environment:- The role of international economic environment is

increasing day by day. If any business enterprise is involved in foreign trade, then it is influenced by not only

its own country economic environment but also the economic environment of the country from/to which it is

importing or exporting goods. There are various rules and guidelines for these trades which are issued by

many organizations like World Bank, WTO, United Nations etc.

Economic Legislations:- Besides the above policies, Governments of different countries frame various

legislations which regulates and control the business.

International monetary system

International monetary systems are sets of internationally agreed rules, conventions and supportinginstitutions that facilitate international trade, cross border investment and generally thereallocation ofcapitalbetween nation states.They provide means of payment acceptable between buyers and sellers of different nationality, includingdeferred payment. To operate successfully, they need to inspire confidence, to provide sufficient liquidity forfluctuating levels of trade and to provide means by which global imbalances can be corrected. The systemscan grow organically as the collective result of numerous individual agreements between internationaleconomic actors spread over several decades.

A Brief History of International Monetary System

The emergency of nation states as the predominant form of political and administrative organization is afairly recent phenomenon. It is difficult to survey international monetary arrangements prior to 1800 except topoint out that all sovereign states specified what form of money would constitute legal tender within theirboundaries, and that most of them minted gold, silver, and/or base-metal (copper, tin, lead) coins fordomestic circulation.

Metallic-standard arrangementsGold standard and other commodity-money systems

1. 1797-1821 Disruption due to Napoleonic wars

2. 1821-1875 England on gold standard; other nations on various commodity-moneyarrangements3. 1875-1914 Worldwide gold standard4. 1914-1945 Disruption from two world wars and intervening depression (brief return to gold

standard, 1925-1931)5. 1947-1971 Bretton Woods system of fixed exchange rates6. 1973-present Floating exchange rates among leading nations

1. The Gold Standard

Gold coins and bullion
http://en.wikipedia.org/wiki/International_tradehttp://en.wikipedia.org/wiki/Foreign_investmenthttp://en.wikipedia.org/wiki/Redistribution_(economics)http://en.wikipedia.org/wiki/Redistribution_(economics)http://en.wikipedia.org/wiki/Redistribution_(economics)http://en.wikipedia.org/wiki/Nation_statehttp://en.wikipedia.org/wiki/International_tradehttp://en.wikipedia.org/wiki/Foreign_investmenthttp://en.wikipedia.org/wiki/Redistribution_(economics)http://en.wikipedia.org/wiki/Redistribution_(economics)http://en.wikipedia.org/wiki/Nation_state


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Impure type of gold-standard, in which the actual circulating medium consisted largely or even entirely ofpaper claims (currency) to units of the monetary commodity (gold) -- Fractional reserves

Par: officially stipulated rate1900, for example, the US dollar price of an English pound was about 4.86(a dollar was equivalent to0.0484 ounce of gold, whereas the figure was 0.2354 ounce for a pound sterling)

How to see the relationship of the gold price and goods prices?

$/good = ($/Gold) (Gold/good)= (price of monetary Gold) (price of commodity Gold)

Under the gold standard, the first term in the right hand side is fixed. Therefore the goods price will beaffected by the price of the commodity Gold, which will be determined by the supply (excavation) anddemand of gold, or the supply and demand of goods. (See Cooper, 1982 in Brookings Papers on Economic

Activity)

Change of money demand or reserves requirement ratio have short term impact, but without long-term effectof the price level.Long- term effect: with pegged price of monetary gold, effect comes from price of commodity gold. (SeeMcCallum, 1996, International Monetary Economics, 70-77)2. From 1800 to 1914

1819-Britain started, after the Napoleonic Wars (1793-1815).1879 USA adopted.

*Under Gold Standard, inflation rate is low, except during the wars.Napoleonic wars kept England off any metallic standard.USAs Civic War of 1860-1865, and fully returned to a metallic basis until 1878.

*Prices in the different nations tended to move together. 1840-50, prices fell because of shortage of gold.After 1900 the supply of gold and silver grew rapidly as the result of mining discoveries and improvements inrefining technique, and price levels rose.*Japans yen became the nations currency unit in 1870, shortly after the Meiji Restoration. The bank ofJapan was created in 1882.

3. From 1918 to 1945

1919, US restored the gold standard.

1922, met in Genoa, Italy, Britain, France, Italy, and Japan agreed to restore the gold standard.Partial

gold exchange standard

1925, Britain restored the exchange rate between gold and its currency by the rate set before the war.

(against Keynes advice) A monetary stringency caused a substantial deflation. During 1926-1932, nominal

wage fell, and a high level of unemployment.

Downturn in economic activity developed into Great Depression in the end of 1929. Exchange rates did notadjust smoothly, using import restrictions.

1931, Britain abandoned the gold standardconfidence problem.

1933 US departed from gold standard, 1934 back again, and the price of gold increase from $20.67 to $35

per ounce. Most of the countries back to the gold standard but with competitive deprecations.

1930US, Smoot-Hawkey tariff.


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Competitive deprecations: beggar-thy-neighbor policyfor obstructing the outflow of the gold and increasing

domestic output (decrease the unemployment)--- provoked foreign retaliation

The turbulence persisted until 1939, WWII

4. Bretton Woods. 1947-1971

After the war, the world expected to build an international monetary system, which would foster fullemployment and price stability while allowing individual countries to attain external balance without imposing

restrictions on international trade. (avoid the disadvantages of both the gold standard and the unsettled

conditions of the 1930s, the breakdown in trade)

Keynes versus Harry Dexter White

IMF founded in 1944, 44 countries met at Bretton Woods. World Bank (or International Bank for

Reconstruction and Development) was founded also. The establishment of International Trade Organization

(ITO) was not passed by USs congress. 1947 GATT was founded.

IMF-gold exchange standard

Gold for dollars at price of $35 per ounce.

Goals and Structure of the IMF

Objectives: convertible currencies, free of the exchange controls and create a mechanism for financing

temporary balance-of-payments difficulties.

a. disciplinefixed to the dollar, which was tied to gold.b. flexibilityIMF lending facilities, under the IMF conditionality.

adjustable parities whenever there is fundamental disequilibrium.

The Changing Meaning of External Balance

1947 began Marshall Plan.The recovery after the war, needs CA deficit of the USA---dollar shortage.

However, international trade was restricted on CA, KA was not allowed. 1958, the restriction on KA

transaction was dismantled, and the foreign exchange trading up.

The External Balance Problem of the United StatesThe role played by US under the Bretton Woods systemUS was required to trade gold for dollars withforeign central banks. US might face the external constraint. However, many countries still hold US dollarsas foreign reserves because gold is limited, and there is interest for dollar deposits. One exception: France,Charles de Gaulle criticized that the Bretton Woods system gave US exorbitant privilege, and in 1956France changed most of its dollars to gold

1960s, Robert Triffin of Yale University raised the issue of confidence problem. Economic growth will bringthe need of US dollars, but the gold is growing slowly. Eventually, dollar is no longer as good as gold. The


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solution lies on (a). Increase the price of gold, (b) SDR (1967).

By October 1961, 7 European central banks and the United States had agreed to create a gold pool, thatwould hold the London market price at $35/oz. It broke down in 1967. Between 1968 and 1971, the price ofgold fluctuated between $36 and $44. August 15, 1971 the USA unilaterally suspended gold sales to foreigncentral banks. December 1971, the Smithsonian agreement, price of gold increases to $38/oz.

5. Floating Exchange Rates, 1973-Present

Predictions of small volumes of official reserves would be held by central banks and that BOP accountswould show very small official settlement balance were not found. Not pure floating-rate system, interventionof monetary authority is very often.

After March 1973, European Community retained 2.25% band, but jointly floated against the dollar---snake.

Over the years 1971-1979, the value of the US dollar declined considerably ------ Inflation plus currentaccount in the USA.

International cooperation in the stabilization of exchange ratesOctober, 1979, Paul Volcker took the office of Fed, and tightened monetary policy, dollar began to rise.

