MS-45 JULY DECEMBER 2016 SOLVED ASSIGNMENT

Solved Assignment July Dec 2016 MS-45 (Sample Copy)

Course Code MS-45 Course Title International Financial Management Assignment Code MS-45/ SEM - II/2016 Assignment Coverage All Blocks

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1. What are the main features of the exchange rate regime that was designed at Bretton Woods? Explain and distinguish between Fixed Exchange Rate and Floating Exchange Rate system. Which one is more suitable and why?

Features of the exchange rate regime that was designed at Bretton Woods-

The nature of exchange rate arrangement has undergone changes over past couple of centuries. There was a time when costly metal was' used as medium of international ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------the gold standard led to upheavals in the exchange rates and then to check it, the-IMF was established. These different regimes need some explanation.

The genesis of the international financial architecture ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------After the end of second world war a series of efforts were made to restore order to the international monetary system which resulted into Bretton Woods Agreement (1944), the main features of which were as follows:

I. All national -------------------------------------------------------------------------- turn was pegged to gold (at $35 an ounce)

II. Capital ------------------------------------------------------------------------------------------ to remain

III. International ------------------------------------------------------------------------------------------- were to be founded.

The exchange rate regime was ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- Woods exchange rate system.

In the fixed parity system, each member ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------parities could not be ruled out. They were to be corrected through active intervention of the monetary authorities of that country.

It may, however, be mentioned that the fixed parity under the ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------approval was necessary. Fundamental disequilibrium was never formally defined; but in practice, it meant continued and chronic balance of payments problem and colossal loss of reserves.

The purpose of the adjustable peg system was, therefore, ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------cautions so that there might not be competitive devaluation. It was maintained through supervision and scrutiny over desired exchange rate changes.

Again, an important aspect of the Bretton ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------directly. In the post-War system, the US dollar came to be the intervention currency what was the British pound during the early decades of the twentieth century.

Fixed Exchange Rate V/S Floating Exchange Rate

Fixed Exchange Rate: A fixed exchange rate is one, whose value is fixed ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------of the dollar at two euros, it may ask its

central bank to sell dollars. If it does so, the supply of dollars traded on the foreign exchange market will increase and price may stay at two euros.

The main advantage of a fixed exchange ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------a considerable amount of foreign currency.

If the exchange rate is under downward pressure-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- parity, it may have to change its value. A change in the value of the currency from one exchange rate to a lower one is referred to as devaluation. A rise in a fixed exchange rate is called a revaluation.

A Floating Exchange Rate: A floating exchange rate is one which is -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------currency or a rise in its supply. Fig. 2 shows a decrease in demand for pounds sterling, causing the price of the pound to fall.

A floating exchange rate may help to eliminate a growing current account deficit. If demand for import rises whilst demand for exports falls, supply of the currency will rise (as individuals and firms sell it to buy foreign currency) and demand for the currency will fall.

This will lower the value of the currency --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------. Firms and individuals may still buy more of the currency to invest in the country, if they think that economic prospects are good.

A floating exchange rate, nevertheless, does allow a government to concentrate on other objectives. The main disadvantage with a floating exchange rate is that it can fluctuate, making it difficult for firms to plan ahead.

Which Is Better: Fixed or Floating Exchange Rates?

The exchange rate is one of the ---------------------------------------------------------------------------------------- finance course. It follows that the choice of exchange rate system is one of the key policy questions.

Countries have been experimenting with different international payment and exchange systems for a very long time. In early history, all trade was barter exchange, meaning goods were traded for other goods. Eventually, especially scarce or precious commodities, for example gold ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------------------almost entirely with international adjustments under a fixed exchange rate system since the world had had few experiences with floating rates.

That experience changed dramatically in 1973 with the ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------exchange rates, this never materialized. Instead, countries embarked on a series of experiments with different types of fixed and floating systems.

For example, the European Economic -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------replaced the national currencies and effectively fixed the currencies to each other immutably.

