Module Evaluation forms!

 Please complete the forms as you come in.

 You have until 12:08
 Note that I take the most notice of the
WRITTEN comments
Announcement:
Meetings today at 2 pm
 Business Studies  Business
 Law Lect Theatre Economics
2  124 Rendall Bldg.
 Julia Hodgson  Stephan
Pfaffenzeller
Portfolios
 I have marked them and they are with the
School Office.
◦ You will be notified when they are ready.
◦ DO NOT contact me or the School Office until
you are notified.
◦
 Note that I have given considerable
feedback on each paper, so please read
it. I cannot reconsider marks except for
procedural reasons.
Feedback on Portfolios
Structure, Style and Presentation
-Double space your work; Keep to a consistent format with page numbers

and table of contents.

-Put the date and time you accessed all web based sources. Do NOT put web

citations in the text!!!!!

-Keep to a professional tone. You are writing from the perspective of a senior

manager in a firm for your colleagues and your report may become a
matter of record.
- If English is not your first language, keep working to improve: it is one of

THE most important improvements you can make to your mark for a
variety of reasons.
-Proofread your work to catch errors. If you need to work on this, get a book

on grammar and review it over the summer.   


Feedback (continued)
For understanding and analysis:


 -Keep working to see things from the perspective of a firm. What matters
to it? What information can you provide that aids in making a
commercially beneficial decision?
 -In line with above, learn to edit out anything that does not contribute to
understanding – far too many of you still think that there are things
that you must tell me (and I read the same over and over and over
again......)
 -For Topic Three, bar TWO of you – you are not cynical enough. WHY do
you think that Trafigurachose the Ivory Coast to “do business” with?
Do you really think that the government did not at minimum know what
Trafigurawas planning/allowing? And regardless of whether it is
obvious to you that Trafigura is evil – you must, must, mustprovide
evidence to convince me if you are basing your argument on this. As I
said in the tutorial, I have worked in the Ivory Coast – I know that what
appears obvious rarely is... “Illegally dumped” – according to whose
laws????? 



Feedback (continued)
For research and referencing:


 -Use a variety of sources and question them (ALL

of them) for reliability.
 -Do NOT cite WIKIPEDIA!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!!
Lecture 13 &
Exam Review Session
 There WILL be a mandatory session next
week. Attendance will be taken and there
may be material that will be on the exam.
 See VITAL for:
◦ The format and advice for preparation
◦ A discussion board. Post your questions for the
review session here. I will then categorize
and produce a session answering the
questions.
◦ Do NOT email me with your individual
questions and do NOT ask me after the
lecture. POST THEM on the Discussion Board.

◦
International Finance
Part 2
Strategy
Foreign exchange risk
Learning Outcomes
nTo be able to describe the forex issues
facing firms
nTo have some understanding of how firms
might minimize forex risks.
 Brief Review
Part I
Principles to remember for Part 2
How does a business make
money?
nIt sells things for more than it cost to make
them.
n
nCosts(Fixed costs + Variable costs)
nRevenue (Price x Quantity Sold)
nProfit = TR – TC
nBreak even point = TC =TR
Core Principle Revisited
n


 INFLOWS > OUTFLOWS

Revenue = Costs or expenditure =

Price x Quantity Sold Fixed costs + Variable Costs
Financial Strategy
nFinancial strategy involves planning to:
nHaving the money (cash flow) to cover costs
nHaving the money (borrowing?) to invest for
the future
nHaving the money (profit) to meet
stakeholders(banks, shareholders,
employees,etc) financial expectations
Two Issues
Interest Rates Taxation
Nominal v Real Don’t forget it has

 Nominal = not to be paid

adjusted for Don’t forget that it

inflation may change

 Real = adjusted How to minimize?

for inflation. 


Strategic Financial
Decisions
nWhat shall be the source of funding? (This
is what a Finance Manager is MOST
concerned with!!!)
nHow to make investment decisions?
nWhat does the firm consider to be
acceptable levels of debt?
nHow can the firm minimize its tax
liabilities?
nHow much should shareholders be paid?
Looking for Finance:
Global Financial Markets
Shares Corporate Bonds
Corporate Eurobonds
bonds Foreign Bonds
Bond
Stock exchanges
markets

Derivatives
trading Foreign
Exchange
markets
Futures Spot trades
Options Forwards
Swaps Commodities
markets Swaps
Options
Futures
Spot trades
Other Ways of Getting
Finance: Debt Discounting
nDebt discountingis one way of getting
finance. It involves selling your debt (esp.
if you are an exporter).
n
Two types of debt discounting = factoring

and forfaiting.