September, 1985 G-5 (France, Germany, Japan, the UK, and the USA)Plaza Accord, cooperative action todrive down the value of dollar.

Early 1987, G-5 the Louvre Agreement, announced their belief that prevailing exchange rates werereasonably appropriate and their intention to cooperative stabilize these rates. The dollar was falling. TheFed tightened monetary policy. Perhaps one of the reason caused the stock market correction.

Debt crisis: Mexico, August 1982 announced that it would be unable to pay its debt, followed by Venezuela,Chile, Peru, the Philippines, and a few African countries. Latin American debtors of 51 billion, nearly twice ofthe capital of the nine largest U.S banks.

From debt rescheduling (of payments), and moving on to debt reduction, debt-equity swaps, buybacks, andcomplex plans devised by James Baker and Nicholas Brady.

The Debt Crisis of the 1980s The great recession of the early 1980s sparked a crisis over developing country

debt. The shift to contractionary policy by the U.S. led to:

The fall in industrial countries' aggregate demand An immediate and spectacular rise in the interest burden debtor

countries had to pay A sharp appreciation of the dollar A collapse in the primary commodity prices The crisis began in August 1982 when Mexicos central bank could no

longer pay its $80 billion in foreign debt, followed by Venezuela, Chile,Peru, the Philippines, and a few African countries. Latin Americandebtors of 51 billion, nearly twice of the capital of the nine largest U.Sbanks.

From debt rescheduling (of payments), and moving on to debtreduction, debt-equity swaps, buybacks, and complex plans devised byJames Baker and Nicholas Brady.

Is sovereign governments debt different?

By the end of 1986 more than 40 countries had encountered several external

financial problems.

4. Reforms, Capital Inflows, and the Return of Crisis

Latin America and Washington Consensus (John Williamson, 1989)

a. fiscal disciplineb. reordering public expenditure prioritiesc. tax reformd. liberalization of interest ratese. a competitive exchange ratef. trade liberalizationg. liberalization of inward foreign direct investment


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h. privatizationi. deregulation

j. property rights

Argentina1970s It tried unsuccessfully to stabilize inflation through a crawling peg.1980s It implemented successive inflation stabilization plans involving currency

reforms, price controls, and other measures.1990s It adopted a currency board (peso-dollar peg).2001-2002 It defaulted on its debts and abandoned the peso-dollar peg.

Brazil 1980s It suffered runaway inflation and multiple failed attempts at stabilization

accompanied by currency reforms. 1990s It introduced a new currency (the real pegged to the dollar), defended it

with high interest rates, and decreased inflation under 10%. Chile

1980s It implemented more reforms and used a crawling peg type of exchangerate regime to bring inflation down gradually.

1990-1997 It enjoyed an average growth rate of more than 8% per year and a20% inflation decrease.

Mexico 1987 It introduced a broad stabilization and reform program and fixed its pesos

exchange rate against the U.S. dollar. 1989-1991 It moved to a crawling peg and crawling band.

1994 It joined the North American Free Trade Area and achieved 7% inflation.

The East Asian Economic Miracle

Until 1997 the countries of East Asia were having very high growth rates. What are the ingredients for the success of the East Asian Miracle?

High saving and investment rates Strong emphasis on education Stable macroeconomic environment Free from high inflation or major economic slumps High share of trade in GDP

Asian Weaknesses Three weaknesses in the Asian economies structures became apparent with the 1997

financial crisis: Productivity

Rapid growth of production inputs but little increase in the output perunit of input

Banking regulation Poor state of banking regulation

Legal framework Lack of a good legal framework for dealing with companies in trouble

The Asian Financial Crisis It stared on July 2, 1997 with the devaluation of the Thai baht. The sharp drop in the Thai currency was followed by speculation against the currencies of:

Malaysia, Indonesia, and South Korea. All of the afflicted countries except Malaysia turned to the IMF for assistance.

The downturn in East Asia was V-shaped: after the sharp output contraction in 1998,growth returned in 1999 as depreciated currencies spurred higher exports.

Crises in Other Developing Regions Russias Crisis

1989 It embarked on transitions from centrally planned economic allocation tothe market.

These transitions involved: rapid inflation, steep output declines, andunemployment.

1997 It managed to stabilize the ruble and reduce inflation with the help of IMFcredits.

2000 It enjoyed a rapid growth rate.


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Brazils 1999 Crisis It had a public debt problem. It devalued the real by 8% in January 1999 and then allowed it to float.

The real lost 40% of its value against the dollar. It struggled to prevent the real from going into a free fall and as a result it entered

into a recession. The recession was short lived, inflation did not take off, and financial-

sector collapse was avoided.

Argentinas 2001-2002 crises Its rigid peg of its peso to the dollar proved painful as the dollar appreciated in

the foreign exchange market.

2001 It restricted residents withdrawals from banks in order to stem the run onthe peso, and then it stopped payment on its foreign debts. 2002 It established a dual exchange rate system and a single floating-rate

system for the peso.

The lessons from developing country crises are summarized as: Choosing the right exchange rate regime The central importance of banking The proper sequence of reform measures

The importance ofcontagion

The Asian crisis convinced nearly everyone of an urgent need for rethinking international monetaryrelations because of two reasons:

The fact that the East Asian countries had few apparent problems before their crisis struck The apparent strength of contagion through the international capital markets

Capital Mobility and the Trilemma of the Exchange Rate Regime The macroeconomic policy trilemma for open economies:

Independence in monetary policy Stability in the exchange rate Free movement of capital

Only two of the three goals can be reached simultaneously. Exchange rate stability is more important for developing than developed countries.

Proposals to reform the international architecture can be grouped as preventive measures or as ex-post measures.

Prophylactic Measures Among preventive measures are:

More transparency Stronger banking systems Enhanced credit lines Increased equity capital inflows relative to debt inflows

The effectiveness of these measures is controversial.

Coping with Crisis The ex-post measures that have been suggested include:

More extensive lending by the IMF Chapter 11 bankruptcy proceeding for the orderly resolution of creditor claims

on developing countries that cannot pay in full.

A Confused Future In the years to come, developing countries will experiment with:

Floating exchange rates Capital controls Currency boards Abolition of national currencies and adoption of the dollar or euro for domestic

transactions

Unit 2 Foreign exchange market and exchange rate determination

I. The Foreign Exchange MarketA. The foreign exchange market is a market where one countrys currency can be exchanged

for another countrys. It has three tiers of operations:i. Individuals and corporations buy and sell foreign exchange through their

commercial banks.


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ii. Commercial banks trade in foreign exchange with other commercial banks in thesame financial center.

iii. Commercial banks trade in foreign exchange with commercial banks in otherfinancial centers.

1. The first is the retail market; the last two are the interbank market.B. Major Participants

i. Commercial Banks1. They operate the payment mechanism meaning a collection system that

transfers money by drafts, notes, etc.2. They extend credit both secured and unsecured.3. Help to reduce risk by using a letter of credit.

a. A letter of credit is a document issued by a bank at the requestof an importer and in the document the bank guarantees tohonor a draft drawn on the importer.

4. Most banks do not have a large amount of currency trading, the marketis dominated by a few large banks.

ii. Global and National Market1. Banks throughout the world serve as market makers in foreign

exchange.2. All foreign exchange banks are linked together using

telecommunication.3. Local banks may have an advantage trading their specific currency (e.g.

Sterling in London), but all foreign exchange banks have global levelactivities.

4. The foreign exchange market is 24 hour.iii. Central Banks

1. They attempt to control the growth of the money supply within their

jurisdictions.2. They also attempt to control the value of their own currency against anyforeign currency.

a. For f ixed exchange rates, this involves absorbing thedifference between supply of and demand for foreign exchangeto maintain the par value.

b. For flexible exchange rates, this involves intervening tomaintain orderly trading conditions.