Some countries have fixed their currencies to a major ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------. Lastly, some countries, like the United States, have allowed an almost pure float with central bank interventions only on rare occasions.

Unfortunately, the results of these many experiments are mixed. Sometimes floating exchange rate systems have operated flawlessly. At other times, floating rates have --------------------------------------------------------------------------------------------------------------------------------------------------------- at times been a salvation to a country, helping to reduce persistent inflation. At other times, countries with fixed exchange rates have been forced to import excessive inflation from the reserve country.

No one system has operated flawlessly in all circumstances. Hence, the best we can do is to highlight the pros and cons of each system and recommend that countries adopt that system that best suits its circumstances.

Probably the best reason to adopt a fixed exchange rate system is to commit to a loss in monetary autonomy. This is necessary whenever a central bank has been independently unable ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------or euroization). For many countries, for at least a period, fixed exchange rates have helped enormously to reduce inflationary pressures.

Nonetheless, even when countries commit with credible systems in place, pressures on the system sometimes can lead to collapse. Argentina, for example, dismantled ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------has been difficult to maintain a credible fixed exchange rate system for a long period.

Floating exchange rate systems have had a similar colored past. Usually, floating rates are adopted when a fixed system collapses. At the time of a collapse, no one really knows ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------excessively rapid growth leads to inflationary tendencies. Since monetary policy acts much more rapidly than fiscal policy, it is a much quicker policy lever to use to help control the economy.

Prudent Monetary and Fiscal Policies

Interestingly, monetary autonomy is both a negative trait ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------have a prudent monetary policy.

A prudent monetary policy is most likely to arise when two conditions are satisfied. First, the central bank, and the decisions it makes, must be independent of the national government that makes government-spending decisions. If it is not, governments have always been inclined to print money to finance ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------for a central bank and floating exchange rates will function well. Mandating fixed exchange rates can also work well, but only if the system can be maintained and if the country to which the other country fixes its currency has a prudent monetary policy.

Both systems can experience great difficulties if prudent ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------in terms of international borrowing. International debt problems have become the bane of many countries.

Unfortunately, most countries have been unable to ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------, exchange rate volatility is also common.

Stability of the international payments system then is less related to the type of exchange rate system chosen than it is to the internal policies of the individual countries. Prudent fiscal and monetary policies are the keys.

With prudent domestic policies in place, a ----------------------------------------------------------------------------------------------------------------------------------------------------------------- a country needs to force itself to a more prudent monetary policy course.

2. Explain the Purchasing Power Parity Theory with the help of an example. Can there be deviations also from Purchasing Power Parity relationship? If so, what factors are responsible for the same?

Purchasing power parity (PPP) is a theory of exchange rate determination and a way to compare the average costs of goods and services between countries. The theory assumes ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------on the capital account, induces changes in the exchange rate.

PPP theory is based on an extension and variation of the "law of one price" as applied to the aggregate economy. To explain the theory it is best, first, to review the idea behind the law of one price.

The purchasing power parity theory is really just ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- of one price that identical goods should sell for identical prices in different markets, then the law ought to hold for all identical goods sold in both markets. A Swedish economist, Gustav Cassel, stated in 1918 that purchasing power of a currency is determined by the amount of goods and services that can be purchased with one unit ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------, the exchange rate between the two currencies will move in such a manner as to reflect purchasing power parity.

Let us illustrate this concept with the help of an example. ------------------------------------------------------------------------------------------------------------------------------------------------ basket of goods and services either from the UK or from the SUA. Then, it would be correct to conclude that the two amounts paid in respective currencies are equivalent. In other words,

£100 = $180

or £I = $1.80

Or, we can simply say that the exchange ------------------------------------------------------------ this exchange rate, then we write: S0 = $1.80/£

Say after one year (period 1), the same basket of goods and services ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- sums are equal. That is,

£103=$186

or £1 =$1.80.58

or the exchange ------------------------------------------------ $1.8050/£.

