DRIVE-SPRING 2014 PROGRAM-MBADS (SEM 4/SEM 6) MBAFLEX/ MBAN2 (SEM 4) PGDFMN (SEM 2) SUBJECT CODE & NAME-MF0015 & INTERNATIONAL FINANCIAL MANAGEMENT BK ID-B1759 CREDIT & MARKS-4 Credits, 60 marks Q1 Write short notes on: a) Measuring exchange rate movements b) Factors that influence exchange rates (Measuring exchange rate movements, Factors that influence exchange rates)5,5 Answer. a) Measuring exchange rate movements The movement of exchange rates is the result of the combined effect of a number of factors that are constantly at play. Economic factors, also called fundamentals, are better guides as to how a currency moves in the long run. Short-term changes are affected by a multitude of factors which may also have to be examined carefully. Changes in one nation's economy are rapidly transmitted to that nation's trading partners. These fluctuations in economic activity are reflected almost immediately in fluctuations of currency values. These changes in exchange rates expose all those firms having export import operations as also multinationals with integrated cross border production and marketing operations. It is useful to be aware of the various factors that influence exchanges rates. By a study of these factors and the trend of movements in the value of particular currency, an experienced businessman may be able to forecast the possible future movement of that currency. This will enable him to: (i) Estimate his risk and (ii) Make an informed, prudent decision as to whether it would be worthwhile for him to carry the risk or to take some appropriate steps to reduce that risk. b) Factors that influence exchange rates The demand factor At the most primary level, a change in the price of a currency will occur because of more or less demand for it. High demand signifies a higher price experience of the currency pair. Less demand signifies fall in the price of the currency pair. An increased demand for a currency suggests a strong economy, while a The supply side factor A basic economic principle of supply says that a currency's value will change with the rise and fall of the levels of supply. The value and price of a currency will diminish if there is a higher supply of a currency. Long term vs. short term A time period of a year or more signifies a long-term supply and demand. Short term is generally thirty days or less than that. The currency prices in both the time periods can be affected by the same factors. A trader should be conscious of the time factor in which a trade is placed. Factors affecting Currency Trading A number of factors affect the rates of exchange. At the end, costs of currency result from the supply of currency. The currency markets all over the world can be considered a huge melting pot. Economic factors These include the economic policy of the government which is made known through various government agencies and the central bank of the country, and economic conditions, generally revealed through economic reports. Q2 The key component of the financial system is the money market that acts as a fulcrum of monetary operations. Write down the important points under each category mentioned below. a) Functions performed by money market b) International interest rates c) Standardized Global Market regulations. (Explanation of important points of functions performed by money market, Explanation of international interest rates, Explanation of standardized global market regulations)3,3,4 Answer. a) Functions performed by money market There are three broad functions that are performed by the money market. 1. For the demand and supply of short term funds, the money market provides an equilibrating mechanism. 2. It helps the lenders and the borrowers of the short term funds in fulfilling the borrowing and investment requirements at a competent market clearing price. 3. It offers an avenue to the central bank to intervene in influencing the cost of liquidity and the quantum in the financial system which in turn transmits monetary policy impulses to the real economy. b) International interest rates Money market rates are interest rates used by banks for operations among themselves. Money market enables the banks to trade their surpluses and deficits. This rate is also commonly known as inter-bank rate. The rates for various countries vary substantially. The reason for this substantial difference in rates is due to the interaction of supply or availability of short term funds (bank deposits) in a particular country versus the demand by borrowers for short term funds in that country. If the supply is more than the demand the interest rate will be low. c) Standardized Global Market regulations. Regulations contribute to the development of international money markets because these impose restrictions on local markets. Local investors and borrowers try to circumvent the restrictions in local markets. Difference in regulations among countries puts banks in some countries to advantageous position compared to banks in other countries. Over a period of time, international banking regulations have been standardized, which permit competitive global banking. Three most significant regulatory events for creating more competitive global level playing field are given below: 1. The Single European Act 2. The Basel I Accord 3. The Basel II Accord Single European Act This was one of the most significant events pertaining to international banking. It was introduced in 1992 throughout the European Union countries. The Basel I Accord In July 1988, central bank governors of 12 countries agreed on standard guidelines for banking regulation under ‘The Basel Accord’. As per the guidelines of The Basel Accord, banks are required to maintain capital equal to minimum of 4 per cent of their assets. The Basel II Accord The banking regulators those formed the Basel Accord introduced a new accord called ‘The Basel II Accord’. The objective of this accord is to rectify some inconsistencies that still exist in the earlier accord. Q3 Thousands of years back the concept of bartering between parties was prevalent, when the concept of money had not evolved. Explain on counter trade with examples (Introduction of counter trade, Explanation of Different forms of counter trade, Examples)3,5,2 Answer. Counter trade When the concept of money had not evolved, a person could give say 100 bags of wheat and get wood or coal, a certain quantity for cooking. These bartering contracts were between individuals or small kingdoms. Bartering exists today also but at