3. Central bank activities include transaction with other central banks,various international organizations, and exchange rate intervention.

4. Serve as their governments banker for domestic and internationalpayments.

II. Foreign Exchange Rate QuotationA. The spot rate is the rate paid for delivery of a currency within two business days after the

day of the trade.

i. A few number of currencies have a different rate for financial or commercialtransactions.

ii. The direct quote is a home currency price per unit of a foreign currency.iii. The indirect quote is a foreign currency price per unit of a home currency.iv. A cross rate is an exchange rate between two non-home currencies.v. Percentage change is the ending rate minus the beginning rate then divided by

the beginning rate.vi. The bid price is the price at which the bank is ready to buy a foreign currency and

the ask price is the price at which the bank is ready to sell a foreign currency.1. The bid-ask spread is the spread between the bid and ask rates.

B. The forward rate is the rate to be paid for delivery of a currency at some future date.i. The rate is determined at the time the contract is made but payment and delivery

are not required until maturity.ii. If the forward rate is less than the spot rate, this is a discount.iii. If the forward rate is more than the spot rate, this is a premium.

iv. There are four participants types in the forward rate:1. Arbitrageurs who seek to earn riskless profits by taking advantage of

differences in interest rates among countries.2. Traders who use forward contracts to eliminate possible exchange

losses on export or import orders denominated in foreign currencies.3. Hedgers who engage in forward contracts to protect the home-currency

value of foreign-currency denominated assets and liabilities.4. Speculators who expose themselves in risk by engaging in forward

contracts to make a profit from exchange rate fluctuation.III. International Parity Conditions

A. There is a relationship between the money market and the foreign exchange market andthere are five major theories that can be used to determine exchange rate levels, whichwill be discussed below.


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B. An efficient exchange market exists when exchange rates reflect all available informationand adjust quickly to new information. This removes all profits in excess of the minimumfrom the system. It depends on three hypotheses:

i. Market prices, such as product prices, interest rates, spot rates, and forwardrates, should reflect the markets consensus estimate of the future spot rate.

ii. Investors should not earn unusually large profits from forward speculation.iii. It is impossible for any market analyst to beat the market consistently.

Exchange rate determination (From C to F)

C. The Theory of Purchasing Power Parity (PPP)i. The absolute version of this theory states that the equilibrium exchange rate

between domestic and foreign currencies equals the ratio between domestic andforeign prices.

1. The world is very complex with many impediments to the equalization ofprices for identical goods worldwide.

ii. The relative version of the theory states that in the long run, the exchange ratebetween the home currency and the foreign currency will adjust to reflectchanges in the price levels of the two countries.

iii. The PPP theory can be used to forecast exchange rates.iv. The weaknesses of the theory are that:

1. It assumes goods are easily traded.2. It assumes tradable goods are identical across countries.3. It is dependent on the use of price indexes.4. Many other factors influence exchange rates beyond relative prices.

D. The Fisher Effecti. The nominal interest rate of each country is equal to a real interest rate plus an

expected rate of inflation.1. The real interest is determined by the productivity in an economy plus arisk premium. It is relatively stable.

2. The nominal interest includes an inflation premium to compensatelenders or investors for a loss in purchasing power.

ii. Real interest rates are equalized across countries through arbitrage.iii. The theory works well for short-term government securities.iv. The theory suffers from an increased financial risk inherent in fluctuations of a

bond market value prior to maturity, by the unequal creditworthiness of theissuers, and from the fact that long-term rates are not the sensitive to pricechanges.

E. The International Fisher Effecti. This states that the future spot rate should move in an amount equal to, but in the

opposite direction from, the difference in interest rates between two countries.1. When investors purchase the currency of country to take advantage of

higher interest rates abroad, they must also consider any possiblelosses due to fluctuations in the value of the foreign currency prior tomaturity of their investment.

ii. It is also hold that the interest differential between two countries should be anunbiased predictor of the future change in the sport rate.

1. This is because, at least in terms of short-term behavior, the exchangerate moves in the same direction as the difference in interest ratesbetween two countries.

F. The Theory of Interest-Rate Parityi. This theory states that the spread between a forward rate and a spot rate should

be equal, but opposite in sign, to the difference in interest rates between twocountries.

1. In a free market, the currency with the higher interest rate will sell at adiscount in the forward market and vice versa.

2. This outcome is a result of arbitrageurs who enter into forward contracts

to avoid the exchange-rate risk.G. The Forward Rate and the Future Spot Rate

i. If speculators think that a forward rate is higher than their prediction of a futurespot rate, they will sell the foreign currency forward.

1. This transaction will bid down the forward rate until it equals theexpected future spot rate.

ii. These speculative transactions will bid up the forward rate until it reaches theexpected future rate thereby removing any incentive to buy or sell a foreigncurrency forward.

H. Synthesis of International Parity Conditionsi. In the absence of predictable exchange market intervention by central banks, an

expected rate of change in a spot rate, differential rates of national inflation and


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interest, and forward premiums or discounts are all directly proportional to eachother.

1. Due to efficient markets, these variables adjust very quickly to changesin any one of them.

IV. ArbitragesA. Arbitrage is the purchase of something in one market and its sale in another market to

take advantage of price differential.i. The goal is to profit on price differences.

B. Geographic Arbitragei. Exchange rates for a given currency are not the same in every geographic

market and this creates the opportunity for arbitrage.C. Two-Point Arbitrage

i. This is an arbitrage transaction between two currencies to take advantage ofdifference in exchange rates in different markets.

D. Three-Point Arbitrage, also known as Triangle Arbitragei. This is an arbitrage transaction among three currencies take advantage of

unequal cross rates between markets.E. Covered-Interest Arbitrage

i. This is the movement of short-term funds between countries to take advantage ofinterest differentials with exchange risk covered by forward contracts.

ii. These activities lead to equilibrium, i.e. interest rate parity.iii. This arbitrage leads to four tendencies:

1. The spot rate of currency one against currency two will tend toappreciate as investors buy currency one against currency two.

2. The forward rate of currency one against currency two will tend todepreciate as investors sell currency one against currency two.

3. Interest rates will tend to rise in country two as investors borrow

currency two.4. Interest rates will tend to fall in country one as investors borrowcurrency one.

Key Terms and Concepts

Spot Rate is the rate paid for delivery of a currency within two business days after the day of the trade.

Direct Quote is a home currency price per unit of a foreign currency.

Indirect Quote is a foreign currency price per unit of a home currency.

Cross Rate is an exchange rate between two currencies when it is obtained from the rates of these two

currencies in terms of a third currency.

Bid Price is the price at which a bank is ready to buy a foreign currency.

Ask Price is the price at which a bank is ready to sell a foreign currency.

Bid-Ask Spread is the spread between bid and ask rates for a currency; this spread is the bank's fee forexecuting the foreign exchange transaction.

Forward rate is the rate to be paid for delivery of a currency at some future date.

Efficient Exchange Markets exist when exchange rates reflect all available information and adjust quicklyto new information.

Theory of Purchasing Power Parity (PPP) holds that the exchange rate must change in terms of a single

currency so as to equate the prices of goods in both countries.

Fisher Effect named after the economist Irving Fisher, assumes that the nominal interest rate in eachcountry is equal to a real interest rate plus an expected rate of inflation.

International Fisher Effect states that the future spot rate should move in an amount equal to, but in adifferent direction from, the difference in interest rates between two countries.

Interest-Rate Parity Theory holds that the difference between a forward rate and a spot rate equals thedifference between a domestic interest rate and a foreign interest rate

Arbitrage is the purchase of something in one market and its sale in another market to take advantage of aprice differential.


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Two-Point Arbitrage is the arbitrage transaction between two currencies.

Three-Point Arbitrage, also known as triangle arbitrage, is the arbitrage transaction among threecurrencies and can occur if any of the three cross rates is out of line.