By looking at the two ----------------------------------------------------------------------------------------------------------------------------------------------------- US dollar over the period of past one year. And, what can we say about the price changes?

In the UK, the prices went up from ----------------------------------------------------------------------------------------------------------------

----------------------------------------------------------- as inflation and the rates of inflation can be calculated as follows:

Rate of inflation in the --------------------------------------------------------- (103 - 100)/100 = 0.03 or 3%

Rate of --------------------------------------------------------------------------------------------------- = 0.0333 OR 3.33%

This shows that the ----------------------------------------------------- USA than in the UK.

It is inferred, then, that the currency of the country where inflation rate is higher is likely to depreciate vis-a-vis the currency of the country with lower rate of inflation.

Now this illustration can be generalized by --------------------------------------------------------------------------- the reference point of time (time zero), the price of the given basket is PA0 in the country A and PB0 in the country B. Therefore,

PA0 = ---------------------------- (Equation 1)

At a later period (time 1), the price changes to PA1 and PB1 respectively. Therefore, ----------------------= S1 x PB1 (Equation 2)

The relation between prices at different points of time is linked through the inflation rate. That is,

PA1 = PA0 --------------------------------- (Equation 3)

and ---------------------------- (1 + rB) (Equation 4)

Where rA and rB are -------------------------------------------------------------------------- A and Country B respectively.

From Equation 1 and Equation 2,

S0 = (PA0/ -------------------)

S1 = (---------------------/ PB1)

Using Equation 3 and Equation 4, we can write:

The Equation 5 is known as --------------------------------------------------------------- rates inflation rates in two countries.

It should be noted that, often inflation --------------------------------------------------------------------------------------------------------------------------------- series which are readily available from economic databases and can be used to calculate inflation rates.

Solved examples that follow illustrate the use of purchasing parity relationship to predict the future exchange rate. Example - Inflation rates in the UK --------------------------------------------------------------------------------------------------------------------------------. What is the expected exchange rate after one year, if it was Rs 78/£ at the beginning?

PPP and Real Appreciation-

As per the PPP, exchange rate between two currencies will fluctuate if and only if the inflation rates are different between two countries. For example, ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------this deviation with the help of an example.

The exchange rate at the reference period is Rs 79/£ and it is observed to be Rs 81/£ after one year. The inflation rates in India and the UK are 6 per cent and 3 per cent respectively. As per the PPP, the real exchange rate after one year should be

Rs 79 x (1.06/1.03) per pound sterling or Rs 81.30/£.

Since normal rate at Rs ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------have been Rs 81.30/£.

Real appreciation of rupee or real depreciation of pound sterling is Re 0.30/£. In terms of percentage, it can be expressed as:

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

Factors responsible for Deviations from Purchasing Power Parity Relationship

Though this relationship has a sound theoretical base, in practice, it does not always give satisfactory results. In other words, there are differences between the exchange rate predicted by the PPP and the actual future rate obtaining in the market. Several factors could be responsible for the deviation.

One factor could be the inflation rates ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------. So if the price indices included only the items traded between countries, the exchange rate predictions might improve.

Another reason for deviation is that the PPP takes into account only movement of goods and services. It does not factor in the capital flows. In other words, it is concerned with only the current account part of the balance of payment, leaving out the capital account part totally. Still, another reason causing deviation may ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------less significant in view of the constant endeavour through the bodies like WTO to liberalize the movement of goods and services across borders.

Speculative activity in the ------------------------------------------------------------------------------------------------------------------------------------------ such buying/selling of currencies has no underlying commercial transaction in the real economy.

It has been seen that, despite its limitations the PPP has good predictive power over relatively longer periods and in conditions of higher inflation rates.

PPP and Real Appreciation/Depreciation

As per the PPP, exchange rate between two currencies will fluctuate if and only if the inflation rates are different between two countries. For example, current ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------this deviation with the help of an example.

