M.

COM
IBO – 06/2020-21
International Business Finance

1.Define Balance of Payments. Explain the interrelationship between Current Account,

Capital Account and Reserve Account with examples. 5+15

The balance of payments (BOP) is a statement of all transactions made between entities in
one country and the rest of the world over a defined period of time, such as a quarter or a
year.

Current vs. Capital Accounts:

The current and capital accounts represent two halves of a nation's balance of payments.
The current account represents a country's net income over a period of time, while the
capital account records the net change of assets and liabilities during a particular year.

In economic terms, the current account deals with the receipt and payment in cash as well
as non-capital items, while the capital account reflects sources and utilization of capital. The
sum of the current account and capital account reflected in the balance of payments will
always be zero. Any surplus or deficit in the current account is matched and canceled out by
an equal surplus or deficit in the capital account.

Current Account
The current account deals with a country's short-term transactions or the difference
between its savings and investments. These are also referred to as actual transactions (as
they have a real impact on income), output and employment levels through the movement
of goods and services in the economy.

The current account consists of visible trade (export and import of goods), invisible trade
(export and import of services), unilateral transfers, and investment income (income from
factors such as land or foreign shares). The credit and debit of foreign exchange from these
transactions are also recorded in the balance of the current account. The resulting balance
of the current account is approximated as the sum total of the balance of trade.

Reserve accounting
A reserve is profits that have been appropriated for a particular purpose. Reserves are
sometimes set up to purchase fixed assets, pay an expected legal settlement, pay bonuses,
pay off debt, pay for repairs and maintenance, and so forth. This is done to keep funds from
being used for other purposes, such as paying dividends or buying back shares. It can serve
as a signal to investors, that a certain amount of cash is not to be distributed to them in the
form of dividends. The board of directors is authorized to create a reserve.

A reserve is something of an anachronism, because there are no legal restrictions on the use
of funds that have been designated as being reserved. Thus, funds designated as a reserve
can actually be used for any purpose. Reserve accounting is quite simple - just debit the
retained earnings account for the amount to be segregated in a reserve account, and credit
the reserve account for the same amount. When the activity has been completed that
caused the reserve to be created, just reverse the entry to shift the balance back to the
retained earnings account.

For example, a business wants to reserve funds for a future building construction project,
and so credits a Building Reserve fund for $5 million and debits retained earnings for the
same amount. The building is then constructed at a cost of $4.9 million, which is accounted
for as a debit to the fixed assets account and a credit to cash. Once the building is
completed, the original reserve entry is reversed, with $5 million debited to the Building
Reserve fund and $5 million credited to the retained earnings account.
2.(a) What is foreign exchange market? Explain its significance and the functions of
participants.

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or
over-the-counter (OTC) market for the trading of currencies. This market determines foreign
exchange rates for every currency. It includes all aspects of buying, selling and exchanging
currencies at current or determined prices. In terms of trading volume, it is by far the largest
market in the world, followed by the credit market.
The main participants in this market are the larger international banks. Financial centers
around the world function as anchors of trading between a wide range of multiple types of
buyers and sellers around the clock, with the exception of weekends. Since currencies are
always traded in pairs, the foreign exchange market does not set a currency's absolute value
but rather determines its relative value by setting the market price of one currency if paid
for with another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc.
The foreign exchange market works through financial institutions and operates on several
levels. Behind the scenes, banks turn to a smaller number of financial firms known as
"dealers", who are involved in large quantities of foreign exchange trading. Most foreign
exchange dealers are banks, so this behind-the-scenes market is sometimes called the
"interbank market" (although a few insurance companies and other kinds of financial firms
are involved). Trades between foreign exchange dealers can be very large, involving
hundreds of millions of dollars. Because of the sovereignty issue when involving two
currencies, Forex has little (if any) supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments by enabling
currency conversion. For example, it permits a business in the United States to import goods
from European Union member states, especially Eurozone members, and pay Euros, even
though its income is in United States dollars. It also supports direct speculation and
evaluation relative to the value of currencies and the carry trade speculation, based on the
differential interest rate between two currencies.
In a typical foreign exchange transaction, a party purchases some quantity of one currency
by paying with some quantity of another currency.
The modern foreign exchange market began forming during the 1970s. This followed three
decades of government restrictions on foreign exchange transactions under the Bretton
Woods system of monetary management, which set out the rules for commercial and
financial relations among the world's major industrial states after World War II. Countries
 gradually switched to floating exchange rates from the previous exchange rate regime,
which remained fixed per the Bretton Woods system.
The foreign exchange market is unique because of the following characteristics:
● its huge trading volume, representing the largest asset class in the world leading
to high liquidity;
● its geographical dispersion;
● its continuous operation: 24 hours a day except for weekends, i.e., trading from
22:00 GMT on Sunday (Sydney) until 22:00 GMT Friday (New York);
● the variety of factors that affect exchange rates;
● the low margins of relative profit compared with other markets of fixed income;
and
● the use of leverage to enhance profit and loss margins and with respect to
account size