Covered Interest Arbitrage is the movement of short-term funds between countries to take advantage ofinterest differentials with exchange risk covered by forward contracts.

Unit 3 Law of one price and management of foreign exchange exposure

The law of one price suggests that in competitive markets free of transportation costs and trade barriers,identical products in different countries must sell for the same price when their price is expressed in terms ofthe same currency.

A less extreme version of the PPP theory states that given relatively efficient markets that is, markets inwhich few impediments to international trade and investment exist the price of a basket of goods shouldbe roughly equivalent in each country

The International Fisher Effect states that for any two countries the spot exchange rate should change inan equal amount but in the opposite direction to the difference in nominal interest rates between twocountries

Currency ConvertibilityA currency is said to be freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency.

A currency is said to be externally convertible when non-residents can convert their holdings of domestic

currency into a foreign currency, but when the ability of residents to convert currency is limited in some way.A currency is nonconvertible when both residents and non-residents are prohibited from converting theirholdings of domestic currency into a foreign currency.

Free convertibility is the norm in the world today, although many countries impose restrictions on the amountof money that can be converted. The main reason to limit convertibility is to preserve foreign exchangereserves and prevent capital flight.

Countertrade refers to a range of barter like agreements by which goods and services can be traded forother goods and services. It can be used in international trade when a countrys currency is nonconvertible.

Foreign exchange exposure and management

Basic Nature of Foreign Exchange ExposuresA Foreign exchange exposure is the possibility that a firm will gain or lose because of changesin exchange rates. There are three types of exchange exposures:

1. Translation exposure, i.e. the account-based changes in consolidatedfinancial statements caused by exchange rate changes.

2. Transaction exposure i.e. changes in exchange rates between the timethat an obligation is incurred and the time that it is settled. This affectsactual cash flows.

3. Economic exposure reflects the change in the present value of the firmsfuture cash flows because of an unexpected change in exchange rates.

Exposure management strategy involves four steps:I. Forecasting the degree of exposure in each major currency

in which the MNC operates.II. Developing a reporting system to monitor exposure and

exchange rate movements to assist in protecting the MNCfrom risk.

III. Assigning responsibility for hedging exposure anddetermining whether to centralize or decentralize exposuremanagement.

IV. Selecting appropriate hedging tools including diversificationof the MNCs operations, a balance sheet hedge, andexposure netting.

Types of ExposureTranslation exposure is caused by account-based changes in consolidated financialstatements that are linked to exchange rate changes.


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Transaction exposure is the potential change in the value of outstanding obligations due tochanges in the exchange rate between the beginning of a contract and the settlement of acontract.

Transactions include credit purchases, credit sales, borrowed funds, loaned funds,receipts, payments, and uncovered forward contracts. All of these transactionsmay be exposed if they are denominated in foreign currencies.

Economic exposure, also known as operating exposure, competitive exposure, or revenueexposure, measures the impact of an exchange-rate change on the new present value ofexpected future cash flows from a foreign investment project.

iv. This type of exposure is broader and more subjective than either translation ortransaction.

Comparison of the three exposures:Management of translation exposure is static and historically oriented butmanagement of transaction and economic exposure is more forward lookingbecause both of these involve actual and potential cash flows.Transaction and economic risk are essentially the same, but they differ in degree.

1. Transaction exposure is objective because it depends on outstandingobligations that existed before changes in exchange rates but weresettled after changes in exchange rates.

2. Economic exposure is subjective because it depends on estimatedfuture cash flows for an arbitrary time horizon.

Transaction Exposure ManagementAn action that removes a transaction exposure is said to cover that risk.A forward exchange-market hedge involves that exchange of one currency for another at afixed rate on some future date to hedge transaction exposure.

This process substitutes a known cost for the uncertain future cost due to foreignexchange risk.

This process does not guarantee the lowest cost due to foreign exchange ratechange -- it just fixes the cost.A money-market hedge involves a loan contract and a source of fund to carry out that contractin order to hedge transaction exposure.

The contract represents a loan agreement.The difference between this process and a forward exchange market hedge is thatthe cost of the money market hedge is determined by differential interest rates, notby the forward premium or discount.

An options-market hedge involves the purchasing a call option or put option to cover exchangerisk.

A call option allows MNCs to cover currency risks for accounts payables.A put option allows MNCs to cover currency risks for accounts receivable.An options market hedge protects MNCs from adverse exchange rate movements,but also allows MNCs to benefit from favorable exchange rate movements.

A forward contract is often an imperfect hedging instrument because it is a fixed agreement to

buy or sell a foreign currency at a specific price in the future. There are practical situationswhere MNCs are not sure whether their hedged foreign-currency cash flows will materialize:

An overseas deal may fall through.A bid on a foreign-currency contract may be rejected.A foreign subsidiaries dividend payments may exceed the expected amount.

Options vs. forward contracts the following rules are suggested to choose between forwardcontracts and currency options:

v. When the quantity of a foreign-currency cash outflow is known, buy the currencyforward; when the quantity is unknown, buy a call option on the currency.

vi. When the quantity of a foreign-currency cash inflow is known, sell the currencyforward; when the quantity is unknown, buy a put option on the currency.

vii. When the quantity of a foreign-currency flow is partially known and partiallyuncertain, use a forward contract to hedge the known portion and an option tohedge the maximum value of the uncertain remainder.

A cross hedge is a technique designed to hedge exposure in one currency by the use of future

or other contracts on another currency that is correlated with the first currency.viii. This is used when there are no futures or forward markets for the currency the

MNC is trying to hedge.A swap-market hedge involves an exchange of cash flows in two different currencies betweentwo MNCs.

1. A currency swap is an agreement between two parties to exchange localcurrency for hard currency at a specified future date.

2. A credit swap is an agreement that is a simultaneous spot and forwardloan transaction between a private company and a bank of a foreigncountry.

3. An interest rate swap is an agreement between two parties to exchangecash flows of a floating rate for cash flows of a fixed rate, or exchangecash flows of a fixed rate for cash flows of a floating rate.


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4. Back-to-back loans or parallel loans are loans between two parentcompanies in two different countries whereby parent company A incountry A lends an agreed amount to the subsidiary of parent company Bin country A and in return parent company B in country B lends an agreedamount to the subsidiary of parent company A in country B.

This process completely avoids currency risk.Economic Exposure Management

It is difficult, if not impossible, to hedge economic exposure.The scope of economic exposure is broad because it can change a companyscompetitiveness across many markets and products.The risks are long-term, hard to quantify, and cannot be dealt with solely throughfinancial hedging techniques.

Analysis of economic exposure should consider how exchange rate influence:A companys sales prospects in foreign markets.The costs of labor and other inputs to be used in overseas production.The home-currency value of financial assets and liabilities denominated in foreigncurrencies.

Diversification production, marketing and financing is one of the main ways to cover economicexposure.

Diversified production involves diversification of plant location, the input mix,product sourcing, and productivity increases.Diversified marketing involves diversification of product strategy, pricing strategy,promotional options, and market selection.Diversified financing involves diversification of the currency denomination of long-term debt, place of issue, maturity of structure, capital structure, and leasing versusbuying.

Currency Exposure Management Practices

A survey of 25 U.S. MNCs found that transaction was the overwhelming choice of ChiefFinancial Officers (CFO) as the type of exposure that merits the most attention (64% ranked it#1).

Economic exposure came in second with 26% of the CFOs raking it #1.Only 13% of CFO ranked translation exposure as their most important exposure.

A different survey found that 65% of the sampled companies hedged their transactionexposure but only 26% hedged their translation exposure.Still another survey, this time of 110 CFOs, found that 38% percent of them considered foreignexchange risk as the important of all of the risks they faced.

The next most important risks were interest rate risk (32%), political risk (10%),credit risk (9%), liquidity risk (7%), and inflation risk (4%).The most commonly used instrument to handle this foreign exchange risk was theforward contract (42%).

