MF0006

International Financial Management – 2 Credits

Assignment Set-1 (30 Marks)

Q. 1 Give possible reasons by which the companies are encouraged to be an MNC?

There is an enormous influence of global brands like “Coca-Cola,” “Canon,” or “BMW”

across the world. These are multinational brands. A Multinational Corporation (MNC) is a
company that has been incorporated in one country and has production and sales operations
in other countries. Often 30% or more of sales and profits of multinationals are generated
outside national borders. A typical multinational company consists of a parent company
located in the home country and at least five or six foreign subsidiaries, with a high degree of
strategic interaction among them.

Firms can be defined as “multinational” on many dimensions, including the following:

• The degree of foreign sales

• The degree of foreign assets

• Source of labour and production

• Source of capital funding

An MNC is a corporation with substantial direct investments in foreign countries (it is not
just an export business) and is engaged in the active management of these off-shore assets (it
is not just holding a passive financial portfolio).

MNCs are a recent phenomenon (mainly after World War II) and they affect all the sectors of
activity (even the service sector). There are about 60,000 MNCs in the world. While not all
MNCs are large, most large companies are MNCs. Multinationals now account for about
10% of world GDP.

Why do companies expand into other countries and become multinationals? Some of the
possible reasons are:

• To broaden markets: Saturated home markets ask for market development abroad (Coca
Cola, Mac Donald’s etc.). Multinationals seek new markets to fill product gaps in foreign
markets where excess returns can be earned.

• To seek raw materials: Multinationals secure the necessary raw materials required to
sustain primary business line (Exxon; Wal Mart). Multinationals also seek to obtain easy
access to oil exploration, mining, and manufacturing in many developing nations.

• To seek new technologies: Multinationals seek leading scientific and design ideas.

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• To seek production efficiencies by shifting to low cost regions (GE).

• To avoid political hurdles such as import quota, regulatory measures of governments,

trade barriers, etc.

• To diversify i.e. to cushion the impact of adverse economic events.

• To postpone payment of domestic taxes.

• To counter foreign investments by competitors.

What is special about multinational management?

Multiple operating environments: Multinationals operate under a diverse pattern of

consumer preferences, distribution channels, legal frameworks and financial infrastructures.

Political demands; political risks: Multinationals have to mesh corporate strategy with host
country industrial development policies; thus there is a potential for conflict.

Global competitive game: Multiple market access and various global scale economies allow
companies new competitive strategic options.

Currency fluctuations (foreign exchange risk): The economic performance of a

multinational is measured in multiple currencies which result in accounting, transaction and
economic exposure.

Q. 2 What do you mean by International Trade Flows? Also explain various factors
affecting international trade flows.

International Trade Flows

International trade is the exchange of goods and services across international boundaries.
The world trade in goods and services has grown much faster than world GDP since 1960.
Since 1960, global trade has grown twice as fast as the global GDP. The share of
international trade in national economies has, in most cases, increased dramatically over the
past few decades. In most countries, international trade represents a significant share of
GDP.

Factors affecting International Trade Flows

 Impact of Inflation: A relative increase in a country’s inflation rate will decrease its
current account, as imports increase and exports decrease.

 Impact of National Income: A relative increase in a country’s income level will

decrease its current account, as imports increase.

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 Impact of Government restrictions: A government may reduce its country’s imports
by imposing a tariff on imported goods, or by enforcing a quota. Some trade
restrictions may be imposed on certain products for health and safety reasons.

 Impact of Exchange Rates: If a country’s currency begins to rise in value, its current
account balance will decrease as imports increase and exports decrease.

Q. 3 (a) Define Swaps. Also explain various types of swaps.

A swap is an agreement to exchange cash flows at specified future times according to certain
specified rues. The two counterparties in a swap agree to exchange or swap cash flows at
periodic intervals.

Various types of Swaps: -

 Interest Rate Swap – An exchange of interest payments and principal in floating-rate

interest payments.

 Currency Swap – An exchange of interest payments and principal in one currency

for interest payments and principal in another currency.

 Cross Currency Interest Rate Swap – An exchange of floating rate interest

payments and principal in one currency for fixed rate interest payments and principal
in another currency.

