BBA F&A Year) (3 rd

International Financial Management

COC642B – SEMESTER 6

International Financial Management COC642B – BBA F&A Jan to May 2023

Risk Management Process
Enterprise risk management (ERM)
➢ The methods and processes used by organizations to manage risks and
seize opportunities related to the achievement of their objectives.
➢ Provides a framework for risk management, which typically involves
identifying particular events or circumstances relevant to the
organization’s objectives (risks and opportunities), assessing them in
terms of likelihood and magnitude of impact, determining a response
strategy, and monitoring progress.
➢ This risk has two components- Systematic risk and Unsystematic risk

International Financial Management COC642B – BBA F&A Jan to May 2023

Systematic risk
➢ That portion of total variability of return which is caused by factors affecting the
prices of all securities.
➢ Economic, political, and sociological changes are sources of systematic risk.
➢ Their effect is to cause prices of nearly all individual common stocks and/or all
individual bonds to move together in the same manner. For example recession
and corporate profits shift down ward, stock price may decline across a board
front.
➢ This part of risk cannot be reduced through diversification.
➢ Investors are exposed to market risk even when they hold well-diversified
portfolios of securities

International Financial Management COC642B – BBA F&A Jan to May 2023

Systematic risk
The usual factors that cause systematic risk are:

(a) The Government changes the interest rate policy.

(b) The corporate tax rate is increased.
(c) The Government resorts to massive deficit financing.
(d) The inflation rate increases.
(e) The Reserve Bank of India promulgates a restrictive credit policy, etc.

International Financial Management COC642B – BBA F&A Jan to May 2023

Unsystematic risk
➢ That portion of total risk that is unique to a firm or industry.
➢ Factors such as management capability, consumer preferences and labour strikes
cause variability of return in a firm.
➢ These factors affect one firm, they must be examined for each firm.
➢ These are uncertainties which are unique to individual securities, and which are
diversifiable if large numbers of securities are combined to form well-diversified
portfolios.
➢ The unique risk of individual securities in a portfolio largely cancel out each
other.
➢ This part of the risk can be totally reduced through diversification

International Financial Management COC642B – BBA F&A Jan to May 2023

Unsystematic risk
The usual factors that cause unsystematic risk are:

(a) Workers declare strike in a company.

(b) The R & D expert of the company leaves.
(c) A formidable competitor enters the market.
(d) The company loses a big contract in a bid.
(e) The company makes a breakthrough in process innovation.
(f) The Government increases custom duty on the material used by the company.
(g) The company is not able to obtain adequate quantity of raw materials from the
suppliers etc. .

International Financial Management COC642B – BBA F&A Jan to May 2023

Foreign exchange Risk & Exposure
Risk and Exposure are similar but not the same:

➢ Foreign exchange risk and exposures are experienced by Companies who have
business operations in multiple countries.
➢ The Key difference is that the foreign exchange risk is the value in one currency
relative to another which will reduce the value of the investment.
➢ Foreign exchange exposure is the degree to which the company is exposed to
the exchange rate risk.
➢ Risk is transaction based and exposure is position based.

International Financial Management COC642B – BBA F&A Jan to May 2023

Types of foreign exchange risk
Transaction Risk:
➢ Exchange rate risk resulting from the time lag between entering into a contract
and settling it.
➢ A firm has transaction risk whenever it has contractual cash flows (receivables
and payables) whose values are subject to unanticipated changes in exchange
rates due to a contract being denominated in a foreign currency.

E.g. Investor A, who is a resident in the UK is obliged to pay a sum of $ 15,000 to another individual as a part of
an agreement in 6 months’ time. The current exchange rate is £/$ 1.26. Since the exchange rates are subjected
to fluctuations and the rate at the end of six months is unknown at present.

International Financial Management COC642B – BBA F&A Jan to May 2023

Types of foreign exchange risk
Translation Risk:
➢ Exchange rate risk resulting from converting financial results of one currency to
another currency.
➢ Translation risk occurs when a firm denominates a portion of its equities, assets,
liabilities or income in a foreign currency. A company doing business in a foreign
country will eventually have to exchange its host country's currency back into
their domestic currency.

E.g. Company G’s parent company is Company A, which is located in the USA. Company G is located in France
and conducts trading in Euro. At the year end, results of Company G is consolidated with the results of
Company A to prepare financial statements; thus, the results of Company G are converted into US Dollar.