1. The other four hedging techniques discussed above (currency swaps,interest-rate swaps, currency options, and futures) were used almost

equally.2. Other surveys have also found that forward contracts are the most

popular hedging instrument.

Key Terms and Concepts

Foreign Exchange Exposure refers to the possibility that a firm will gain or lose due to changes inexchange rates.

Operational Techniques are operational approaches to hedging exchange exposure that includediversification of a companys operations, the balance sheet hedge, and exposure netting.

Financial Instruments are financial contracts to hedging exchange exposure that include currency forwardand futures contracts, currency options, and swap agreements.

Transaction Exposure refers to the potential change in the value of outstanding obligations due to changesin the exchange rate between the inception of a contract and the settlement of the contract.

Economic Exposure also called operating exposure, competitive exposure, or revenue exposure,measures the impact of an exchange rate change on the net present value of expected future cash flowsfrom a foreign investment project.

Forward Exchange-Market Hedge involves a forward contract and a source of funds to fulfill that contract.

Money Market Hedge involves a loan contract and a source of funds to carry out that contract.


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Options Market Hedge protects the company from adverse exchange rate movements but allow thecompany to benefit from favorable exchange rate movements.

Swap Market Hedge involves an exchange of cash flows in two different currencies between twocompanies.

Cross Hedge is a technique designed to hedge exposure in one currency by the use of futures or othercontracts on another currency that is correlated with the first currency.

Currency Swap is an agreement between two parties to exchange local currency or hard currency at aspecified future date.

Credit Swap is a hedging device similar to the foreign currency swap.

Interest Rate Swap is a technique where companies exchange cash flows of a floating rate for cash flowsof a fixed rate, or exchange cash flows of a fixed rate for cash flows of a floating rate.

Unit IV

Multinational capital budgeting, like traditional domestic capital budgeting, focuses on the cash inflows andoutflows associated with prospective long-term investment projects. Multinational capital budgetingtechniques are used in traditional foreign direct investment (FDI) analysis, such as the construction ofa manufacturing plant in another country, as well as in the growing field of international mergers andacquisitions.

Capital budgeting for a foreign project uses the same theoretical framework as domestic capitalbudgetingwith a few very important differences. The basic steps are:

a. Identify the initial capital invested or put at risk.b. Estimate cash flows to be derived from the project over time, including an estimate of the terminal

or salvage value of the investment.c. Identify the appropriate discount rate for determining the present value of the expected cash

flows.d. Apply traditional capital budgeting decision criteria such as net present value (NPV) and internal

rate of return (IRR) to determine the acceptability of or priority ranking of potential projects.

2. Foreign Complexities. Capital budgeting for a foreign project is considerably more complex than thedomestic case. What are the factors that add complexity?

Capital budgeting for a foreign project is considerably more complex than the domestic case. Severalfactors contribute to this greater complexity:

Parent cash flows must be distinguished from project cash flows. Each of these two types of flows

contributes to a different view of value. Parent cash flows often depend on the form of financing. Thus we cannot clearly separate cash

flows from financing decisions, as we can in domestic capital budgeting.

Additional cash flows generated by a new investment in one foreign subsidiary may be in part or inwhole taken away from another subsidiary, with the net result that the project is favorable from asingle subsidiarys point of view but contributes nothing to worldwide cash flows.

The parent must explicitly recognize remittance of funds because of differing tax systems, legal andpolitical constraints on the movement of funds, local business norms, and differences in the wayfinancial markets and institutions function.

An array of nonfinancial payments can generate cash flows from subsidiaries to the parent,including payment of license fees and payments for imports from the parent.

Managers must anticipate differing rates of national inflation because of their potential to causechanges in competitive position, and thus changes in cash flows over a period of time.

Managers must keep the possibility of unanticipated foreign exchange rate changes in mindbecause of possible direct effects on the value of local cash flows, as well as indirect effectson the competitive position of the foreign subsidiary.

Use of segmented national capital markets may create an opportunity for financial gains or maylead to additional financial costs.

Use of host-government subsidized loans complicates both capital structure and the parents abilityto determine an appropriate weighted average cost of capital for discounting purposes.

Managers must evaluate political risk because political events can drastically reduce the value oravailability of expected cash flows.


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Terminal value is more difficult to estimate because potential purchasers from the host, parent, orthird countries, or from the private or public sectors, may have widely divergent perspectives on thevalue to them of acquiring the project.

3. Project versus Parent Valuation.

a. Why should a foreign project be evaluated both from a project and parent viewpoint? A strongtheoretical argument exists in favor of analyzing any foreign project from the viewpoint of theparent. Cash flows to the parent are ultimately the basis for dividends to stockholders, reinvestmentelsewhere in the world, repayment of corporate-wide debt, and other purposes that affect thefirms many interest groups. However, since most of a projects cash flows to its parent, or to sistersubsidiaries, are financial cash flows rather than operating cash flows, the parent viewpointusually violates a cardinal concept of capital budgeting, namely, that financial cash flows should

not be mixed with operating cash flows. Often the difference is not important because the two arealmost identical, but in some instances a sharp divergence in these cash flows will exist.

Evaluation of a project from the local viewpoint serves some useful purposes, but it shouldbe subordinated to evaluation from the parents viewpoint. In evaluating a foreign projectsperformance relative to the potential of a competing project in the same host country, we must payattention to the projects local return. Almost any project should at least be able to earn a cashreturn equal to the yield available on host government bonds with a maturity the same asthe projects economic life, if a free market exists for such bonds. Host government bondsordinarily reflect the local risk-free rate of return, including a premium equal to the expectedrate of inflation. If a project cannot earn more than such a bond yield, the parent firm shouldbuy host government bonds rather than invest in a riskier project.

b. Which viewpoint, project or parent, gives results closer to the traditional meaning of net presentvalue in capital budgeting? Multinational firms should invest only if they can earn a risk-adjustedreturn greater than locally based competitors can earn on the same project. If they are unable to

earn superior returns on foreign projects, their stockholders would be better off buying shares inlocal firms, where possible, and letting those companies carry out the local projects. Apart fromthese theoretical arguments, surveys over the past 35 years show that in practice multinationalfirms continue to evaluate foreign investments from both the parent and project viewpoint.

c. Which viewpoint gives results closer to the effect on consolidated earnings per share?Theattention paid to project returns in various surveys probably reflects emphasis on maximizingreported consolidated net earnings per share as a corporate financial goal. As long as foreignearnings are not blocked, they can be consolidated with the earnings of both the remainingsubsidiaries and the parent. As mentioned previously, U.S. firms must consolidate foreignsubsidiaries that are over 50% owned. If a firm is owned between 20% and 49% by a parent,it is called an affiliate. Affiliates are consolidated with the parent owner on apro rata basis.Subsidiaries less than 20% owned are normally carried as unconsolidated investments. Even inthe case of temporarily blocked funds, some of the most mature MNEs do not necessarilyeliminate a project from financial consideration. They take a very long-run view of world businessopportunities.

4. Cash Flow. Capital projects provide both operating cash flows and financial cash flows. Why areoperating cash flows preferred for domestic capital budgeting but financial cash flows given majorconsideration in international projects?

If reinvestment opportunities in the country where funds are blocked are at least equal to the parentfirms required rate of return (after adjusting for anticipated exchange rate changes), temporaryblockage of transfer may have little practical effect on the capital budgeting outcome, because futureproject cash flows will be increased by the returns on forced reinvestment. Since large multinationalshold a portfolio of domestic and foreign projects, corporate liquidity is not impaired if a few projectshave blocked funds; alternate sources of funds are available to meet all planned uses of funds.Furthermore, a long-run historical perspective on blocked funds does indeed lend support to the beliefthat funds are almost never permanently blocked. However, waiting for the release of such funds canbe frustrating, and sometimes the blocked funds lose value while blocked because of inflation orunexpected exchange rate deterioration, even though they have been reinvested in the host country to

protect at least part of their value in real terms.

