Course Title: International Business of Finance

Course Code: ACFN 613

Credit Hours: 2
 Course Description

The course describes :

- the environment of international financial
management,
 foreign exchange risk management,
 multinational working capital management,
 foreign investment analysis, financing foreign
Course Objective:

The objective of this course is to

provide inputs into the theory and
practice of international financial
management.
Course Contents

Chapter one: Environment of International Financial Management

Chapter two: Foreign Exchange Risk Management
Chapter three: Multinational Working Capital Management
Chapter four: Foreign Investment Analysis
Chapter five: Financing "Foreign Operations”
Chapter six: International Banking:
ASSESSEMENT &EVALUATION

 Overall grading will be in line with the following scheme:

Individual Assignment…………………………. 10%
Group Assignment (Term Paper)……………….. 40%
Group Presentation……………………………… 10%
Final Examination………………………………. 40%
Total …………………………………………… … 100%
 Chapter One: Environment of International Financial Management

DETERMINING EXCHANGE RATES: EQUILIBRIUM APPROACH

MAJOR FINANCIAL SYSTEMS :
 GOLD STANDARD – CURRENTLY NO COUNTRY IS IN USE OF THIS FINA. SYS
 FIAT MONEY – WHAT IS CURRENTLY BEING USED
 CRYPTO- CURRENCY ? HAS NOT BEEN ABLE TO CREATE ECONOMY IN ITS OWN
EQUILIBRIUM RATE – MUST BE MAINTAINED AT PAR. HOW DO WE GET TO
DETERMINE THIS RATE IS EXPLAINED IN THE THEORIES EXCHANGE RATE
DETERMINATION
Theories of Exchange Rate Determination

Mint Parity Theory of Equilibrium Rate of Exchange ( Obsolete)

 Mint Ratio-the exchange rate between two precious metal, gold/silver
 The theory explaining the determination of exchange rate between countries which are on the same
metallic standard – Mint Parity theory.
Eg.1) If currency A contains 20 grams of gold and currency B contains 10 grams of gold , the rate of
exchange is : 1A: 2B
2) Suppose the official price of gold in USA is 20 dollar per gram and IN Ethiopia it is Birr 1000
per gram (mint price of the countries) . The rate of exchange would then be $20=1000Birr or $1=50 Birr
 Cont.

 The actual rate of exchange could vary by the extent of cost of gold export.
Criticisms:
 The international gold standard has been abandoned therefore is unrealistic
 The theory presupposed unrealistic free international gold movement
Purchasing Power Parity Theory


equilibrium rate of exchange is determined by the equality of the
purchasing power of two inconvertible paper currencies.
 Rate of exchange = f(internal price levels in two countries)
Versions of PPP theory
 Cont.
The absolute version
Eg Suppose 10 Units of commodity X ,12 units of commodity Y and 15 units of commodity Z can be bought
through spending Birr 1,500 and the same quantities of X,Y and Z commodities can be bought in the united
states for $25.
The equivalency of purchasing power of the two currencies forms the basis of determining the rate of exchange
between the two currencies.
Ex Rate : $ 25= Br 1,500
or $1=Br 60
 Cont.

 Relative Version
R1= R0* PB1/PB0 = R0 * PB1 * PA0
PA1/PA0 PB0 PA1

R1= Rate of exchange in the current period

PB1,PB0= the price indices in country B in the current and base periods respectively.
PA1/PA0= the price indices in country A in the current and base periods respectively.
 Cont.

Eg., Suppose that the original or base period rate of exchange between Birr and dollar was
$1=50Birr. The price inex in Ethiopia (Country B) in the current period (PB1) is 180 and the
price index in the USA in the current period is 150. The price indices of the two countries in
the base period were 100.
Ro = 50/1, PA1=150, PA0=100, PB0=100
Now R1= 50/1*180/100*100/150= 60
Criticism : Direct functional relationship between Ex rate and purchasing power ( Bop ,
capital flow, speculation tariff structure)
1.2. International Monetary System

 Money serves three important roles :

1) unit of account - a yardstick by which we measure the value of
goods, assets, and foreign currencies.
2) Medium of exchange( double coincidence of wants) – absence of
medium of exchange initiates countertrading. It may be necessitated
when the value of money drops extremely.
As a result of high inflation money could loss the above two features
3) Store of value replaced by interest-yielding assets, foreign currency,
or durables that rise in value along with inflation.
 Cont.

 Dollarization –Aregentina & peru ( when home currency becomes worthless as a medium
of exchange )
 a coin’s value- cost to mint = “seigniorage” or “mint profits.
 Fiat money—paper money not exchangeable for a commodity, such as silver— came
about to save on the mint costs of mining gold and silver.
 Easier to carry around than heavy coins
 Broader currency zone the fewer the transaction costs the more useful it is.
Money and exchange Rates

 Great central banks , Bank of England and the Banque de France- gold windows
 Fixed currency price ( for buying and selling gold)
E.g. if the Bank of England sets £10 per ounce of gold as the buy/sell rate and the Banque
de France 100 francs, the equilibrium exchange rate is set at 100 francs per £10 or 10 francs
a £1.
 Arbitrage in gold kept the exchange rates within a narrow band of gold points.
E.g Exchange rate fall to 9.5 francs a £1.
 Arbitrageur purchases £10 for 95 francs, and presents the £10 to the Bank of England gold
window in exchange for an ounce of gold. The arbitrageur then insures and ships the gold to the
Banque de France, selling it for 100 francs, pocketing 5 francs less insurance and shipping as
profits.
- This gold arbitrage kept the exchange rates within narrow margins known as gold points
 Cont.

 countries that were on the gold standard had fixed exchange rates between
themselves
 Countries in Asia were on Sliver Standard
 Their currencies were pegged to one another and had corresponding silver points
 there was no fixed relationship between the price of gold and sliver
 A sliver standard country floated its exchange rate with respect to the gold
standard country
 The value of sliver had depreciated during the great depressions in the west until
1934 (implicit revaluation) destroyed Chinese export –import competing
industries leading to major recession which caused famine in the countryside.
Foreign Exchange

 Foreign trade
 Barter – local purchase
 Foreign Exchange
 When uniform metallic coins come into being
Gold, sliver and copper facilitated valuation and conversion – counterfeiting
- Bill of Exchange( a written order ) precursor of L/C – since carrying large
amounts of coins was risky
- The bills were traded as financial instruments in trade fairs - precursors of
modern stock and foreign exchanges.
 Cont.