(b) What is political risk? How do international firms manage political risk arising in the
host countries? 10+10

Political risk is the risk an investment's returns could suffer as a result of political changes or
instability in a country. Instability affecting investment returns could stem from a change in
government, legislative bodies, other foreign policymakers or military control. Political risk is
also known as "geopolitical risk," and becomes more of a factor as the time horizon of
investment gets longer. They are considered a type of jurisdiction risk.

For multinational companies, political risk refers to the risk that a host country will make
political decisions that prove to have adverse effects on corporate profits or goals. Adverse
political actions can range from very detrimental, such as widespread destruction due to
revolution, to those of a more financial nature, such as the creation of laws that prevent the
movement of capital.

Instability affecting investment returns could stem from a change in government, legislative
bodies, other foreign policymakers or military control.

The Two Types of Political Risk

In general, there are two types of political risk, macro risk, and micro risk. Macro risk refers
to adverse actions that will affect all foreign firms, such as expropriation or insurrection,
whereas micro risk refers to adverse actions that will only affect a certain industrial sector or
business, such as corruption and prejudicial actions against companies from foreign
countries. All in all, regardless of the type of political risk that a multinational corporation
faces, companies usually will end up losing a lot of money if they are unprepared for these
adverse situations.

For example, after Fidel Castro's government took control of Cuba in 1959, hundreds of
millions of dollars worth of American-owned assets and companies were expropriated.
Unfortunately, most, if not all, of these American companies had no recourse for getting any
of that money back.

How to Minimize Exposure to Political Risk

So how can multinational companies minimize political risk? There are a couple of measures
that can be taken even before an investment is made. The simplest solution is to conduct a
little research on the riskiness of a country, either by paying for reports from consultants
that specialize in making these assessments or doing a little bit of research yourself, using
the many free sources available on the internet (such as the U.S. Department of State's
background notes). Then you will have the informed option to not set up operations in
countries that are considered to be political risk hot spots.

While that strategy can be effective for some companies, sometimes the prospect of
entering a riskier country is so lucrative that it is worth taking a calculated risk. In those
cases, companies can sometimes negotiate terms of compensation with the host country, so
that there would be a legal basis for recourse if something happens to disrupt the
company's operations. However, the problem with this solution is that the legal system in
the host country may not be as developed, and foreigners rarely win cases against a host
country. Even worse, a revolution could spawn a new government that does not honor the
actions of the previous government.

Buying Political Risk Insurance

If you do go ahead and enter a country that is considered at risk, one of the better solutions
is to purchase political risk insurance. Multinational companies could go to one of the many
organizations that specialize in selling political risk insurance and purchase a policy that
would compensate them if an adverse event occurred. Because premium rates depend on
the country, the industry, the number of risks insured and other factors, the cost of doing
business in one country may vary considerably compared to another.

However, be warned that buying political risk insurance does not guarantee that a company
will receive compensation immediately after an adverse event. Certain conditions, such as
trying other channels for recourse and the degree to which the business was affected, must
 be met. Ultimately, a company may have to wait for months before any compensation is
received.

3.What is translation exposure? How is it different from transaction exposure? Discuss the
various techniques of managing translation Exposure. 5+5+10

Translation exposure (also known as translation risk) is the risk that a company's equities,
assets, liabilities, or income will change in value as a result of exchange rate changes. This
occurs when a firm denominates a portion of its equities, assets, liabilities, or income in a
foreign currency. It is also known as "accounting exposure.”

Accountants use various methods to insulate firms from these types of risks, such as
consolidation techniques for the firm's financial statements and using the most effective
cost accounting evaluation procedures. In many cases, translation exposure is recorded in
financial statements as an exchange rate gain (or loss).