5. Risk-Adjusted Return. Should the anticipated internal rate of return (IRR) for a proposed foreignproject be compared to (a) alternative home country proposals; (b) returns earned by local companiesin the same industry and/or risk class; or (c) both of the above? Justify your answer.

The key to distinction is risk-adjusted. Foreign projects will be, by most methodologies, be of higher riskthan a domestic or home country project. The anticipated returns should therefore take this intoconsideration. At the same time, comparing expected returns with those earned by local companies inthe target markets will not capture the cross-border risks (such as blocked funds) which a foreigninvestor may experience. In the end, the answer is (c), both of the above, and more.


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6. Blocked Cash Flows. In the context of evaluating foreign investment proposals, how should amultinational firm evaluate cash flows in the host foreign country that are blocked from beingrepatriated to the firms home country?

The impact of blocked funds on the rate of return from the investors perspective would depend onwhen the blockage occurs, what reinvestment opportunities exist for the blocked funds in the captivecountry, and when the blocked funds would eventually be released to the investor. As with all cashflow-based financial analyses, the critical element is when the parent investor will regain the ability tomove the blocked funds freely.

7. Host Country Inflation. How should a multinational enterprise (MNE) factor host country inflation intoits evaluation of an investment proposal?

Inflation is factored into the expected cash flows of the project rate of return. Relative inflation affectsthe expected exchange rate due to purchasing power parity.

8. Cost of Equity.A foreign subsidiary does not have an independent cost of capital. However, in orderto estimate the discount rate for a comparable host country firm, the analyst should try to calculate ahypothetical cost of capital. As part of this process, the analyst can estimate the subsidiarys proxycost of equity by using the traditional equation: ke krf (km krf). Define each variable in this equationand explain how the variable might be different for a proxy host country firm compared to the parentMNE.


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The cost of capital and equity of a specific project or subsidiary such as this would be expressed inlocal currency terms, while the parent company will ultimately measure the projects expected returnsand risks based on its own parent currency terms. Therefore, the risk free rate would be a local currencygovernment bond or government bond yield. The market return would be the expected return on themarket portfolio in the local market (typically based on recent historical returns). The local projectsbeta would be first based on other like firms in the local market and their historical covariance with thevariance of the market.

9. Viewpoints. What are the differences in the cash flows used in a project point of view analysis and aparent point of view analysis?

The project viewpoint focuses on the cash flows which are traditionally isolated and analyzed by anyprospective investmentthe operational cash flows of the proposed project (initial investment,

operating cash flows, terminal value). The parent viewpoint analysis, must however focus on thosecash flows which flow between the parent and the project of any kindincluding operating cash flows(operating returns, intrafirm sales and margins, etc.) as well as financing cash flows (dividends asdistributed to the parent from the project).

There are many methods for evaluating the profitability of investment proposals. The various commonlyused methods are:

Traditional methods:

(I) Payback period method (P.B.P)

(II) Accounting Rate of return method (A.R.R)

Time adjusted or discounting techniques:

(I) Net Present value method (N.P.V)

(II) Internal rate of return method (I.R.R)(III) Profitability index method (P.I)

Pay-back period method:

The pay back some times called as payout or pay off period method represents the period in which totalinvestment in permanent assets pay back itself. This method is based on the principle that every capitalexpenditure pays itself back with in a certain period out of the additional earnings generated from the capitalassets.

Decision rule:

A project is accepted if its payback period is less than the period specific decision rule. A project is acceptedif its payback period is less than the period specified by the management and vice-versa.

Pay Back Period

Initial Cash Outflow

=

------------------------------

Annual Cash Inflows

Advantages:

Simple to understand and easy to calculate. It saves in cost; it requires lesser time and labour as compared to other methods capitalbudgeting. In this method, as a project with a shorter pay back period is preferred to the one having a longerpay back period, it reduces the loss through obsolescence. Due to its short-term approach, this method is particularly suited to a firm which has shortage ofcash or whose liquidity position is not good.

Disadvantages:

It does not take into account the cash inflows earned after the pay back period and hence thetrue profitability of the project cannot be correctly assessed.


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This method ignores the time value of the money and does not consider the magnitude andtiming of cash inflows. It does not take into account the cost of capital, which is very important in making soundinvestment decisions. It is difficult to determine the minimum acceptable pay back period, which is subjective decision. It treats each asset individually in isolation with other assets, which is not feasible in realpractice.

Accounting Rate of Return Method

This method takes into account the earnings from the investment over the whole life. It is known as averagerate of return method because under this method the concept of accounting profit (NP after tax and

depreciation) is used rather than cash inflows. According to this method, various projects are ranked inorder of the rate of earnings or rate of return.

Decision rule

The project with higher rate of return is selected and vice versa.

The return on investment method can be used in several ways, as

Average Rate of Return Method

Under this method average profit after tax and depreciation is calculated and then it is divided by the total

capital out lay.

Average Annual profits (after dep. & tax)

Average rate of return = ---------------------------------------------------x 100

Net Investment

Advantages:

It is very simple to understand and easy to calculate. It uses the entire earnings of a project in calculating rate of return and hence gives a true view of

profitability. As this method is based upon accounting profit, it can be readily calculated from the financialdata.

Disadvantages:

It ignores the time value of money. It does not take in to account the cash flows, which are more important than the accountingprofits. It ignores the period in which the profits are earned as a 20% rate of return in

2 years is considered to be better than 18% rate if return in 12 years.

This method cannot be applied to a situation where investment in project is to be made in parts.

Net Present Value MethodThe NPV method is a modern method of evaluating investment proposals. This method takes in toconsideration the time value of money and attempts to calculate the return on investments by introducingtime element. The net present values of all inflows and outflows of cash during the entire life of the project isdetermined separately for each year by discounting these flows with firms cost of capital or predeterminedrate. The steps in this method are

1. Determine an appropriate rate of interest known as cut off rate.2. Compute the present value of cash outflows at the above-determined discount rate.

3. Compute the present value of cash inflows at the predetermined rate.


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4. Calculate the NPV of the project by subtracting the present value of cash outflows from present value ofcash inflows.

Decision rule

Accept the project if the NPV of the project is 0 or +ve that is present value of cash inflows should be equalto or greater than the present value of cash outflows.

Advantages:

It recognizes the time value of money and is suitable to apply in a situation with uniform cash outflowsand uneven cash inflows.

It takes in to account the earnings over the entire life of the project and gives the true view of theprofitability of the investment

Takes in to consideration the objective of maximum profitability.

Disadvantages:

More difficult to understand and operate.

It may not give good results while comparing projects with unequal investment of funds.

It is not easy to determine an appropriate discount rate.

Internal Rate of Return MethodThe internal rate of return method is also a modern technique of capital budgeting that takes in to accountthe time value of money. It is also known as time-adjusted rate of return or trial and error yield method.Under this method the cash flows of a project are discounted at a suitable rate by hit and trial method, whichequates the net present value so calculated to the amount of the investment. The internal rate of return canbe defined as "that rate of discount at which the present value of cash inflows is equal to the present valueof cash outflows".

Decision Rule:

Accept the proposal having the higher rate of return and vice versa.

If IRR>K, accept project. K = cost of capital.

If IRR


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1. Prepare the cash flow table using assumed discount rate to discount the net cash flows to thepresent value.1. Find out the NPV, & if the NPV is positive, apply higher rate of discount.1. If the higher discount rate still gives a positive NPV, increase the discount rate further. Until theNPV becomes zero.1. If the NPV is negative, at a higher rate, NPV lies between these two rates.

Advantages:

It takes into account, the time value of money and can be applied in situations with even and even cashflows.

It considers the profitability of the projects for its entire economic life.

The determination of cost of capital is not a pre-requisite for the use of this method.

It provides for uniform ranking of various proposals due to the percentage rate of return.

This method is also compatible with the objective of maximum profitability.

Disadvantages:

It is difficult to understand and operate.