The exchange rate at the reference period is Rs 79/£ and it is observed to be Rs 81/£ after one year. The inflation rates in India and the UK are 6 per cent and 3 per cent respectively. As per the PPP, the real exchange rate after one year should be

Rs 79 x (1.06/1.03) per pound sterling or Rs 81.30/£.

Since normal rate at Rs 81/£ (as --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------. In other words, rupee has appreciated in real terms while pound sterling has depreciated in real terms since the rate is Rs 81/£ while it should have been Rs 81.30/£.

Since normal rate at Rs 81/£ (as actually observed in the market) is less than the real rate, the Indian currency is said to be overvalued while the UK -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------percentage, it can be expressed as:

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

3. What do you understand by Exchange Rate Exposures? Describe different types of exchange rate exposures and the techniques used to manage them.

Exchange rate exposure describes the influence of exchange rate movements on the value of a firm or sector of the economy. Exposure is typically measured as the ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------of exposure on firm or industry behaviour.

Foreign currency exposures are generally categorized into the following three distinct types: transaction (short-run) exposure, economic (long-run) exposure, and translation exposure. Short-Run -----------------------------

A firm has transaction exposure/ short-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------foreign exchange market with exchange rates constantly fluctuating, the firms face a risk of changes in the exchange rate between the foreign and domestic currency.

Long--------------------------

A firm has economic exposure / long-term exposure to the degree that its market value is influenced by unexpected exchange rate fluctuations. Such exchange rate adjustments can severely affect the firm's position with regards to its competitors, the firm's future cash flows, and ultimately the firm's value. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ the demand for a good in some country would also be an economic exposure for a firm that sells that good.

Transaction Exposure

This exposure arises when a company has assets and liabilities the value of which is contractually fixed in foreign currency and these items are to be liquidated in the near future. For example, -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------foreign entities or to be received from them.

To illustrate, let us consider that a company buys ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------depreciation of dollar will result in a smaller rupee outflow.

Translation Exposure

A firm's translation exposure is the extent to which its financial reporting is affected by exchange rate movements. As all firms generally must prepare consolidated financial statements for reporting purposes, the consolidation process for multinationals entails translating foreign assets and liabilities or the ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------Translation gives special consideration to assets and liabilities with regards to foreign exchange risk, whereas exposures to revenues and expenses can often be managed ex ante by managing transactional exposures when cash flows take place.

For the purpose of illustration, let us take an Indian parent company having a subsidiary in the USA. In the beginning of the year, the US subsidiary has capital equipment, ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------, there is a translation "gain" of Rs 5,50,000

on asset side of the balance sheet. Likewise there must have been a translation "loss" on liabilities of the subsidiaries such as, debts . denominated in dollars.

Economic -------------------------------

Economic exposure -------------------------------------------------------------------------- value of which is not contractually defined, as is the case of transaction exposure. Some examples of operating exposure are given below;

a) Tender submitted for a -------------------------------------------------------------------------------------------------------------------------------------------------------- contract. Once the contract is awarded, it becomes transaction exposure.

b) A deal for buying --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- negotiated may be affected by fluctuations in the exchange rate.

c) If a part of raw material --------------------------------------------------------------------------------------- of the home currency.

d) Interest cost on working --------------------------------------------------------------------------------------- of the home currency.

e) Domestic inflation -------------------------------------------------------------------------------------------------------------------------------------------------------------- will adversely affect its competitiveness vis-a-vis the firms of other countries.

Exchange rate will affect future revenues as well as -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------and location of production facilities etc.

For example, continued appreciation ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------shifted their manufacturing activities in USA:

Techniques for Managing Exchange Rate Exposure

A firm's economic exposure to the exchange rate ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------hedges and financial hedges.

Financial Techniques of Managing marketing Exposure

Transaction exposure hedging should have been discussed in some detail in the previous international finance course; however, we will briefly go over the standard financial ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------transaction exposure are:

i) Forward Contracts - When a firm has an ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------date, independent of the change in the exchange rate over the remaining life of the contract.

ii) Futures Contracts - These are equivalent ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------to totally eliminate the exposure.

iii) Money Market Hedge - Also known as a ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------the appropriate amount of home currency given the current spot exchange rate.

iv) Options - Foreign currency options are ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------cutting off the benefit form upside risk.