1. Interest Rate Swap

A standard fixed-to-floating interest rate swap (also referred to as “exchange of borrowings”)

is an agreement between two parties, in which each contracts to make payments to the other
on particular dates in the future till a specified termination date. One party, known as the
fixed rate payer, makes fixed payments all of which are determined at the outset. The other
party known as the floating rate payer will make payments the size of which depends upon
the future evolution of a specified interest rate index (such as the 6-month LIBOR). The
floating “leg” is typically periodically reset. The fixed and floating payments are calculated
as if they were interest payments on a specified amount borrowed or lent. It is only used to
compute the sequence of payments. In a standard swap, the national principal remains
constant through the life of the swap. An agreement by a company to receive 6-month
LIBOR & pay a fixed rate of 5% per annum every 6 months for 3 years on a national
principal of $100 million is an example of an interest rate swap.

2. Currency Swaps

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In an interest rate swap the principal is not exchanged. In a currency swap the principal is
exchanged at the beginning and the end of the swap. A currency swap is an agreement
between two parties in which one party promised to make payments in one currency and the
other promises to make payments in another currency. An example would be a U.S.
company needing Euros to fund a project in Germany. It has a choice to either issue a fixed-
rate bond in Euros or issue a fixed-rate bond in dollars and convert those dollars to Euros. It
may be much easier for the company to raise funds in dollars in USA where it is we-known,
than to raise funds in Euros in Germany where it may not be so well-known. Therefore, the
company chooses to issue a fixed rate bond in dollars and convert them to Euros. One way to
convert the dollars to Euros is to construct a dollar/Euro currency swap. And one of the
simplest ways to do this is at the beginning of the transaction, the company takes the dollars
received from the issue of the dollar denominated bond and pays them up front to a swap
dealer who pays the company an equivalent amount in Euros. The swap dealer pays interest
payments in dollars to the company which it can use to pay the dollar coupon interest to the
bondholders in USA from whom it has raised money. At the same time, the company pays
an agreed-upon amount of Euros to the swap dealer. At maturity the company and the swap
dealer re-exchange the principal; the company pays the same amount of euros to the swap
dealer as it had received at the initiation of the swap and received the same amount of dollars
it had given the swap dollar in exchange. Thus, upon maturity, the company pays back
principal to its bondholders in dollars. As a result of this swap, the company has converted a
dollar-denominated loan into a Euro –denominated loan.

3. Cross Currency Interest Rate Swap

A fixed-to-floating currency swap also known as cross-currency swap will have one payment
calculated at a floating interest rate while the other is at a fixed interest rate. It is a
combination of a fixed-to-fixed currency swap and a fixed-to-floating interest rate swap.
Each counterparty to a currency swap can be described in terms of the type of interest (fixed
or floating), and the currency that he pays and also the type of interest and the currency that
he receives. For example, in a cross currency interest rate swap, one of the counterparties
may be a payer of a six month dollar LIBOR and a receiver of a five year sterling fixed
interest. (The other counterparty therefore will pay a five year sterling fixed interest and
receive six month dollar LIBOR).

Cross-currency interest rate swaps allow a company to switch to switch from one currency to
another. For example, a French company wishing to start operations in the USA can tap a
source of fixed rate funds in the euro market, where its name may be well-known and its
credit well-perceived, and swap it into floating rate dollars, to achieve funding at a level
significantly better than what a direct issue in floating rate dollar market would offer.

(b) Define foreign bonds with their salient features.

A country’s foreign bond market is that market in which the bonds of issuers not domiciled in
that country are sold and traded. For example, the bonds of a German company issued in the

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U.S. or traded on the U.S. secondary markets would be part of the U.S. foreign bond market.
The definition of "foreign" refers to the nationality of the issuer in relation to the market
place. For example, a US dollar bond sold in the United States by the Swedish car producer
Volvo is classified as a foreign bond while one issued by General Motors is a domestic bond.

Features of the Foreign Bonds:

1. Foreign bonds are sold in the currency of the local economy.

2. Foreign bonds are subject to the regulations governing all securities traded in the national
market and sometimes special regulations governing foreign borrowers (e.g., additional
registration).

