INTERNATIONAL FINANCES

Unit 3: International Financing

7. SOURCES OF FUNDING

The purpose of this chapter is to discuss the nature and implications of corporate
financing sources from a general angle. Figure 7 presents a diagram of the financing
possibilities for a company.

Some basic aspects of International Banking are discussed in this chapter. The
numerical treatment of the Bonds and Shares is presented in chapter 8 of this text.

BUSINESS FINANCING

Fig. 7 - Sources of Company Financing

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7.1 NATURE OF FINANCING

7.1.1 Discussion

Given the philosophy of property rights, the market economy recognizes individual
wealth, that is, the possession of goods or money held by individuals in a society. This
position generates two clear elements, the first, that every company, as a good, is
assigned property to individuals, it is not alone, in ruins, but is owned and managed by
owners; the second, that every owner of wealth (manifested as goods or as money) will
act rationally to maintain, increase and maximize it.

These holders of wealth are known as investors (a name that perhaps represents the
situation that they, by possessing liquid money, do not want to convert it into well-being
(goods and/or services to be well) yet, but rather they want to get rid of it for a time to
increase their possibility of future well-being, that is, they reverse their position for a time
(they had money, they no longer have it)).

Those who own wealth in the form of companies will be called entrepreneurial investors
or investors in real assets, since these assets are productive and are managed by them.
On the other hand, those who have money invested or to invest it without taking control
of the company will be called financial investors, since what they manage are their own
placements in financial assets (bonds, securities) or real assets (shares), which
ultimately provide companies, but they do not manage them.

7.1.2 Business Financing

In the capital market, business financing studies the way investors ' money is placed in
companies .

An investor is a shareholder of the company if he places his money directly and

acquires ownership titles over it. This property confers management of the company if
your investment is the dominant one among the shareholders (in this case you become
an investor in real assets); But if his investment is not enough to take over the
administration of the company, he will be a financial investor, despite being a
shareholder, since he is subject to the result of the management of others. The
shareholder's capital represents a source of financing for the company, called OWN
CAPITAL ( equity ) or SOCIAL CAPITAL or simply SHARES.

A creditor places his money in the company but its securities do not represent
ownership of the company. The creditor's capital represents a source of financing for the
company, called DEBT.

Debt can be obtained by the company in several ways:

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- Directly , when investors acquire company bonds . This constitutes a public debt,
since the company issues the bonds with certain conditions and it is the public that
subscribes to them; However, the characteristic is maintained that the company
contracts with each investor individually. There is also direct non-public debt, either
for securities (promissory notes, bills, etc.) or for accumulations in contracts
(accounts payable, taxes payable, salaries payable, etc.).

- Indirectly , the company takes money from investors through a bank or financial
institution, which serves as a guarantor intermediary. The Bank's function is to
capture the capital of many investors and place them in an investment portfolio,
mainly in companies, but positioning itself as a transferor (and therefore as a
guarantor) in both situations.

From now on, the company's financing sources will be worked on in three aspects, as
shown in Figure 7; these are:

- SHARES or direct property titles.

- DEBT in BONDS or direct debt securities.

- DEBT as bank CREDITS.

While the shares and bonds correspond to public financing issues for the company, the
credits constitute specific contracts between the contracting parties.

In the case of issues (stocks and bonds), the company appropriates the corresponding
money only in the event in which it places (sells) the issue in the PRIMARY MARKET (or
market without endorsements, where investors acquire the securities directly from the
company or a commission intermediary thereof). Subsequent transactions are made
between investors in the so-called SECONDARY MARKET (or market for transferring
ownership of securities through endorsements) and do not affect the company's money
flow, although they do affect its intrinsic value.

Finally, it should be noted that when a financing case is studied for the company, an
investment case for the investor is being studied in parallel; It's like looking at two sides
of the same coin.

7.2 NATURE OF THE INVESTMENT

7.2.1 Discussion

As discussed in the previous section, business financing arises from the opportunity
provided by the capital in the hands of investors when seeking possibilities that provide
them with greater wealth. The mechanism that generates investment and financing
activities is then common.

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A greater specificity of the activity will be discussed here, from the investor's perspective,
which has to do with the gains of economic benefit in themselves and in relation to the
risk assumed.

A universally accepted notion of risk corresponds to the variability of possible outcomes

when an action is taken. Thus, for example, understanding one's life as the most
valuable asset that someone can count on, it would turn out that playing "Russian
roulette" entails greater risk than playing dice, since in the first game the results range
from being alive until committing suicide (in technical terms), while in the second the
results range from being rich to being poor (but alive).