Understanding Translation Exposure

Translation exposure is most evident in multinational organizations since a portion of their
operations and assets will be based in a foreign currency. It can also affect companies that
produce goods or services that are sold in foreign markets even if they have no other
business dealings within that country.

In order to properly report the organization's financial situation, the assets and liabilities for
the whole company need to be adjusted into the home currency. Since an exchange rate can
vary dramatically in a short period of time, this unknown, or risk, creates translation
exposure. This risk is present whether the change in the exchange rate results in an increase
or decrease of an asset's value.

Translation risk can lead to what appears to be a financial gain or loss that is not a result of a
change in assets, but in the current value of the assets based on exchange rate fluctuations.
For example, should a company be in possession of a facility located in Germany worth €1
million and the current dollar-to-euro exchange rate is 1:1, then the property would be
 reported as a $1 million asset. If the exchange rate changes and the dollar-to-euro ratio
becomes 1:2, the asset would be reported as having a value of $500,000. This would appear
as a $500,000 loss on financial statements, even though the company is in possession of the
exact same asset it had before.

4.What are the benefits of project export? What are the risk included in project exports?
Discuss the various kinds of bonds/guarantees in project Export. 6+6+8

Host Country Benefits of Export Projects

Hydropower, as an affordable, reliable and sustainable source of electricity, has played an
important role in the growth and industrialisation of many emerging market economies,
including Laos, Kenya, Sarawak (Malaysia), China (in the 1980s and 1990s) and Brazil, to name
a few. Nevertheless, the hydropower potential of many emerging market countries remains
undeveloped due to the difficulties surrounding project bankability, particularly the credit risk
of domestic offtakers and a risk-reward imbalance in the eyes of investors.

As one strategy for unlocking their hydropower potential, the governments and state-
owned utilities of some of these countries may have the option of exporting hydropower
production to a neighbouring country for the development of such potential opportunities.
Figure 1 below provides an overview of the benefits that exporting hydropower production
can bring to a host country when compared with a hydropower project established
exclusively for domestic production and the remainder of this articles describes these
benefits in more detail.
Improving Project Bankability

The aggregate payments for hydropower projects remitted by a state-owned utility (“SOU”)
under a long-term power purchase agreement (“PPA”) can involve substantial amounts
(e.g., from roughly USD 1.5 billion to USD 6.5 billion for a 100 MW and 700 MW facility,
respectively, over 25 years). For this reason, a weak balance sheet of a domestic SOU can
prevent projects designated for domestic production from ever proceeding beyond the
stage of a feasibility assessment. From the standpoint of project lenders and investors, the
PPA provides a contractually guaranteed revenue stream that the company established by
such investors can use to repay project debt and recover a return on investment. If,
however, a domestic SOU’s credit cannot support the significant PPA payments, then
project investors will find the risk/reward ratio too small and/or lenders will decline to
provide debt financing.

By reconfiguring the project's offtake strategy to export surplus energy into an international
market with one or more creditworthy offtakers, the government of the host country can
greatly enhance the creditworthiness of the project. In other words, an export strategy can
effectively replace the weak balance sheet of a host country SOU with the stronger balance
sheet of an international offtaker, transforming an unbankable project into a bankable one.

Some examples of the successful implementation of an export strategy by host governments

in emerging market countries include the Shuakhevi Project in Georgia, which, upon
completion, will export power into the Turkish wholesale spot market. Other examples
include Nam Theun 2 as well as the many other hydropower projects moving forward today
in Laos, which currently export (or will export upon completion) power to EGAT, the Thai
SOU. Likewise, the government of the Democratic Republic of Congo (“DRC”) has expressly
adopted an export strategy to develop its hydropower potential on the Congo River.
Currently under a competitive tender process, the 4,800 MW Inga III project, will, if
completed as described in the current documentation tendered by the DRC government,
export half of its production from the DRC to South Africa's SOU Eskom.

Avoiding Hidden Costs of “Free Carry” and Royalties

Governments in emerging market countries such as Nepal, Myanmar, Laos and Papua New
Guinea increasingly desire to participate in the equity ownership of hydropower projects
developed by the private sector, and often require the private sector to provide them “free
carry,” i.e., to fund the government’s equity portion. This form of public-private partnership
(“PPP”) gives the public sector access to project dividends without contributing to
development costs, effectively driving up the cost of the project, which investors defray by
increasing the power tariff.