Operational Techniques for Managing Transaction Exposure

Transaction exposures can also be managed by adopting operational strategies that have the virtue of offsetting existing foreign currency exposure. These techniques are especially important when well functioning forward and derivative market do not exist for the contracted foreign currencies. These strategies include:

i) Risk Shifting- The most obvious way to ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------bears the currency risk may also impact the final price at which the contract is set.

ii ) Currency risk sharing - An alternative to trying ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ now of $1 = FC10, thus costing the U.S. firm $10. However, under risk sharing the U.S. firm and the foreign firm agree to share the exchange rate gain or loss faced by the U.S. firm by adjusting the FC price of the good accordingly.

iii) Leading and Lagging - Another operating ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------in which a nominal contract is denominated is depreciating, you would like to take the receivables early and pay off the liabilities later.

iv) Reinvoicing Centers - A reinvoicing center is a separate corporate subsidiary that manages in one location all transaction exposure from intracompany trade. The manufacturing affiliate sells the goods to the foreign distribution affiliates only by selling to the reinvoicing center. The reinvoicing ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------sales, the ability to set foreign currency prices in advance to assist foreign affiliates budgeting processes, and an improved ability to manage intra affiliate cash flows as all affiliates settle their intracompany accounts in their local currency.

Marketing Strategies for Managing Operating Exposure

Market Selection: A major strategic consideration for a firm is what market to sell in and the relative marketing support to devote to each market. For example, ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------parameters within which a company can adjust its marketing mix over time. They are primarily medium and longer term decisions and may not be feasible strategies to react to exchange rate exposure in the short run. For shorter run marketing reactions to exchange rate exposure, the firm may have to turn to pricing or promotional policies.

Pricing Policies: As we saw previously, in response to changes in real exchange rates, a firm has to make a decision regarding market share versus profit margin. This involves the pass through decision with respect to the foreign currency price of foreign sales. Of course, such a decision should be made ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------unit profitability is apparent. The longer the exchange rate change is expected to persist, the greater the price elasticity of demand, the greater are the economies of scale and the greater is the possibility of attracting competition, the greater will be the incentive to lower home currency price and expand demand in light of a home currency depreciation, and to keep home currency price fixed and maintain demand in light of a home currency appreciation.

Promotional Strategies: An essential issue in any marketing program is the size of the promotional budget for advertising, selling and merchandising. These budgets should explicitly build in exchange rate impacts. An example is ----------------------------------------------------------------------------------------------------------------------------------------- on advertising in the U.S. for ski vacations in the Alps as the costs compared to the Rocky Mountains has fallen due to the currency movements.

4. Why is cost of capital important for a firm? Explain the reasons for variations in the cost of capital across different countries. Describe the factors contributing to differences in the risk-free rate and the risk premium

How important is the Cost of Capital to your company? Cost of Capital-

Every company in its normal course of ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------to the company because they are irreversible decisions; having a long-term implication and involve huge amount of funds.

When making an investment decision, ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- are generally risk-averse and demand a premium for bearing risk. The greater the risk of an investment opportunity, the greater would be the risk-premium required by the investors.

The company’s objective is to maximise ------------------------------------------------------------------------------------------------------------------------- be more than the next best alternative investment opportunity and the risk borne by the investor.

Importance of Cost of Capital in Decision Making

(i) Capital Budgeting Decisions. Cost of -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------by discounting cash flows under present value method. Commonly, it is the technique used to accept or reject the project.

(ii) Designing the Optimal Capital Structure. The cost of capital is very much helpful in formulating firm’s sound and economic capital structure. An excellent financial ---------------------------------------------------------------------------------------------------------------------- upon the analysis, finance manager comes to correct conclusion and forms a suitable capital structure of the firm.