different level. For example, Iran may give 100 million barrels of oil to France and get 5000 guns of certain type in exchange. We can say that bartering is exchange of goods between parties as per agreed terms without the use of money. Today, most business is transacted with money as medium. Trading between countries is through respective currencies using international exchange rate. Countertrade means all types of foreign trade in which the sale of goods to another country is associated with parallel purchase of some other goods from that country. Different forms of counter trade The different forms of countertrade are: • Barter • Buy-back • Counter purchase Countertrade takes many different forms as explained below: (i) Barter: It is exchange of goods without the use of money. Typical examples are: (a) Oman exchange oil for air conditions with Taiwan (b) Sri Lanka exchange fish for mobile handsets with Germany (ii) Buy back: In this part, the payment of the price of contract is through supply of related products. Typical examples are: (a) A firm in China purchases plant & technology for manufacture of high precision bearings from Germany, and the firm in Germany agrees to buy a part of bearings produced by the plant in China. (b) An Indian aerospace firm sets up production facility for manufacture of executive jets under technical collaboration from an American firm who in turn agrees to provide a part of worldwide business of overhauling of executive jets to the Indian firm. (c) A firm establishes gas pipeline for another firm to transport gas and produce electricity and in turn agrees to buy a portion of electric power for prolonged period at predetermined terms. (iii) Counter purchase: In such cases, there is direct purchase of items as exchange deals. Typical examples are: (a) A firm in US sold soft drinks to Russian counterpart and imported vodka in exchange. (b) Canada sold wheat to Indonesia in exchange for import of rubber. (c) A German firm sold machine Examples Examples of countertrade are many and in a variety of forms. Though countertrade is existing to create win-win situation between parties involved, it has its own ills; typically following issues are existing: 1. The exporting country sells high technology items at inflated prices and the items which they import are disposed off to other countries at a discount, using a part of high premium charged on their exports. 2. The middlemen in the countertrade agreements are usually shrewd traders who exploit the political and social circumstances to obtain large gains for themselves. 3. The goods that are offered in countertrade are not the required items, because the desirable items have already been exported. For example, if Switzerland sells high precision machines to Brazil, it may like Brazilian coffee beans in exchange, but what it may get is only leather goods. Q4 There are different techniques of exposure management. One is the Managing Transaction Exposure and the other one is the managing operating exposure, So you have to explain on both Managing Transaction Exposure and Managing Operating Exposure. (Explanation of Managing transaction exposure, Explanation of Managing operating exposure) 5, 5 Answer. Managing transaction exposure Transaction exposure calculates gains or losses which occur after the current financial compulsions according to terms of reference are resolved. Taken that the deal would lead to a future inflow or outflow of foreign currency cash, any unprecedented alterations in rate of exchange amid the period in which transaction is entered and the time taken for it to settle in cash would guide to a change in worth of net flow of cash in terms of the home currency. For example a transaction exposure of an Indian company will be the account receivable which is associated with a sale denominated in US dollars or the compulsion of an account payable in Euro debt. Presume an Indian firm sells goods with an open account to a German buyer for €1,800,000 payment of which is to be done in 2 months. The current exchange rate is ` 50/€, and the Indian seller expects to exchange the euros received for ` 90,000,000 when payment is received. If euro weakens to `45/€ when payment is received, the Indian seller will receive only `81,000,000, or some `9,000,000 less than anticipated. Opposite will be the case should euro strengthen. Thus exposure is a chance of either gain or loss. Managing operating exposure Operating exposure is alternatively known as economic exposure. It evaluates the changes that occur in the current value of the firm. The change in the current value may be a result of the change that takes place in predicted operating cash flows on account of fluctuations in exchange rates. They are similar in that they both deal with future cash flows. They differ in terms of which cash flows management considers. Transaction exposure deals with the predicted cash flows for future that have already been contracted and hence accounted for. At the same time, the operating exposure focuses on the predicted-but not yet contracted-cash flows in future. These future cash flows may undergo changes in case of a major fluctuation in the exchange rate, resulting in changes in the overall competitiveness at international level. Some firms face operating exposure without even dealing in foreign exchange. Consider an Indian perfume manufacturer who sources and sells only in the domestic market. Since the firm’s product competes against imported perfumes (say from Paris) it is subject to foreign exchange exposure. It faces severe competition when rupee gains against other currencies (here, euro), lowering the prices of imported perfumes. Q5 Every firm is going on concern, whether domestic or MNC. Explain the techniques of capital budgeting and the steps to determine cash flows. (Explanation of techniques of capital budgeting-NPV, IRR , PI , Payback period, Determination of cash flow)5,5 Answer. Techniques of capital budgeting-NPV, IRR , PI , Payback period There are many techniques which can be used to analyze the projects. These techniques can be broadly classified into discounted cash flow techniques, which include net present value (NPV), internal rate of return (IRR), profitability index (PI) and discounted payback methods, and non-discounted cash flow techniques which include payback and accounting rate of return (ARR) methods. The most commonly and most widely accepted technique is NPV method. We now describe some of these techniques in brief and NPV