For domestic projects, the government of the host country will in turn fund this through
subsidisation of the domestic SOU purchasing the power, since the domestic ratepayers
often cannot afford to pay for the full cost of power generation. Depending on the size of
the free carry, power prices can increase by up to 30%, which represents a hidden cost of
domestic PPP arrangements. A host country government effectively self-funds the dividends
paid to itself (i.e., the public sector shareholder) by a project set up exclusively for domestic
production, notwithstanding the label of “free carry” given to this type of PPP.

For export projects, by contrast, the government of the export country and/or its electricity
ratepayers fund these incrementally higher power prices, not the host country. This means
that the host government receives an actual “free carry” on its equity interest in the project.
Thus, while PPPs established for domestic projects involve hidden costs paid by the host
government, PPPs established for export projects avoid such costs and make commercial
sense for the host government.

Similar to the free carry issue, emerging markets often require water royalties and other
taxes from hydropower projects, which essentially get passed to local ratepayers in the form
of higher power prices for domestic electricity consumption. For export projects, foreign
ratepayers instead bear some or all of these royalty costs, lessening or removing the burden
on domestic ratepayers.

Providing Additional Foreign Exchange

An SOU will typically pay the local currency equivalent of an invoice amount, denominated
(or indexed) in an internationally convertible currency such as US dollars, under a PPA for
the purchase of power from a domestic hydropower project. The project company then
needs to convert a large portion of these local currency payments into US dollars inside the
host country to fund debt service, dividend distributions to foreign shareholders and other
offshore expenses. The central banks of many emerging market countries maintain
insufficient foreign reserves on their accounts to meet these conversion requests, which
becomes another major impediment to the bankability of a hydropower project designed
for domestic supply.

By configuring a project for export, the company can set its power prices in US dollars, or a
mix of internationally convertible currencies, and collect payments in the same currencies,
denominated in foreign exchange. At a minimum, this alleviates the need for the host
country to use its limited foreign reserves for the project and often can even increase the
foreign reserve surplus of the host country because the project company needs to convert
foreign exchange into local currency to fund its local expenses and remit dividends to local
shareholders.

Improving the Sovereign’s Balance Sheet

Most domestic projects funded by the private sector in emerging market countries require
host government support. This often takes the form of a guarantee, issued in favour of the
project company and backed by the sovereign balance sheet of the host government,
covering monthly payments by the domestic SOU under the PPA over the entire 20-25 year
supply period, and very large payments for early termination. These guarantee
commitments represent contingent liabilities on the sovereign balance sheet, which in many
cases can diminish the sovereign credit rating/capacity of the host country for decades, and
also limit access to international capital markets and other sources of sovereign-level debt
required for funding ongoing expenses of the host country’s public sector. While export
projects will also involve host government support, often in the form of a project
development or concession agreement, the host government typically does not guarantee
payments under the project's PPA, which greatly reduces the contingent liabilities on the
host country's balance sheet.

Improving Overall Energy Security and Reliability

Export projects, and the resultant cross-border grid interconnections, create a number of
energy security and reliability gains shared by interconnected countries. These can
collectively produce cost savings for domestic utilities that can be passed on to local
ratepayers or reinvested into further development of clean energy. Examples include:

● By sharing ancillary services, such as spinning reserve and emergency generation

capacity, interconnected parties can better stabilise system frequency, absorb
sudden variations, reduce load shedding and improve system reliability.
● Hydropower export and grid interconnection allows interconnected parties to
optimise their collective generation mix. They may, for instance, balance the
 intermittency of solar and wind with the energy storage function of pumped storage
and/or reservoir hydropower.
● Interconnected parties can take advantage of seasonal differences in demand (e.g.,
winter versus summer demand peaks) or supply (such as excess hydropower in wet
seasons) through diversity contracts to ensure reliable year-round electricity supply.

Exporting a portion of the electricity produced by a large-scale hydropower project can help
some emerging market governments overcome initial stumbling blocks of such project’s
development, including bankability concerns and the large liabilities on the host country’s
balance sheet.

Another King & Spalding article will also explore some of the unique drawbacks of these
export projects. The authors published a version of these articles as an IHA Briefing in
December 2016

5.Define yield curve. How is it constructed? How does interest rate risk influence yield
curve. Explain.