(iii) Deciding about the Method of Financing. An efficient financial manager has a thorough knowledge of the capital market fluctuation. The ultimate aim of the -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------source of finance in a particular situation. (iv) Helpful in the Evaluation of ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- project. If marginal return on investment exceeds the cost of financing, the expansion project should be accepted, otherwise it should be rejected. (v) To Evaluate the Financial Performance of Top Management. ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- of the project undertaken with the projected overall cost of capital and an appraisal of the actual cost incurred in raising the expected funds. (vi ) Other Areas. The concept of cost of ----------------------------------------------------------------------------------------------------------------------------------------------------------------------- etc. The value of the firm normally depends upon its cost of capital.

The market determines the required rate of return. ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- established by the demand and supply forces. From the shareholder’s point of view, the company’s cost of capital is the rate of return required by them for financing the company’s investment projects by buying various securities. A company obtains its capital from three major sources: debt, preference shares and equity shares. Determining cost of a specific source of capital is important because ----------------------------------------------------------------------------------------------------------

--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------the residual assets and cash flow. They may be paid dividends from the cash remaining after interest and preference dividend are paid. Thus equity share is riskier than both preference share and debt. Since the securities have risk differences, investors will want different rates of return on various securities. An understanding of why cost of capital varies across different countries provides -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------in the pattern of capitalization of different MNCs.

As such, the following paragraphs are devoted to discussion of country differences in the cost of debt and cost of equity.

Country Differences in the Cost of Debt:

Cost of debt to an MNC is the function of two variables, viz; risk-free rate of interest in the currency borrowed and the premium for additional risk required by creditors. ---------------------------------------------------------------------------------------------------------------------------- reasons for country differences in the risk-free rate and in the risk premium.

Country Differences in the Risk free Rate: Differences in the risk-free interest rate in different countries depend on supply of and demand for funds. A host of ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- of economy influence supply of and demand for funds.

Tax laws in different countries differ in terms of tax rate, ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------may also vary because of provisions of depreciation and investment tax credits and consequently interest rate differs.

Demographic condition of a country impacts demand and supply of funds and thereby the interest rate. A country with a majority of population -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- thrifty and demand more money to satisfy their varied needs.

Monetary policy of Central bank of a ------------------------------------------------------------------------------------------------------------------------------------------------------------------------ tendencies in the country will raise bank rate and hence the interest rate.

Because of varying levels of economic development, interest rates differ across countries. Thus, in relatively advanced countries and so also highly ------------------------------------------------------------------------------------ lower than the less developed nations.

Country Differences in the Risk Premium: Amount of premium to compensate for the risk arising out of borrowers' inability to repay the loan ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- corporations and creditors, government intervention, and degree of financial leverage.

In case of economic stability, possibility of the country experiencing recession is relatively low and so also the borrowers defaulting in repayment. Under such a situation, risk premium is likely to be low.

Risk premium will be relatively ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- health and always ready to help their client to get over the illiquidity crisis. In such a situation amount of risk premium will be less.

Governments in some countries like the ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------in the case of the former will be lower than the latter.

Risk premium also differs across countries because of varying degree of financial leverage of firms in those countries. For instance, firms in Japan and Germany have a ------------------------------------------------------------------------------------------ factors being equal. In fact, the reason for higher leverage of the firm is their unique relationship with creditors and governments.

Country Differences in the Cost of Equity:

Cost of equity representing ------------------------------------------------------------------------------------------------------------------------------------------ interest rates, noted above, vary among countries, the costs of equity obviously differ among countries.

In countries with tremendous investment -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- to Mc Cauley and Zimmer, country's cost of equity can be estimated by first applying the price/earnings multiple to a given stream of earnings.

The cost of capital is related to the price-earnings multiple. ---------------------------------------------------------------------------------------------------------------------------------------------------------------------- hence the cost of equity financing is low. There is however, need to adjust to the price-earnings multiples for the effects of a country's inflation, earnings growth and other factors.