The results of NPV and IRR methods may differ when the projects under evaluation differ in their size, lifeand timings of cash flows.

This method is based on the assumption that the earnings are reinvested at the IRR for the remaining lifeof the project, which is not a justified assumption.

Profitability index method:

It is also a time-adjusted method of evaluating the investment proposals. PI also called benefit cost ratio ordesirability factor is the relationship between present value of cash inflows and the present values of cashoutflows. Thus

PV of cash inflows

Profitability index = ------------------------------------

PV of cash outflows

Advantages:Unlike net present value, the profitability index method is used to rank the projects even when the costs of

the projects differ significantly.

It recognizes the time value of money and is suitable to applied in a situation with uniform cash outflowsand uneven cash inflows.

It takes into an account the earnings over the entire life of the project and gives the true view of theprofitability of the investment.

Takes into consideration the objective of maximum profitability.

Disadvantages:

More difficult to understand and operate.

It may not give good results while comparing projects with Unequal investment funds.

It is not easy to determine and appropriate discount rate.

It may not give good results while comparing projects with unequal lives as the project having higher NPVbut have a longer life span may not be as desirable as a project having some what lesser NPV achieved in amuch shorter span of life of the asset


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Unit 5

V. Internal Sources of FundsA Equity Contributions

i. Every new foreign subsidiary must receive some funds in the form of equity tosatisfy both authorities in the host country and outside creditors about itssolvency.

ii. Sometimes, MNCs use an equity investment for their own foreign subsidiary.1. This gives the foreign subsidiary an increased capital base to support

additional loans.iii. Equity contributions of cash are used for the following:

1. To acquire going concerns.

2. To buy out local minority interests.3. To set up new foreign subsidiaries.4. To expand existing subsidiaries.

iv. Common stockholders have residual claims on earnings and assets in the eventof liquidation.

1. This makes an equity investment not very flexible for the investors, butmost acceptable to the host country and outside creditors.

v. Dividends are the profit remittances derived from equity investments.1. They are typically subject to local income taxes and withholding taxes.

B. Direct Loansi. MNCs may provide investment funds through intracompany loans.

1. The intracompany loan usually contains a specified repayment periodfor the loan principal.

2. The intracompany loans usually earn interest income that is taxedrelatively lightly.

ii. Parent loans are more popular than equity contribution for the following reasons:1. Parent loans give a parent company greater flexibility in repatriating

funds from its foreign subsidiary.2. The tax rate is typically lower than the rate on dividends, making the tax

burden lower.3. MNCs can provide credit to their subsidiaries not only by making loans,

but also by delaying the collection of accounts receivable.C. Parent Guarantees

i. When foreign subsidiaries have difficulty borrowing money, a parent may affix itsown guarantees.

ii. There are four type of parent guarantees:1. The parent may sign a purchase agreement under which it commits

itself to buy its subsidiarys note from the lender in the event of thesubsidiarys default.

2. The lender may be protected on only a part of the specific loanagreement.

3. Another type of guarantee is limited to a single loan agreement betweena lender and the subsidiary.

4. The strongest type requires that the lender be protected on all loans tothe subsidiary without limits on amount or time.

D. Funds Provided by Operationsi. Internal funds flows, i.e. retained earnings and depreciation, are the major

sources of funds for newly formed subsidiaries.1. Typically, these internal funds, paired with local credits, leave small

need for funds from the parent.ii. Foreign subsidiaries are not always free to remit their earnings in hard currency

elsewhere.1. Many developing nations, due to balance of payments problems, restrict

repatriation of funds.

E. Loans for Sister Subsidiariesi. The availability of intersubsidiary credit greatly expands the number ofpossibilities for internal funding.

1. Many countries impose exchange restrictions on capital movements andthis limits the range of possibilities for intersubsidiary loans.

ii. The use of many intersubsidiary financial links makes it extremely difficult for theparent company to control its subsidiaries effectively.

iii. An MNC may wish to have its central staff handle all excess funds or to establisha central pool of these funds on worldwide basis under two conditions:

1. The number of financial relationships does not exceed the capability ofthe main office to manage them effectively.

2. A parent company does not want to lose control over its subsidiaries.

VI. External Sources of Funds


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A. Subsidiaries borrow local for the following reasons:i. Local debts represent automatic protection against losses from a devaluation of

local currency.ii. Subsidiary debts frequently do not appear on the consolidated financial

statement issued by a parent as part of its annual report.iii. Some host countries limit the amount of funds that foreign companies can import

from outside the host country.iv. Foreign subsidiaries often borrow locally to maintain good relations with local

banks.B. Commercial Banks

i. Commercial banks are the most important external source of financing for non-trade international operations.

ii. Most of the local loans obtained by subsidiaries are short-term credits.1. They are largely used to finance inventory and accounts receivable.2. They are self-liquidating loans to the extent that sufficient cash flows are

produced to repay the credits as inventories are sold on credit andreceivables are collected.

iii. There are variety of principal instruments used by banks to service an MNCsrequest for a loan:

1. Overdrafts are a line of credit that permits the customer to write checksbeyond deposits.

a. The bank establishes the maximum amount.b. The borrower agrees to pay the amount overdrawn and

interest on the credit.2. Unsecured short-term loans are loans to cover seasonal increases in

current assets that are made on an unsecured basis.a. Most MNCs prefer to borrow on a n unsecured basis because

the bookkeeping costs of secured loans are high and becausethese loans have a number of highly restrictive provisions.3. Bridge loans are short-term bank loans used while a borrower obtains

long-term fixed rate loans from capital markets.a. Bridge loans are repaid when the permanent financing

arrangement is completed.4. Currency swaps are agreements to exchange one currency with another

for a specified period after which the two currencies are re-exchanged.a. Arbi loans are the best know example of these swaps.b. Swaps allow the MNCs to borrow in one market for use in

another market and to avoid foreign exchange risks.5. Link financing is an arrangement where banks in strong-currency

countries help subsidiaries in weak-currency countries obtain loans byguaranteeing repayment on the loans.

a. Banks is strong-currency countries typically require some sort

of deposits from the borrowers parent company.iv. Interest rate on must business loan are determined through direct negotiations

between the borrower and the bank.1. The prevailing lending rate and the credit worthiness of the borrower are

the two major factors.2. Interest rate may be paid in two different ways:

a. On a collect basis where interest is paid at the maturity of theloan. This makes the effective rate of interest equal to thesatiated rate of interest.

b. On a discount basis where interest is paid in advance. Thisincreases the effective rate of interest.

v. Compensating balances are those that borrowers are required by their bank tokeep their account. These are used to:

1. Cover the cost of accounts.2. Increase the liquidity position of the borrower that can be used to pay off

the loan in case of default.3. Increase the effective costs of borrowing.

vi. In reality, the value of the currency borrowed changes over time and this changeaffects the actual cost of a bank credit.

1. The effective interest rate is computed using the equation -- r =(1 + if)(1 + ie) 1

a. r = the effective interest rate in U.S. dollars.

b. if= the interest rate of the foreign currency.c. ie = the percentage change in the foreign currency against the

U.S. dollar.


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vii. Edge Act and Agreement corporations are subsidiaries of American banks thatare physically located in the United States but engage in international bankingoperations.

1. The Edge Act of 1919 allows American banks to perform as holdingcompanies and to own stock in foreign banks.

a. These banks con provide loans and other banking services forAmerican-owned companies in most countries.