3. Foreign bonds provide foreign companies access to funds they often use to finance their
operations in the country where they sell the bonds.

4. Foreign bonds are regulated by the domestic market authorities. The issuer must satisfy all
regulations of the country in which it issues the bonds.

The difference between a domestic and a foreign bond is that the issuer of the latter is a
foreign entity which may be beyond investors’ legal reach in the event of default. However,
since investors in foreign bonds are usually the residents of the domestic country, investors
find them attractive because they can add foreign content to their portfolios without the added
exchange rate exposure.

Foreign bonds are known by different names in different countries. They are called Yankee
bond, Samurai bonds, Matador bonds, Bulldog bonds and Rembrandt bonds in USA, Japan,
Spain, UK and Netherlands respectively.

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MF0006
International Financial Management – 2 Credits
Assignment Set-2 (30 Marks)

Q. 1 (a) Explain the responsibilities of IMF.

IMF is the central institution of the international monetary system. The responsibilities of
IMF are:

• To promote international monetary co-operation: prevent or manage financial crises.

• To facilitate expansion and balanced growth of international trade.

• To promote exchange rate stability.

• To assist in establishing multilateral system of payments.

• To lend to member countries experiencing balance of payments difficulties.

The IMF gets its resources from the quota countries’ pay when they join the IMF and from
periodic increases in this quota. The quotas determine a country’s voting power and the
amount of financing it can receive from the IMF.

World Bank

The World Bank is the sister organization of the IMF. Its primary objective is to fight poverty
and assist less developed countries in their efforts to improve standards of living and reduce
poverty. The World Bank Group consists of the following five institutions:

International Bank for Reconstruction and Development (IBRD): The IBRD aims to
reduce poverty in middle-income and creditworthy poorer countries. It is able to borrow at
low cost and offer its clients good borrowing terms.

International Development Association (IDA): IDA provides interest-free credits and

grants to the world’s poorest countries that otherwise have little or no capacity to borrow on
market terms.

International Finance Corporation (IFC): Working with business partners and without
government guarantees, the IFC promotes economic development through the private sector
by providing equity, long-term loans, finance and risk management products, etc.

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Multilateral Investment Guarantee Agency (MIGA): MIGA helps promote foreign direct
investment in developing countries by providing guarantees to investors against non-
commercial risks, such as expropriation, currency inconvertibility, war and civil disturbance,
etc.

International Centre for Settlement of Investment Disputes (ICSID): ICSID helps

encourage foreign investment by providing international facilities for conciliation and
arbitration of investment disputes, thereby helping foster an atmosphere of mutual confidence
between states and foreign investors.

(b) Describe two types of exchange rates.

Flexible Exchange Rate System

Multinationals use forecasting models to forecast exchange rates. There are two types of
forecast: market-based and model-based (Fundamental and Technical Analysis).
Multinationals also forecast exchange rate volatility. This enables them to specify a range
(confidence interval) and develop best-case and worst-case scenarios along with their point
estimate forecasts.

1. Market-based forecasting involves developing forecasts from market indicators such as

forward rates, spot rates, and interest rates. It is based on the concept that these market
indicators efficiently incorporate expected future currency changes. Multinationals often
track changes in the spot rate and then use these changes to estimate the future spot rate. It is
often assumed that the current forward rate is a consensus forecast of the spot rate in the
future. The forecasting of forward rates is limited to about one year since forward contracts
for maturities beyond one year have low trading volumes and are not widely quoted.
Multinationals use interest rate differential to predict exchange rates beyond one year. The
interest rates on risk-free instruments can be used to determine what the forward rates should
be according to Interest Rate Parity for long-term forecasting. Forecasting horizons are a few
days for spot rates, a few months for forward rates, and a few years for interest rates.

2. Fundamental analysis is a currency forecasting technique that uses fundamental

relationships between economic variables and exchange rates. The economic variables used
include inflation rates, national income growth, changes in money supply, and other such
macroeconomic variables. The simplest form of fundamental analysis uses the theory of
purchasing power parity (PPP) discussed above.