Combining the Costs of Debt and Equity:

The costs of debt and equity can be combined to obtain an ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------share capital at a relatively low cost.

A term from international finance and ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------and, in particular, disagree about the value of a particular investment.

As a starting point, suppose that the price of stock XYZ is ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------, the pressure of selling in Boston will lower the price there, and the value of XYZ across the two cities will converge.

Extending the example internationally, in the absence of barriers or substantial trading costs, XYZ will sell for about the same price in Boston and in Halifax. However, we can ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------and it cannot even be traded in Boston or New York due to national law or provisions in the company’s charter that forbid Americans or other non Canadians to own the stock.

If limitations to foreign investment apply not just to XYZ ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------trading costs, and other factors are magnified, rather than for Canada or the US.

The stereotype is that a developing country lacks savings for development and segmentation of its equity market drives away inexpensive capital from overseas that might help ------------------------------------------------------------------------------------------------------------------------------------------------------------------------ capital market impede or prohibit their investing some of their savings overseas. Thus, market segmentation may be viewed as damaging the potential growth and health of an economy.

There is a counter-argument to the notion that equity ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------economy from being buffeted by short term inflows and outflows.

Because most countries are either ----------------------------------------------------------------------------------------------------------------------------------- segmented”, “partially segmented”, or “integrated”. Researchers continue to struggle with this question.

Factors contributing to differences in the risk-free rate and the risk premium-

A risk-free rate is simply the -------------------------------------------------------------------------------------------------------------------------------------------------------- cost of capital purposes, it is first necessary to identify the relevant modeling context.

Differences in the risk-free interest rate in different countries depend on supply of and demand for funds. A host of factors such as tax laws, --------------------------------------------------------------------------------------- of and demand for funds.

In estimating the risk-free rate in this context, there are three principal considerations:

(a) The ------------------------------------------------------------------------------------------------------- risk-free asset;

(b) The period of time at, or over, which the rate is estimated; and (c) the term, or maturity, of bond used for setting the risk-free rate.

The market risk premium is the --------------------------------------------------------------------------------------------------------------------------- require to accept the uncertain outcomes associated with investment, relative to the return provided by a risk-free asset.

In the context of the CAPM, the market -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------method of estimation, as all methods have both strengths and weaknesses.

Risk premium will be relatively lower in countries -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- financial health and always ready to help their client to get over the illiquidity crisis. In such a situation amount of risk premium will be less.

Governments in some countries like the -------------------------------------------------------------------------------------------------------------------------------------------------------------------------- to them. However, in the USA, the probability of Government intervention to rescue firms from incipient sickness is low. Hence, risk premium in the case of the former will be lower than the latter.

Risk premium also differs across countries -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------with other factors being equal. In fact, the reason for higher leverage of the firm is their unique relationship with creditors and governments.

5. How is working capital management in multinational enterprises different from that of domestic enterprises? Discuss the transactions incorporated under intra-corporate transfer of funds and the variables which influence such transfers.

A multinational enterprise to survive and succeed in a fiercely competitive environment must manage its working capital prudently. Working capital management in an MNC requires managing its current assets and current liabilities in such a way as to reduce funds tied in working capital while ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------domestic counterparts. Further, working capital management in a multinational firm focuses on inter subsidiary transfer of funds as well as transfers from the affiliates to the parent firm. Besides, there are specific approaches to manage cash, receivables and inventories in MNCs. All these aspects are dealt with in this unit in this unit.

Although the fundamental principles governing the managing of working capital such as optimization and suitability are almost the same in both --------------------------------------------------------------------------------------- the following:

MNCs, in managing their ---------------------------------------------------------------------------------------------------------------------------------------------------- and investing of funds, such as the exchange rate risk and the political risk.

Unlike domestic firms, ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ of subsidiaries by the parent, borrowings from local sources including banks and funds from Eurocurrency markets, etc.