A life maxim is that activities that generate greater risk have greater profitability or
benefit . For example, have you asked yourself why a bullfighter can earn in one day (or
less) what a professional would earn in 10 or 20 years of work, with all the advantage of
study that this has?, or Why Does an analogous case happen with a singer or an
important painter?, or Why does the lottery pay such a large jackpot compared to the
value of each individual participation? Well, the answers are found in the risk of the
activities. Indeed, the result of the professional performance of the bullfighter is that he
wins a lot of money or loses everything (life itself); For the artist, the result is that he
gains a lot of enjoyment or that he is an unknown person without a lucrative profession; It
is evident that the ranges of results for these two professions are much wider than for the
practice of a professional; In the case of the lottery player, he has a very high probability
of not winning (losing), while the non-player does not assume that probability.

Thinking about it sensibly, it is not random that humanity aligns with this maxim; The only
way to make higher risk activities persist is if there is a motivator to carry them out, and
that motivator is the additional benefit that they provide to their executor.

This is the basis for the characterization of the different financing items of the company.

7.2.2 Characterization of business financing items

ACTIONS:

• They are property titles of the company; Therefore, shareholders have the right to
participate in discussions about its administration, although it is only the dominant
shareholder who has the power to make the decision.

• They have no expiration period since the property does not constitute a loan; If the
holder needs the money from the investment, he simply sells (by endorsement) his
rights to third parties.

• They do not have stipulated terms of acquisition of benefits in amount or time, since
the contract itself is a property title, granting the investor the theoretical right of its
administration.

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• Investing in stocks represents the greatest capital risk in a company. Indeed, in the
event of bankruptcy, it is the last investment that can be rescued (this is stipulated by
the laws in all countries, taking into account the fact that if the shareholders failed in
their management, it is fair that control now passes to the others. investors to try to
rescue as much as they can). But in the case of normal operation (not bankruptcy)
the benefit of the shareholders is marginal or residual, after deducting interest and
taxes from the operating profit; This actually leads to periods of very low (even
negative) profits (net profit) if the company's situation turns out to be very bad and to
periods of very high profits if the company's situation turns out to be generous.

• Being the most risky, investment in shares then demands the highest profitability
from the company's financing sources. This is verifiable in the history of capital
markets in long-term series of figures (10 years or more).

• The relationships between Risk and Return of investment in Shares have been
studied intensively, giving rise to theoretical models, among which the CAPM (
Capital Assets Pricing Model ) stands out for its simplicity and diffusion. This model
will be discussed in Chapter 13 of this book.

BONUSES:

• They are debt securities as public debt of the company, therefore they do not
constitute property rights over it.

• They have an expiration period (except in some very unique cases of perpetual bond
issuance).

• They have stipulated the terms, in amounts and time, of access to benefits and
capital remuneration.

• Investment in bonds represents less variability in results (generally the income is

fixed, and in the event of bankruptcy you redeem your capital before the equity
capital) than investment in stocks.

• As they are less risky than stocks, investing in bonds allows the investor to deliver a
lower return than stocks.

CREDITS:

• They are credit titles in the form of institutional credit; They are debt and do not grant
property rights over the company, at most reserving ownership over some assets that
act as guarantors of some of these credits.

• As debt they are, they have an expiration period.

• They have stipulated the terms, in amounts and time, of access to benefits and
capital remuneration.

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• For the investor, they represent a lower risk than bonds, since their placement in a
bank dilutes the risk generated by the investment in a particular company, to the
entire portfolio of placements managed by said bank. For this reason, raising money
by a bank pays the financial investor the lowest rate of all.

• For the bank, the risk of placement is comparable to that of investments in bonds, but
this adds intermediation costs (managing a large number of savers), resulting in a
source that is theoretically more expensive than bonds for the company.

7.3 COMMENTS ON BANKING AND ON

INTERNATIONAL BANKING

7.3.1 Nature of Banking

Banking plays as a very special intermediary in the capital market; It takes the resources
of multiple savers (investors) and places them among its clients, forming an investment
portfolio. The great added value is that the Bank does not operate as a simple
commission intermediary (the one that brings the parties together to earn commissions)
but rather operates as an actor, since it interposes its legal reason in the intermediation;
In effect, it is the Bank that contracts with the savers and it is the bank that independently
contracts with its debtors.

The previous situation allows the Bank to diversify the risk of investors (savers); But even
more, given the legal and explicit nature of the contracts, both for acquisition and
placement, it can cross and balance its cash flows with greater security than a company
in the real sector could do, since it does not have any insured its contracts for the
placement of merchandise in all quantities or periods as the Bank does with its loans.

It is then easy to interpret the fundamental role of the Bank as a kind of risk manager in
the intermediated capital market, together with other commercial services in the financial
field.

Within these financial services, international intermediation is of fundamental importance

for companies that have international trade or operations.