method in greater detail. Net Present Value (NPV) In this method all future cash flows occurring in different time periods are discounted to present value using opportunity cost of capital as discount rate. Whenever there is a cash inflow, we take it with positive sign and cash outflow, we take it as negative sign. If present value (PV) of cash inflows is greater than present value (PV) of cash outflows the project can be accepted. However, if there are more than one project and only one can be accepted then the project with highest difference of PV of all cash inflow and PV of cash outflows is accepted. The difference of PV of all future cash flows and initial investment is known as NPV. So, we can say that project with positive NPV can be accepted and in case of more than one project, the project with highest NPV will be accepted. Internal Rate of Return (IRR) Internal rate of return is defined as that discount rate at which NPV is equal zero. This internal rate of return is compared with opportunity cost of capital. If IRR is greater than opportunity cost of capital the project can be accepted; if IRR is less than opportunity cost of capital the project cannot be accepted as in such a case, the project will not be able to generate even the opportunity cost of capital. If IRR is equal to opportunity cost of capital the project will not generate any extra returns so it can either be accepted or rejected. The greater the magnitude by which IRR exceeds the opportunity cost of capital the greater will be the profitability, so ranking of projects can be done based on the magnitude of difference. Profitability Index (PI) It is defined as the ratio of present value of all cash inflows divided by the initial cash outflow. It is similar to NPV in the sense that it also uses discounted cash flows and initial outflow but instead of subtracting initial cash outflow from discounted cash flows, here we divide the discounted cash flows by initial cash outflow. We accept the project if PI is greater than one, reject it if PI is less than one and may or may not accept it if PI is equal to one. Payback Period This is a non-discounted cash flow technique. It finds out the time in years in which the initial investment would be recovered. It is the easiest method as far as computation is concerned but drawback being that it does not consider time value of money. Mathematically, it is calculated by dividing initial cash outflow by annual constant cash inflows. Determination of cash flow We need to determine the incremental cash flows over the existing cash flows which will take place by acceptance of the project under evaluation. Any expenses which are already incurred will not be included in cash flows. Such expenses are called sunk costs. The step of determining cash flows with accuracy is the most important step in capital budgeting analysis as further process is dependent on it, but it is a difficult task due to the following reasons: 1. Future is uncertain, and uncertainty gives rise to risks 2. Accounting information which is based on various assumptions is used as basis to determine cash flows 3. Economic conditions may change suddenly due to some event In any capital investment project there will be three main cash flows: • Initial cash outflow • Cash flows during the project. It may be inflow or a mix of inflow and outflow • Final period cash flow; generally referred to as terminal cash flow Though cash flows (not profits) are used as basis for evaluation of capital projects, both are important. These are connected by the following equation: Cash Flow = Profit (P) + Depreciation (D) – Capital Expenditure (CAPEX) The drawback with the use of profit as basis of the evaluation is that it is based on past data and does not fully reflect the likelihood of future cash flows. Q6 Write short note on: a) American Depository Receipts(ADR) b) Global Depository Receipts(GDR) (Explanation of ADR, Explanation of GDR) 5, 5 Answer. American Depository Receipts(ADR) It represents ownership in the shares of a non-US company and trades in the American stock markets. ADRs enable American investors to buy shares in foreign company without any issue of cross-border and cross-currency transactions. ADRs carry price in American dollar, pay dividend in the same currency and can be traded like any other share of US-based companies. Each ADR is issued by a US depository bank and can represent one share. The owner of ADR has the right to obtain the foreign stock it represents, but US investors are more interested in owning ADR as they can diversify their investments across the globe. ADR falls within the regulatory framework of the US and requires registration of the ADRs and the underlying shares with the SEC. Features of ADRs The following are the features of ADR: • ADR can be listed on American Stock Exchange. • A single ADR can represent more than one share. One ADR can be two shares or any fraction also. • The holder of the ADRs can get them converted into shares. • The holders of ADR have no right to vote in the company. Global Depository Receipts(GDR) They are used in Global Equity offering to international investors. It can be considered as global finance instrument that allows an investor to raise capital at the same time from two or more markets. Depositing receipts helps in cross border trading and settlement helps to reduce transaction costs and increases the investment base among the institutional investors. GDR is a negotiable certificate that represents a company’s publicly traded equity or debt. They are created when a broker purchases the company’s shares on domestic stock market and deliver them to the depository’s local custodian bank who instructs the depository bank to issue GDRs. They are traded on a stock exchange where they are listed and in OTC market. Let us understand the concept of GDR with the help of an example. Consider an European investor who wants an exposure in Indian securities. He can do so in two ways. The two ways are as follows: 1. First one is to enter the Indian stock market and buy the company’s stock on one of the Indian markets. The investors get exposed to the exchange risks and other compulsory rules and regulations that are formulated for the purchase and sale of securities in the Indian markets. 2. Second route is through GDRs that would give the investor ownership of the Indian Company’s stock without being subject to Indian stock market regulation. GDRs are considered same as selling equity in the Euromarkets.