MNCs enjoy greater latitude than the ---------------------------------------------------------------------------------------------------

----------------------------------------------------------------- subsidiaries, leading to fuller utilization of the resources.

MNCs face a number of problems in managing working capital of their subsidiaries because they are widely separated geographically ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ of decision making in the case of MNCs' subsidiaries is complex.

Finance managers of ----------------------------------------------------------------------------------------------------------------------

----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- systems and tax rates.

In sum, though MNCs have ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------because of additional risks in the form of the currency exposure and political risks as also due to differential tax codes and taxation rates.

DOMESTIC VERSUS MNC WORKING CAPITAL- The cost of capital for MNCs may differ from that for domestic firms because of the following characteristics that differentiate MNCs from domestic firms:

Size of firm. An MNC that often ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------if it is not willing to operate internationally. Because MNCs may more easily achieve growth, they may be more able than purely domestic firms to reach the necessary size to receive preferential treatment from creditors.

Access to international capital markets. ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------if the prevailing interest rates in the host country are relatively low.

The use of foreign funds will not --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- the same currency. In this case, the subsidiary is not relying on the parent for financing, although some centralized managerial support from the parent will most likely still exist. Example 1-

The Coca-Cola Co.’s -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------term debt, results in a lower overall cost of borrowing.” Example 2-

Exxon Mobil has much experience ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------to the required return of related projects. The adjustment also reflects a possible increase in its working capital. (Summary of Factors That Cause the Working Capital of MNCs to Differ from That of Domestic Firms)

In sum, it is difficult to generalize that MNCs have always working capital lower than their domestic counterparts. Each MNC should evaluate the implications of each of these factors on the working capital and determine the net impact on overall working capital. The five factors that distinguish the ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------whether the net effects of its international operations on the cost of capital are favorable. INTRA CORPORATE TRANSFER OF FUNDS-

Intra corporate transfer of funds comprises transfer of funds from affiliates/ subsidiaries to the parent company and also transfer of funds as among affiliates. Such transfers ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------, usually under a licensing arrangement. Royalties are usually stated as percentage of sales revenue so that the owner is compensated in proportion to the volume of sales.

Transfer of funds by way of dividend payments from the affiliates to the parent company is dependent upon host country's policy of dividend payment, and dividend transfer policy of the affiliates.

Remittance of dividends is a ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------. Parent countries generally levy a tax on foreign dividends received but allow tax credit for foreign taxes already paid on that income.

In case of political uncertainty, parent firm may require affiliates to remit the entire locally generated funds not needed to finance their expansion programmes. Pursuance of ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------to strong currencies. However, decisions to accelerate dividend payments ahead of the event should take into consideration interest rate differences and the likely impact on host country relations. Speeding up or slowing down payments is termed as "Lead and Lags".

Liquidity position of the affiliate also influences -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------amount of cash collected from past receivables may decide to pay higher dividend so as to transfer funds to the parent.

Conflicts of interest of joint venture partners may also affect dividend transfer policy of an MNC parent. An MNC desirous to position funds internationally may not be liked ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------so as to avoid possible conflicts of interests with outside shareholders.

Intra-corporate transfer of funds has a number of constraints with which a finance. manager of an MNC must be familiar. The greatest problem in this respect is political in nature --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------, the problem of loan service can be eased because the host country may not take penal action against such an arrangement for fear of damage to their international credit standing.

Problem generally arises in most of the ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------be reduced if dividend transfer policy is spelt out at the outset and communicated to the host country's authorities.

At times, MNCs are constrained to source ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------. However, the policy of stockpiling should keep in view the following variables:

Expected rate ----------------------------------------------------- against the parent currency

Expected rise in the price of imported parts and components in terms of the suppliers' currencies

Holding ----------------------------------------------------------------- inventories

Opportunity -------------------------------------------------------------- lands

Basic rules the governing the working capital management are the same in both domestic and foreign firms. However, MNCs have to consider certain specific variables ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------, foreign exchange risk, and liquidity factor.

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