3. Technical analysis is a currency forecasting technique that involves the use of historical
price data to predict future values. The approach is to sell or buy certain currencies if their
prices deviate from past patterns. Technical analysis includes statistical analysis and time
series models. This focuses solely on past prices and volume movements and not on
economic and political factors. The methods of technical analysis attempt to identify trends
and reversal of trends. These methods are explicitly extrapolative; that is, they infer future
price changes from those of the recent past. Formal methods of detecting trends are necessary
because prices move up and down around the primary (or longer-run) trend. To distinguish
trends from shorter-run fluctuations, technicians employ two types of analysis: charting and
mechanical rules.

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Charting, the older of the two methods, involves plotting the history of prices over some
time period to predict future patterns in the data from the existence of past patterns.
Forecasters use charts to find peaks and troughs in the price series and then use these to
signal up and down trends.

4. Mechanical rules (like filter rule, moving average, oscillators) are a type of technical
analysis where a set of rules, based on mathematical functions of present and past exchange
rates, is used to help make this subjective process more disciplined. Local peaks on charts
that the technical analysts use are called resistance levels and local troughs are called support
levels. A filter rule or “trading range break” rule suggests that investors buy a currency when
it rise by x percent above it support level and sell a currency when it falls x percent below its
resistance level. The size of the filter, x, which is chosen by the technician from past
experience, is generally between 0.5 percent and 3 percent. A second variety of mechanical
trading rule is the “moving average” class. Moving averages bypass the short-run movements
of the exchange rate to permit the technician to examine trends in the series. A final type of
mechanical trading rule is the class of “oscillators,” which are said to be useful in non-
trending markets, when the exchange rate is not trending up or down strongly. Oscillator
rules suggest buying (selling) the foreign currency when the oscillator index takes an
extremely low (high) value.

Speculators may find the technical analysis models useful for predicting day-to-day
movements. However, since they typically focus on the near future and rarely provide
point/range estimates, they are of limited use to multinationals. A combination of forecasting
techniques is sometimes employed to forecast exchange rates. Mixed forecasting refers to the
use of a combination of forecasting techniques. The actual forecast is a weighted average of
the various forecasts developed.

Q. 2 Illustrate Political Exposure in Foreign Exchange Market?

Political risk stems from political actions taken by political actors that affect business. The
political actors may be the members of the government, political parties, public interest
groups that are trying to affect the political process, supra-governmental entities (e.g. WTO,
NAFTA) or other corporations that might act in a political way. Political action has a direct
bearing when political actors change laws, regulations, etc. or take other actions that directly
affect business. An example of such direct effect is the nationalization of business. The
indirect effect of political action occurs when the political actors change the economic
environment, the attitudes of the population, or some other factor that then indirectly affects
specific businesses. An example of such indirect effect is when the local business lobbies the
government against the entry of foreign companies.

Country risk and political risk are sometimes used interchangeably. Country risk comprises
all the socio-political and economic factors which determine the degree and level of risk
associated with undertaking business transactions in a particular country; the likelihood that
changes in the business environment will occur that reduce the profitability of doing business
in a country.

Examples of political risk:

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1) Nationalization: Nationalization is the appropriation of private assets by a national
government.

2) Creeping Expropriation: Creeping expropriation occurs when the government changes

the rules and makes profit impossible. An example: The host government may require that
the company sell its products only to the local enterprises and that export opportunities are
not pursued. This limits the profit potential of the company.

3) Contract Repudiation: Here, the terms of operating arrangements are changed or

renegotiated once their operations are in place and have proved successful. Thus additional
taxes may be imposed. Companies with large fixed investments are vulnerable due to the
“hostage” effect. They cannot credibly threaten to withdraw. Companies with stable
technologies are vulnerable because locals could take over the operation without need for
continuing foreign technology transfer.

4) Political Pressure in a Democratic System: Spread of democracy increases popular

criticism of foreign investors. Opposition parties may use attacks on foreign investors as
nationalistic position to gain voter support (but pro-business opposition can also provide
protection against government arbitrary policies, such as tariff increases). There is evidence
to prove that business grows faster under democracies even though many believe that
suppressive authoritarian regimes are more favourable to business.