A yield curve is a line that plots yields (interest rates) of bonds having equal credit quality
but differing maturity dates. The slope of the yield curve gives an idea of future interest rate
changes and economic activity. There are three main types of yield curve shapes: normal
(upward sloping curve), inverted (downward sloping curve) and flat.

Yield Curve Works

This yield curve is used as a benchmark for other debt in the market, such as mortgage rates
or bank lending rates, and it is used to predict changes in economic output and growth. The
most frequently reported yield curve compares the three-month, two-year, five-year, 10-
year and 30-year U.S. Treasury debt. Yield curve rates are usually available at the Treasury's
interest rate web sites by 6:00 p.m. ET each trading day,

A normal yield curve is one in which longer maturity bonds have a higher yield compared to
shorter-term bonds due to the risks associated with time. An inverted yield curve is one in
which the shorter-term yields are higher than the longer-term yields, which can be a sign of
an upcoming recession. In a flat or humped yield curve, the shorter- and longer-term yields
are very close to each other, which is also a predictor of an economic transition.
The normal yield curve
In general, short-term bonds carry lower yields to reflect the fact that an investor's money is at
less risk. The thinking behind this is that the longer you commit funds, the more you should be
rewarded for that commitment, or rewarded for the risk you take that the borrower may not
pay you back. This is reflected in the normal yield curve, which slopes upward from left to right
on the graph as maturities lengthen and yields rise. You'll generally see this type of yield curve
when bond investors expect the economy to grow at a normal pace, without significant
changes in the rate of inflation or major interruptions in available credit. There are times,
however, when the curve's shape deviates, signaling potential turning points in the economy.

Steep curve
Since 1990, a normal yield curve has yields on 30-year Treasury bonds typically 2.3 percentage
points (also known as 230 basis points) higher than the yield on 3-month Treasury bills,
according to data from the US Treasury. When this "spread" gets wider than that—causing the
slope of the yield curve to steepen—long-term bond investors are sending a message about
what they think of economic growth and inflation.
A steep yield curve is generally found at the beginning of a period of economic expansion. At
that point, economic stagnation will have depressed short-term interest rates, which were
likely lowered by the Fed as a way to stimulate the economy. But as the economy begins to
grow again, one of the first signs of recovery is an increased demand for capital, which many
believe leads to inflation. At this point in the economic cycle long-term bond investors fear
being locked into low rates, which could erode future buying power if inflation sets in. As a
result, they demand greater compensation—in the form of higher rates—for their long-term
commitment. That's why the spread between 3-month Treasury bills and 30-year Treasury
bonds usually expands beyond the "normal" 230 basis points. After all, while short-term
lenders can wait for their T-bills to mature in a matter of months, giving them the flexibility to
buy higher-yielding securities should the opportunity arise, longer term investors don't have
that luxury.
Inverted curve
At first glance, an inverted yield curve seems counterintuitive. Why would long-term investors
settle for lower rewards than short-term investors, who are assuming less risk? The answer:
When long-term investors believe that this is their last chance to lock in current rates before
they fall even lower, they become slightly less demanding of lenders. As you might expect,
since lower interest rates generally mean slower economic growth, an inverted yield curve is
often taken as a sign that the economy may soon stagnate. While inverted yield curves are
rare, investors should never ignore them. They are very often followed by economic slowdown
—or an outright recession—as well as lower interest rates along all points of the yield curve.
Flat or humped curve
Before a yield curve can become inverted, it must first pass through a period where short-term
rates rise to the point they are closer to long-term rates. When this happens the shape of the
curve will appear to be flat or, more commonly, slightly elevated in the middle.
While it's important to note that not all flat or humped curves turn into fully inverted curves,
you shouldn't discount a flat or humped curve. Historically, economic slowdown and lower
interest rates follow a period of flattening yields.

Using yield curves

In addition to using the shape of the Treasury yield curve to help determine the current and
future strength of the economy, the Treasury yield curve occupies a special place compared to
all other yield curves as it is generally regarded as the "benchmark curve." Yields on Treasury
bonds and other securities are generally among the lowest because they’re backed by the full
faith and credit of the US government. This allows bond investors to compare the Treasury
yield curve with that of riskier assets such as the yield curve of Agency bonds or A-rated
corporate bonds for example. The yield difference between the two is referred to as the
"spread." The closer the yields are together the more confident investors are in taking the risk
in a bond that is not government-backed. The spread generally widens during recessions and
contracts during recoveries.