Financial Management in the
Big International Firm
Strategies to move
money
nFunds positioning techniques:
strategies used to move monies from
one multinational operation to another
nTransfer price: an internal price set by a
company in intra-firm trade such as the
price at which one subsidiary will sell a
product to another subsidiary
nArm’s length price: the price a buyer will
pay for merchandise in a market under
conditions of perfect competition.
Table 14.1 Shifting profits by transfer pricing
 nTax havens: low-tax countries that are
hospitable to business

Table 14.2 Transfer pricing through tax havens

A banking system for
Africa?
 If you were running a waste management
system in the Ivory Coast and worried
about how to pay your contractors
without going through corrupt banks or
government officials, how might you do
it?
 Answer: mobile phone banking
One of the most common (and growing)

banking systems in Africa today.

**Find out something about this through your

own research.
 PART II
Foreign Exchange Risk Management
Recall Cash Flow
nCash management is one of the primary
functions of a finance department:
nBudgeting and financing foreign operations
nForecasting exchange rates and reducing
transaction, translation and economic
exposure risks.
 Managing cash flows
nInternal flow of funds
nWorking capital: the difference between
current assets and current liabilities

Common example of internal sources and flows of funds

What is a currency?
 In international business it is either a
means of exchange or a commodity – or
both.

 *a currency is bought and sold just like
other commodities (metals, grain, coal,
etc.).

 Examples: Yen, $, £, Euro, Yuan, Real.
Which countries have these currencies?
An Alternative Currency?
nCimarrones = one of at least 10
alternative currencies in Venezuela. None
can be exchanged for the bolivar, the
legal currency and can only be used in
local markets.
nNot been much of a success so far…
Foreign Exchange -
Definition
nThe nominal price of one nation’s money in
terms of another.
n
nE.g. the number of Yen it takes to buy one
£.
Exchange Rate - definition
nThe price at which one currency is
exchanged for another currency. These
transactions are carried out on the
forward (or spot) market in the foreign
exchange markets.
Exchange Rate Basics
nThe price of a currency is usually
determined by supply and demand.
Basics- supply & demand
nSupply and demand are determined by
(among other things):
nThe balance of payments (deficits or
surpluses) of economies and which direction
the markets think that this balance is moving.
nE.g. China has a positive balance of payments
and the US a negative one.
Basics: Appreciation
nAppreciation = the increase in the value of
a currency against other currencies.
nIe. An appreciation of a currency’s value makes
imports cheaper and exports more expensive
n
n

Brazil (2011)
nThe real has been appreciating (now at
1.58 to the $).
nWhat are the consequences of this?
nMakes exports more expensive
nMakes it difficult to tackle inflation, since
already high interest rates are attracting
foreign capital.
Depreciation
nA fall in the value of a currency against
other currencies.
nI.e. The depreciation of a currency’s value
makes imports more expensive and exports
cheaper.
Example - the rouble
(2009)
nGrowth in Russia has stopped, Inflation was
at 13% and the rouble lost more than 1/3
of its value.
nRussia allowed the rouble to slide slowly,
which allowed Russians to adjust to it, but
which has also stymied growth.
Example - The Yuan
n Chinese currency was pegged to the $ at 8.28 for the last
decade and there was a big push for a revaluation. The
People’s Bank of China was been forced to buy huge
amounts of US securities to prevent the yuan rising.
n Why?
n To boost Chinese consumer’s purchasing power?
n To reduce US current account deficit?
n No, China had only 10% of US trade (Economist ibid)
n No, Chinese exports have a large import content
n