5) Threats from Local Business: Local business interests use political connections to secure
favourable treatment over foreign companies or resist market liberalization. Many local
business people become wealthy during the period of protected markets and do not want to
eliminate protectionist policies. As a result of lobbying by local business, governments may
require foreign investors to have local partners or make laws that keep foreigners entirely
away from some “critical” sectors or enact licensing procedures that delay investment. When
liberalization occurs, local business still tries to create adverse political conditions. They try
to prevent foreign companies from winning government contracts, or try to slow licensing
and other approvals for foreign companies to decrease their relative efficiency.

The multinational’s interest in political risk lies in forecasting that risk so that it can be
avoided or managed. Assessment of political risk is the projection of possible losses that
result from governmental and societal sources. The goal of political risk assessment is to
provide projections that will guide the multinational in decision-making about investment,
corporate strategy, and specific business tactics.

Investors cannot always choose projects or countries where the risk is low and it is not
possible to insure against all risks. There are steps that the investor can take to reduce risk in
a given project. The prudent investor takes advantage of available information and
relationships to manage political risks in the same way in which he manages economic or
financial risks.

Q. 3 Explain Trade deficits and Trade surplus in regard to Balance of Payments.

A closed economy is one in which there are no economic relations with other countries: there
are no exports, no imports and no capital flows. An open economy interacts freely with other

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economies around the world. A country with an open economy interacts with other countries
in two ways: it buys and sells goods and services in world product markets and it buys and
sells capital assets in world financial markets. The balance of payments (BOP) is a
country’s record of all transactions between its residents and the residents of all foreign
countries. Inflows of funds generate credits for the country’s balance, while outflows of funds
generate debits. If all transactions are recorded correctly, then the sum of all credit items
necessarily equals the sum of all debit items, because the foreign exchange that is bought
must also have been sold. Thus the balance of payments entries are always balanced; the
entries add up to zero.

The trade balance is the difference between a country’s output and its domestic demand-the
difference between what goods and services a country produces and how many goods and
services it buys from abroad. A trade deficit occurs when, during a certain period, a nation
imports more goods and services than it exports. A trade surplus occurs when a nation
exports more goods and services than it imports.

According to the BOP identity (Current Account + Capital Account =Change in Official
Reserve Account), any trade deficit must be offset by surpluses on other accounts. Since the
official reserves are limited, a surplus on the Official Reserve Account (which means selling
of the foreign exchange reserves by the central bank) can at best be a temporary measure.
Thus the trade deficit must be "financed" by foreign income or transfers, or by a capital
account surplus. A capital account surplus consists of capital purchases (stocks, bonds etc.)
by foreign nationals. A capital account surplus (an increase in net foreign investment) may
result in an increase in the net outflow of income (dividend, interest) to foreign nationals on
these investments in the future. Thus, such payments to foreigners could have
intergenerational effects: they shift consumption over time, and future generations have to
pay for the consumption by the present generation. However, a trade deficit can also lead to
higher consumption in the future, if, for example, it is used to finance profitable domestic
investment, which generates returns in excess of what is paid to the foreign nationals on their
investments in the country. Such a situation may arise if a country experiences a gain in
productivity as a result of these investments.

A trade surplus implies an increase in the net international investment of the residents of the
country and the shifting of consumption to future rather than current generations. Even trade
surpluses can be undesirable for a country. An example where a trade surplus was not
beneficial for the country is Japan in the 1990s. The positive trade balance that Japan had was
partly due to the protectionist measures that were adopted by the Japanese government. These
measures caused the price of goods in Japan to be much higher than what they would have
been, had imports been freely allowed. The foreign currency that the Japanese companies
earned overseas were kept abroad and not converted into yen in order to keep the value of the
yen low and maintain the competitiveness of Japanese exports. However, a weak yen also
prevented Japanese consumers from importing goods from abroad and benefiting from the
trade surplus. The foreign exchange earned abroad as a result of the trade surplus was partly
squandered by spending it on real estate purchases in the United States that often proved
unprofitable.

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