International Financial Management COC642B – BBA F&A Jan to May 2023

Types of foreign exchange risk
Economic Risk:
➢ Economic risk reflects the risk of the present value of future operating cash
flows from exchange rate movements. Economic risk is concerned with the
effect of exchange rate changes on revenues (domestic sales and exports) and
operating expenses (cost of domestic inputs and imports).
➢ In every organization, economic risk refers to the possibility that
macroeconomic conditions will influence an investment, especially in a foreign
country.
E.g. Company C is a medium scale local business based in Country Y that sells wheat. Since the wheat
production in the country is limited, wheat is also being imported from a neighboring country. Due to currency
appreciation, imported wheat is cheaper. As a result, the demand for wheat in Company C is declining.

International Financial Management COC642B – BBA F&A Jan to May 2023

Functional Currency Vs Reporting Currency
➢ The functional currency is the currency in which a company earns most of
its revenues and incurs most of its expenses (or local currency of the
country in which business is carried on).
➢ The choice of the functional currency depends on whether a foreign
subsidiary is just an extension of the parent company set up to facilitate
the business of the parent company in a foreign country or whether it is
an entity with a separate business model and revenues and expenses.
➢ The reporting currency is the currency in which the financial statements
amounts are presented.
➢ It may be different than the function currency in which case the functional
currency financial statements must be converted to the reporting
currency.
International Financial Management COC642B – BBA F&A Jan to May 2023
Difference between Transaction & Economic Exposure

International Financial Management COC642B – BBA F&A Jan to May 2023

Types of Translation method
➢ Current / Non-Current Method –
All current assets and current liabilities of foreign affiliates are translated into
the parent company at current exchange rate
All noncurrent assets and noncurrent liabilities and equity capital are translated
at historical exchange rate
➢ Monetary / Non-monetary method
All monetary balance sheet accounts (cash, marketable securities, accounts
receivable etc.) of a foreign subsidiary are translated at the current exchange
rate
All other (non-monetary) balance sheet accounts (Equity capital, Land, P & M,
Inventory etc.) are translated at the historical exchange rate in effect when the
account was first recorded

International Financial Management COC642B – BBA F&A Jan to May 2023

Types of Translation method (cont..)
➢ Temporal Method
Monetary assets and liabilities (cash, accounts receivable, in general all
liabilities and long term loans) are translated at the current exchange rate
Non monetary assets (inventory and fixed assets), non monetary liabilities (debt
capital, retained earnings etc) and Equity capital are translated at the historical
exchange rates
➢ Current Rate Method
All assets and liabilities except common equity are translated at the current
exchange rate.
Common equity is translated at historical exchange rates. Any imbalance
between the book value of assets and liabilities is recorded as a separate equity
account called the CTA (Cumulative Translation Adjustment)

International Financial Management COC642B – BBA F&A Jan to May 2023

Summary of Translation method
➢ The current/noncurrent method treats only current assets
and liabilities as being exposed.
➢ The monetary/nonmonetary method treats only monetary
assets and liabilities as being exposed.
➢ The temporal method translates assets and liabilities valued
at current cost as exposed and historical cost assets and
liabilities as unexposed.
➢ The current rate method treats all assets and liabilities as
exposed.

International Financial Management COC642B – BBA F&A Jan to May 2023

Illustration 1 for Translation method
A US parent establishes a subsidiary in the year 2009 in
Europe. The accounts of the subsidiary are denominated in
Euros. At the end of the year balance sheet translated at the
prevailing exchange rate of $1.00 / Euro. Now there is a 25%
depreciation of the Euro against the dollar. What is the
translation loss or gain?
Calculation of translation loss or gain under the four
translation methods:
Historical value = 1 and Current value of dollar = 0.75 per Euro

International Financial Management COC642B – BBA F&A Jan to May 2023

Illustration for Translation method
Historical rate 1 EUR = 1 USD Current Value 1 USD = 0.75 EUR

Current / Monetary /
Non Current Non Temporal in All Current
Value in EUR in $ Monetary in $ $ in $
Assets
Cash & Marketable
Securities 2,500 1,875 1,875 1,875 1,875
Accounts Receivable 2,500 1,875 1,875 1,875 1,875
Inventory 2,500 1,875 2,500 1,875 1,875
P&M 7,500 7,500 7,500 7,500 5,625
Total Assets 15,000 13,125 13,750 13,125 11,250
Liabilities
Accounts Payable 2,500 1,875 1,875 1,875 1,875
Short Term Debt 2,500 1,875 1,875 1,875 1,875
Long Term Debt 5,000 5,000 3,750 3,750 3,750
Capital 5,000 5,000 5,000 5,000 5,000
CTA - 625 1,250 625 - 1,250
Total Liabilities 15,000 13,125 13,750 13,125 11,250
International Financial Management COC642B – BBA F&A Jan to May 2023