The Yuan in 2009/11
nStill under attack as being undervalued.
nIs it?
nForex reserves surged
nPrices are cheaper than in US
nHuge current account surplus
nBut according to its purchasing power
parity (PPP) and Big Mac Index, it may be
5% undervalued.
The Petrodollar Problem
nWhereas China had a $200 billion surplus,
oil-exporting countries had a $500 billion
surplus in 2008.
nThe six members of the Gulf Co-operation
Council peg their currencies to the dollar.
nMost of this money is stashed in official
reserves or investment funds which are
much less transparent than the People’s
Bank of China.
nWhat has happened to this money since
the start of the unrest in the Middle East?
Tools
nHow do policy-makers know whether an
exchange rate is “correctly” valued?
nPPPS
nBIG MAC Index
Tool: Purchasing Power
Parities
nPPPS are often used instead of market
exchange rates because they market
rates often understate the size of
economies and their standard of living.
nPPPS take account of international
differences in prices of the same goods
and services (e.g. non-tradable products
are generally much lower in developing
economies).
Tool: The Big Mac Index
nThe relative price of a Big Mac around the
world
nChina ($1.30) is cheapest relative the dollar
($3.15) indicating that it is 59% undervalued.
 (2009, Economist Intelligence Unit).
The Consequence of
Measuring in PPPs
nUsing market rates, the developing
economies share of global output fell in
2007 whereas using PPPs, it rose.
Exchange Rates and
Firms
Fluctuations
Predictions
Buying Currencies
Dealing with Risk (Hedging)
Basics- Fluctuation
nExchange rate fluctuation- exchange rates
will fluctuate over time reflecting such
things as differences in inflation and
interest rates between countries
n
nSpeculation – the buying and selling of
currency in the hope of making a windfall
profit
Basics- Exposure of Firms to
Fluctuations
nExchange rate exposure – the extent of a
firm’s potential gains or losses on its
overseas operations (as measured in the
domestic currency)
Example - VW (2003)
nVW blamed a fall in its profits of more than
€1 billion on the fall in the $.
Example of why prediction is
hard- the value of the $
nBill Gates, Warren Buffet and most financial
market analysts predicted that the $
would fall in 2005. It did not: rather, it
rose by 3.5% against a broad basket of
currencies. Why?
n-difference between interest rates. Higher US
rates attracted foreign capital thus forcing the
$ up.
What might the $ in 2011?
Appreciate: nDepreciate:
 if US interest nIf US interest
rates rise faster rates do not rise
relative to other
than other
countries
countries nChina’s policy
toward the Yuan
nThe rising US
current account
deficit
Exchange rates – the
markets
nSpot Market – provides for the buying and
selling of currencies (and other
commodities) for immediate delivery
nSpot Rate = exchange rate applicable to the
trading of foreign currencies in which the current
rate of exchange is used and delivery is
considered immediate.
nForward Market-provides for the delivery of
a currency at some future point in time
 Buy £ with
€
Local stockbroker
bank
Major banks
Forex Interbank
broker LIFFE
market IMM

Local bank stockbroker

Buy € with
£

LIFFE = London International Futures Exchange

IMM = International Money market
Foreign Exchange Exposure
Risks
nA. economic risks
nB. transaction risks
nC. translation risks
Types of exchange rate
exposure
Time when exchange rate changes

Translation Transaction Economic Exposure

Exposure Exposure (plan ahead)
(record) (manage)
Translation Exposure
nArises when consolidating assets, liabilities,
revenues and expenses from overseas
subsidiaries (which are in foreign
currencies) into the parent company’s
accounts (which are in the domestic
currency).

Accounting Rules
nThere are well known accounting rules to
deal with translation exposure
n

Transaction Exposure
And how to deal with the risk
Transaction Exposure
nArises when a firm exports and imports
products and borrows funds from abroad
or invests overseas.
Relate to:

 payables and receivables outstanding

 borrowing or investment abroad


n
n
Example – transaction
exposure
nFirm exports product and invoices the
customer in the customer’s currency.
Payment is due, say, 60 days from the
time of invoice. The firm is then exposed
to currency fluctuations during that 60
day period. So if the value of the foreign
currency were to fall during that period, it
could eliminate the profit (or worse).
Question
nWhy should a company be more conscious
of its transaction exposure than its
translation exposure?
Dealing with transaction
exposure
nHedging = transferring the risk associated
with future cash flows to the party selling
the hedge. This reduces the uncertainty
about the future value of the currency.
nForward exchange rates
nFutures exchange rates
nForeign currency options
History
 Rice futures in Osaka in 17th Century
 European derivatives markets in the 18th
Century
 1970’s and the collapse of the Bretton
Woods System is when the use of
derivatives really took off.
Derivatives
 A contract whose value is “derived” from
the the price of a commodity (copper,
currencies) or other asset (shares, bonds)


 Can really be based on anything, so long as

the parties are willing to trade risks and
agree on a price.