7.3.2 International Banking Operation

There are different organizational figures in this field:

CORRESPONDENT BANK: Bank that provides international services in other countries

and provides services in its country to external requirements, in a permanent operation
agreed with a foreign bank, without any other type of integration than the management of

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corresponding accounts between both banks.

SUBSIDIARY BANK: Local bank that has been incorporated in its entirety or majority into
a foreign Bank.

BRANCH BANK: Foreign bank with its own operations and offices in another country.

REPRESENTATIVE: Person who is in charge of representing a foreign bank to attend to

and accompany very particular matters of specific clients, such as multinational
companies.

7.3.3 International Capital Market

7.3.3.1 EUROCURRENCIES

They are currencies that are traded in markets other than their country. For example,
Eurodollars, Euroyen, Euroeuros, etc.

Note that here the prefix euro does not mean European nor does it refer to the currency
of the European Union, but rather to the fact that the currency is traded abroad.

7.3.3.2 INTERNATIONAL RATES

To indicate rates in Dollars, the following are used:

LIBOR ( London Interbank Offered Rate ): The average Eurodollar interbank lending rate
on the London Stock Exchange. You can also take Libor in other currencies (Euroyen,
Canadian Eurodollars, etc.), or take the indicators of other exchanges (SIBOR from
Singapore, PIBOR from Paris, BRIBOR from Brussels, etc.)

PRIME RATE: The average rate of interbank lending of Dollars in the United States.

These rates are generally quoted in terms of a mixed numerical figure, where
submultiples of ½ (1/4, 1/8, etc.) and multiples of these (3/4, 5/8, etc.) are used; e.g.
Libor = 4 ½% asv Obviously to operate these figures you have to take them to decimal
form, for example, Libor = 4.5% asv

Short-term loans in eurocurrencies are normally agreed with roll over , that is, with the
possibility of automatic reform of the loan at maturity, with an update of the interest rate
according to the market.

7.3.4 Risk Management in International Banking

Among many other elements contained in the International Banking Agreement in Basel,

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Switzerland (natural headquarters of branches and main international banks), in 1988,

the definition of a risk indicator, with mandatory compliance, that allows each Bank
manage its accounts with relative security, the VaR ( Value at Risk ):

VAR =M σ D z NS √ T

INTERNATIONAL FINANCES 1
7. SOURCES OF FUNDING 1
BUSINESS FINANCING 1
7.1 NATURE OF FINANCING 2
7.1.1 Discussion 2
7.1.2 Business Financing 2
7.2 NATURE OF THE INVESTMENT 3
7.2.1 Discussion 3
7.2.2 Characterization of business financing items 4
7.3 COMMENTS ON BANKING AND ON INTERNATIONAL BANKING 6
7.3.1 Nature of Banking 6
7.3.2 International Banking Operation 6
7.3.3 International Capital Market 7
7.3.4 Risk Management in International Banking 8
VAR = M σ D z NS √ T 8

z NS = z value (standard normal) for a service level ns t =reaction period (days)

Intuitively you can follow the development of the formula:

Let M be the average amount of a Bank's loan portfolio;

Let X be the loss that the Bank can accumulate in t days;

Let NS be the level of service or probability that money will be available to replace the loss;

Let VaR be the amount previously assigned (reserve, provision or reserve) to address the accumulated
loss in t days;

Let µ t and σ Dt be the mean and standard deviation of the accumulated profitability in the period of t
days;

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It is possible to state in probabilistic terms: p [ X < VaR ] = NS

And continue: p [ (X – M µ t ) / (M σ Dt ) < (VaR - M µ t ) / (M σ Dt ) ] = NS

EITHER: p [ z < z NS ] = NS

I mean: ( VaR – M µ t ) / (M σ Dt )=z NS

VaR = z NS M σ Dt +mµ t

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But µt = 0 , because it is the average of the income arising from

variations in exchange rates (which must be balanced in
the long-term)

So: VaR = z NS M σ Dt

Now: σ Dt 2 = tσ D 2
, by accepting that daily returns are
independent

So: σ Dt =
√t σD

Resulting: VaR = M — z NS √ t σ D

In the Basel agreement, the parameters 10 business days (t = 10) were chosen as the
control period (represents 15 calendar days or half a month) and 99% compliance (NS =
0.99), whose z value corresponds to 2.326. .

EXAMPLE: Banco Universo in its London subsidiary maintains an average portfolio of

two billion Eurodollars, establishing a typical variation in daily profitability of
0.05%. Find the safe reserve amount, according to the Basel Accord:

VaR = 2,000'000,000 * 0.0005 * 2.326 * (10) 1/2 = USD 7'355,458

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