International Financial
Markets
By- Rahul Jain
Foreign Exchange Rate
Determination

Determined by Demand and Supply
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This also depends on the relative economic
performance of the two countries
Three Types of Exchange
Rate Exposure
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Transaction Exposure
Economic Exposure
Translation (accounting) Exposure
Transaction Exposure
Transaction exposure arises whenever a
company is committed to a foreign-currencydenominated transaction. Since the transaction
will result in a future foreign currency cash
inflow or outflow, any change in the exchange
rate between the time the transaction is entered
into and the time it is settled in cash will lead
to a change in the dollar (HC) amount of the
cash inflow or outflow.
Transaction Exposure
Measures how greatly exchange rate fluctuations
may affect cash transactions

Affects exposure to net cash flow
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consolidates subsidiaries’ cash in/outflows
e.g., minimal exposure in Mexican peso if

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Subsidiary A has net inflow of PS9,000,000
Subsidiary B has net outflow of PS8,700,000
MNC net flow = PS300,000
Transaction Exposure
Transaction exposure measures gains or losses that arise from
the settlement of existing financial obligations, namely
o Purchasing or selling on credit goods or services when
prices are stated in foreign currencies
o Borrowing or lending funds when repayment is to be
made in a foreign currency
o Being a party to an unperformed forward contract and
o Otherwise acquiring assets or incurring liabilities
denominated in foreign currencies
http://www.businessfaculty.utoledo.edu/pkozlowski/FINA3500/c
h08.ppt.
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Transaction Exposure

Steps to assess transaction exposure
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assess MNC’s position in each currency
estimate how an exposure in a currency affects the
MNC

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use standard deviations and correlations
assess the “net” effect of currency exposures
Economic Exposure
Measures how greatly an MNC’s present value of future
cash flows is affected by unexpected exchange rate
fluctuations

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Transaction is a subset of economic exposure
Currency fluctuations affect more than currency
transactions
-- e.g., an increase in inflation in France may:
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1. lower value of outflow from France (transaction exposure)
2. increase subsidiary’s French sales
3. raise financing cost in France
Economic exposure
It measures how greatly a firm’s present value of
future cash flows is affected by unexpected
exchange rate fluctuations.
Economic Exposure

Indirect exposure

implies even domestic firms have foreign
exchange risk
Economic Exposure

Exposure of domestic firms

impacted by foreign competition and financial
markets
Economic Exposure

Exposure of MNCs


face exposure on domestic and foreign operations
Jan-May 1993:13% appreciation of Japanese yen
against $US

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many US firms increase US market share
Japanese firms often priced out of the US market
Economic Exposure:
Measurement

Assess sensitivity of earnings to exchange
rate fluctuations
A firm is relatively insulated from exchange rate
movements if costs and revenues are affected by
similar magnitudes.
Translation (Accounting) exposure
The change in the value of a firm’s foreign
currency denominated accounts due to a
change in exchange rates.
Translation Exposure
Measures impact that exchange rate fluctuations have
upon an MNC’s consolidated financial statement


Affects value of assets, liabilities and earnings
Argument for relevance to MNC
 affects financial statements (MNC performance)
Translation Exposure
Determinants

Level of foreign
involvement by foreign
subsidiaries

a greater exposure exists
when:

a larger contribution is made
offshore
Translation Exposure
Determinants

Locations of foreign subsidiaries
 affects currencies used in initial
measurements
Translation Exposure
Determinants

Accounting methods

affect how and what financial numbers are
reported
Summary

Exchange rate exposure may affect financing
costs


volatile cash flow from exchange rate changes
increases risk
Transaction exposure

reflects the exposure of an MNC’s future cash
transactions to exchange rate movements
Summary

Economic exposure


measures the direct and indirect risks to cash flows
from exchange rate movements
Translation exposure

focuses on consolidated financial statements
Characterstics of Foreign Bond
The bond is issued by a foreign entity (such as a
government, municipality or corporation)
The bond is traded on a foreign financial
market
The bond is denominated in a foreign currency
“
Euro Bond
“Eurobond is a bond issued and traded in a
country other than the one in which its
currency is denominated. A Eurobond does not
necessarily have to originate or end up in
Europe although most debt instruments of this
type are issued by non-European entities to
European investors.”
Foreign Currency Convertible
Bond - FCCB

A type of convertible bond issued in a
currency different than the issuer's domestic
currency. In other words, the money being
raised by the issuing company is in the form of
a foreign currency. A convertible bond is a
mix between a debt and equity instrument. It
acts like a bond by making regular coupon and
principal payments, but these bonds also give
the bondholder the option to convert the bond
into stock.
Features
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Sweetening Debt
Deferred Equity Financing
Cash Inflow in Future
May keep the share prices high.
Investor enabled to have access to shares
without investing now.
Risks