Buying and Selling
Derivatives
 Two Routes:
 Contracts with standardized terms are
traded on exchanges.
 “Over the counter” through dealers (banks)

 OTC market is huge, much greater than the
those created via contract.
Risk shifting
 From airlines who are worried about the
fuel prices can limit or fix its bills.
 A bank worried about default exposure can
shift its risk to other banks.
Types of Derivatives
◦ Options (right, but not the obligation to buy or
sell at a given price)
◦ Futures
◦ Forwards (similar to futures but not traded on
exchanges)
◦ Swaps (exchanging one lot of obligations for
another)

Derivatives
 The Good  The Bad (OTC?)
(Contract) ◦ Enron
◦ An excellent tool ◦ AIG
for risk ◦ Orange County
management ◦ Lehman Bros
◦
Forward Contracts
nIn exchange rate - a contract to exchange a
given amount of one foreign currency for
another at a specified future date (usually
one to three months).
nThis is done when the firm is worried that
the currency may fluctuate considerably
over time = risk and uncertainty
minimization.
Forward contracts
nAllow the buyer and seller of currencies to
be certain of the value of a transaction.
Key is firm’s in-house forecasting ability.
nE.g. firm buying component from supplier
nNo forward contract = firm hopes supplier’s
currency depreciated, thus lower total cost
nForward contract = firm buys currency on
forward market to lock in a price.
n
Futures
 Agreements to trade something at a set
price at a given date.
 The simplest form of derivative.
Futures Contracts
nObligate the buyer of the contract to buy a
foreign currency from the seller at a
specified price on a specified future date.
nRule: whenever an underlying asset is
likely to lose its value, you should get into
a futures contract which is likely to gain in
value thus offsetting some of the
potential loss.
Example
 Aluminium futures were bought last year as
the world’s manufacturers assumed there
would be a rebound. So speculators
bought up stock and stored it. But now it
is flooding the market, keeping the price
low.
Futures v. Forward
Contracts
nDiffer from forward contracts in that:
nIn a forward market, no money changes hands
until the contract expires
nForward contracts are not traded on the market
nForward contracts are generally not speculative
Options
nGives a buyer the right, but NOT AN
OBLIGATION, to buy or sell something.
Options are a useful hedge against
against adverse currency movements.
n
nCall Option = the right, but not the
obligation, to buy a currency at a specified
date within a specified period
nPut Option = the right to sell a currency at a
specified price.
n
n

Currency option - example
nA buyer of a currency option has the right,
but not the obligation, to exchange a
fixed amount of one currency for another
at a fixed exchange rate on or before a
pre-determined future date.
SWAPS
nA currency swap involves the exchange of
one currency for another currency
according to a specified schedule. This
means it is a simultaneous spot and
forward transaction.
n
Economic (or cash
flow) Exposure
And how to manage the risk
Economic (or cash-flow)
Exposure
nInvolves the impact of exchange rate
variations on the future cash flows
generated by a company’s production
and marketing operations.
nLong term – long term effect of a change
in the value of a currency on a firm’s
profitability.
Example- economic
exposure
nA firm which produces its products in
domestic factories and exports may
decide to establish local factories if an
exchange rate appreciation were to make
its export prices uncompetitive.
Dealing with economic
exposure
nIt is not easy to deal with economic
exposure through financial instruments
Methods:

nRevenue and pricing strategies

nSourcing from different locations
nDiversifying the manufacturing base
geographically

Steps businesses take in creating system
for managing currency exchange

n Decide the types and degrees of economic exposure

that the company is willing to accept.
n Develop the necessary expertise for monitoring
exchange rates and for forecasting those rates that
are applicable to the identified exposures.
n Construct a reporting system that allows the firm to
identify exposed accounts, to measure this exposure,
and to feed back information on what the firm is
doing and the status of these decisions.
n Include all units in this reporting system so that each
better understands the risks it is assuming and is
aware of the actions that must be taken to deal with
these risks.
n Keep senior-level management fully apprised of what is
going on in each area of responsibility so that every
manager is able to periodically revise the exposure
risk.
Information Sources
nThe Financial Times
nBack of the Economist