2. Edge Act corporations are domestic subsidiaries of banking organizedcharter by the Federal Reserve Board.

3. Agreement corporations are Edge equivalents chartered by individualstates.

4. Both of these corporations engage in three types of activities:a. International banking, which includes the following:

i. Hold demand and time deposits of foreign parties.ii. Make loans but these loans to any single borrower

may not exceed 10 percent of their capital andsurplus.

iii. Open and confirm letters of credit.iv. Make loans or advances to finance foreign trade.v. Create bankers acceptances.vi. Receive items for collection.vii. Remit funds abroad.viii. Buy or sell securities.ix. Issue certain guarantees.x. Engage in foreign exchange transactions.

b. International financing, which includes the following:i. Invest in the stock of nonblank financial concerns,

development corporations, or commercial andindustrial companies.ii. The major purpose of such financing activities is to

provide promising foreign companies with capital atan early or important stage.

c. Holding companies, which includes the following:i. Own shares of foreign baking subsidiaries and

affiliates.ii. Member banks of the Federal Reserve System are

not permitted to own shares of foreign bankingsubsidiaries.

iii. A subsidiary can more advantageous than a branchfor two reasons 1) foreign branches are allowed tocarry on only the activities allowed to their parentbanks in the U.S. and 2) certain countries do not

permit non-domestic banks to open branches in theirterritory.

viii. International banking facilities (IBFs) (allowed since December of 1981) arevehicles that enable bank offices in the Unites States to accept time deposits ineither dollars or foreign currency from foreign customers free of reserverequirements and other limitations.

1. Some states have exempted IBFs from state and local income taxes.2. In other words, the creation of IBFs means the establishment of offshore

banking facilities in the U.S. similar to other Eurocurrency marketcenters.

3. Two qualify for IBFs, institutions must be depository institutions, Edge orAgreement corporations, or U.S. branch offices of foreign banks that arelegally authorized to do business.

4. IBFs have a the following advantages over foreign locations:a. Small banks can enter into the Eurocurrency market easily.

b. U.S. banks can reduce operating costs because they havemore direct control and use existing support services.

5. IBFs have the following disadvantages over foreign locations:a. IBFs must receive writer acknowledgement from their

customers that deposits do not support activities within theU.S. and that IBF loans finance only operations outside theU.S.

b. IBFs are prohibited from offering demand deposits ortransaction accounts that could possibly substitute for suchaccounts now held by nonresidents in U.S. banks.

c. IBFs are prevented from issuing negotiable certificates ofdeposits or bankers acceptances through they can issueletters of credit and undertake repurchase agreements.


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d. Time deposits offered to nonbank foreign residents requireminimum deposits and withdrawal of $100,00 to preserve thewholesale nature of the business.

C. Strategic Alliancesi. A strategic alliance is any collaborative agreement between two companies that

is designed to attain some strategic goal.1. A key advantage of strategic alliances is financial synergy, i.e. when a

financially strong company helps a financially weak company.ii. International licensing agreements, a type of strategic alliance, are agreements

whereby an MNC (the licensor) allows a local firm (the licensee) to produce thelicensors products in the firms local markets in return for royalties, fees, andother forms of compensation.

iii. Management contracts are arrangements where one party (an MNC)contractually agrees to manage an enterprise owned by another party (localinvestors).

iv. Joint ventures are corporate entities in which two or more parties, for example anMNC and host-country companies, have equity interest. There are four types:

1. Two companies from the same country form a joint venture to conduct abusiness in a third country.

2. An MNC forms a joint venture with host-country companies.3. An MNC and a local government form a joint venture.4. Companies from two or more countries establish a joint venture in a

third country.v. There are many motives for using strategic alliances:

1. Spread and reduce costs.2. Avoid or counter competition.3. Secure horizontal and vertical links.

4. Specialize in a number of selected products, assets, or technologies.5. Learn from other companies.6. Gain location-specific assets.7. Overcome legal constraints.8. Diversity geographically.9. Minimize exposure in risky environments.

D. Project finance refers to an arrangement whereby a project sponsor finances a long-termcapital project on a non-recourse basis.

i. Non-recourse means that the project sponsor has legal and financialresponsibilities for the project.

ii. Three characteristics differ project finance from other forms of financing:1. The project is established as an individual legal entity and relies heavily

on debt financing.2. The debt repayment is contractually tied to the cash flow generated by

the project.

3. Government participation comes in the form of infrastructure support,operating or financing guarantees, or assurances against political risk.

iii. Project finance offers several benefits over conventional debt financing:1. Restricts the usage of the projects cash flows.

a. The lenders, rather than the managers, can decide whether toreinvest excess cash flows or to use them to reduce the loanbalance by more than the minimum required.

2. Project f inance increases the number and type of investmentopportunities, thereby making the capital markets more complete.

3. Project finance permits companies whose earnings are below theminimum requirements to obtain additional debt financing.

iv. There are two types of project finance:1. A build-operate-own (BOO) contract where the sponsor assumes

ownership of the project at the end of the contract life.2. A build-operate-transfer (BOT) contract where ownership of the project

is transferred to the host government.

VII. Development BanksA. The World Bank Group is a group of worldwide financial institutions organized after World

War II to aid economic reconstruction.i. The International Bank for Reconstruction and Development (IBRD), commonly

known as the World Bank, was established at the Bretton Woods conference in1944 as a companion institution to the International Monetary Fund (IMF).

1. The initial objectives of the World Bank were to help reconstruct Europepost World War II.

a. It did this mainly through the Marshall Plan.2. Recently, its main objective has been to loans to underdeveloped

countries for social infrastructure.


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3. It also encourages private investors to finance the portion of projectcosts that it cannot finance. To facilitate this it has adopted thefollowing high credit standards:

a. The Bank makes loans only for projects whose cost andrevenue estimates are reasonably accurate.

b. When loans are made to private companies, their governmentsmust guarantee these loans.

c. An additional 1 percent is added to the regular interest rate.These funds go into reserve funds to meet losses in the evenof default.

d. Member countries are required to pay the unpaid portion oftheir quotas in the event that funds are needed to meet losses.

4. The basic equity capital for the bank comes from member countries.Each member country is assigned a subscription quota based on theirsize and wealth.

a. 10% of the quota is due upon joining.b. 90% is subject to call.

5. The World Bank has a number of problems providing financialassistance to less developed countries for the following reasons:

a. All loans have to be guaranteed by governments.b. The Bank provides only loans.c. It finances only the foreign exchange requirements for a project

and ignores local expenditures or working capitalrequirements.

d. It typically finances only large projects of public importance.ii. The International Finance Corporation (IFC) was founded in 1956 primarily to

finance private enterprises in less developed countries not covered by the World

Bank.1. The IFC regards development finance companies and industrial projectsas the proper outlets for its limited capital.

2. It does not typically invest in infrastructure projects.iii. The International Development Association (IDA) was founded in 1960 to meet

the specific needs of less developed countries.1. IDA loans are designed to finance projects for companies that cannot

adhere to loan repayment schedules with conventional terms.a. Credit terms are generally extended for 50 years with very low

or no interest.b. Repayment begins after a 10-year grace period and may be

made in local currencies.2. All World Bank members are free to join the IDA and more than 100

have.3. IDA resources are separate from World Bank resources and nearly 90%

of the IDSs capital comes from subscriptions of its member countries.a. The second biggest source of capital is the World Banks

contribution.B. Regional Development Banks

i. The U.S. and 19 Latin American countries founded the Inter-AmericanDevelopment Bank (IDB) in 1959 to further the economic development of itsmember countries.

1. Twenty-six Latin American countries and 15 other countries now ownthe bank.

2. IDB loans are available only when private sources are not available onreasonable terms and typically finance no more than 50% of the totalproject cost.

3. The IDB has three types of activities:a. With its Ordinary Capital Resources Fund, the Bank makes

development loans to both public and private institutions.

These loans are earmarked for projects that promote LatinAmericas economic development.

b. With it U.S. created Social Progress Trust Fund, the Bankmakes loans to finance projects with high social value.

c. With its Fund for Special Operations, the Bank makes loanswhose terms are much more lenient than those available in theregular money and capital markets. Maturities may beextremely long, repayment may be made in the borrowerscurrency, or interest rates may be arbitrarily low.

ii. The European Bank for Reconstruction and Development (EBRD) was foundedin 1990 by

Documents

Notes of GFM