 The area of fixed exchange came to an end when the gold window
was closed
 London is still by far the largest FOREX market today in terms of
daily turnover.
 Cont.

BANKS AND BANKING

 The first modern bank was the Bank of Amsterdam, founded in 1609.
THE FEDERAL RESERVE SYSTEM
THE INTERNATIONAL MONETARY INSTITUTIONS
 The International Monetary Fund (IMF) was established in 1944 at the Bretton Woods
Conference in New Hampshire. Its purpose:
- to establish orderly exchange rate arrangements based on a par value system,
- to eliminate exchange controls,
 to provide temporary short-term balance of payments assistance via loans to member
countries that are short of foreign exchange reserves.
 Cont.

 The Bank for International Settlements

 It does not do business with private individuals or corporations; only with
central banks and international institutions.
 Stock exchanges
 principal–agent problem (Agency Theory)
 The shareholder can enter a venture by buying shares, and exit it by selling
them.
 corporation is a business in which large numbers of people are organized in
a single venture.
 Cont.

 Some of the main stock exchanges are:

 The New York Stock Exchange
 Dow Jones Industrial Average (DJIA)- Only General Electric
remains of the original 12
 The NASDAQ - National Association of Securities Dealers
Automated Quotations.
 The American Stock Exchange (AMEX),
 The London Stock Exchange, The Footsie 100 Index is the
Financial Times Stock Exchange Index of the 100 largest
companies listed on the London Stock Exchange.
 Cont.

 The Tokyo Stock Exchange

- Japan’s Nikkei 225 Index is an average of stock market prices
similar to the DJIA.
 The Paris Bourse, The CAC 40 Index- 40 French companies listed
on the Paris Stock Exchange.
 The Shanghai Stock Exchange (SSE) - The Shanghai Composite
Index is a composite of hard-currency B shares sold to foreigners
and yuan-denominated A shares sold to the Chinese.
 Cont.

 The Frankfurt Stock Exchange, Its main index, the DAX, consists
of the 30 largest issues traded on the exchange.
 The performances of the international stock markets indices are
related.
Conclusion

 Currency Conversion (to compare prices and rates of return)

foreign exchange risk in investing and operating internationally
foreign exchange markets have arisen to deal with spot and forward
currency options to either hedge or speculate.
 FOREX market exchange costs = ask price - the bid price ( bid–
ask spread)+ commission associated with the conversion.
1.3. Balance of Payment & International
Linkage .

Balance of payment concepts

• The Balance of Payments (BOP) measures all international economic and
financial transactions over a specified period of time

- economic transaction : - transfer of goods ,

- the rendering of services ( including saving and risk-taking)
- and transfer of money and other investment between residents of
one country and residents of another country.
 Cont.

 There are two categories of economic transactions :

- two way transaction ( involving quid pro quo )
e.g. -sales of goods or the retendering of services against payment
- barter
- the interchange of capital items, such as sales of securities
- one-way transaction (not involving quid pro quo)
e.g. – gifts in kind, i.e., in the form of goods and services
- gifts of money and other capital items
 Cont.

 Financial transactions: an agreement or communication carried out between a buyer and

a seller to exchange an asset for payment. It involves a change in status of the finances of
two or more business or individuals - E.g. purchases, loan, Mortgage, Bank account ,
credit card Debit card,
• Usually over a calendar year

• In theory, BOP uses double-entry bookkeeping ( currency inflow called credits , currency
outflow called debits )
 Cont.

 Examples of credits
In a firm: firm sells goods or services,
firm borrows : money from a bank or issues bonds.
In a household: you do a week’s work, you sell some old furniture in a yard sale, you take
out an auto loan or new mortgage.
In a nation: The Ethiopia Exports coffee , an Ethiopian company sells shares to a Holland
based company. A Japanese firm called JTI buys NTE.
 Cont.

 Examples of debits:
In a firm: firm buys new office equipment, has workers work, firm pays interest or
principal on a loan.
A business donates to a local charity.
In a household: you buy groceries, invest in a savings bond. You make payments on your
debit card.
In a nation: A Ethiopian company imports laptops from Dubai , The government pays its
membership assessment to the U.N., Ethiopian citizens invest in foreign stock market. Some
of us go to overseas . We use Lufthansa .
 Cont.

• Debits and credits should match up

• For a Nation, there are three Major Accounts:
1. Current Account: records net flow of goods, services, interest payments, and unilateral
transfers. Essentially measures economic activity
2. Capital Account: records public and private investment and lending. Investment Activity
3. Official Reserves Account: records changes in foreign reserves owned by the central
bank .
 Cont.

• Official Reserves include

(1) Foreign currency in the form of securities (usually in a foreign Government’s T-
bills)
(2) to a much lessor extent, gold. This gold is often stored , at the national bank of
Ethiopia or at the Bank for International Settlements in Basle, Switzerland. If the Fed
intervenes to support the Birr, it sells reserves, and buys back Birr . This results in a credit to
the BOP. (think of it as exporting gold)
 Cont.

 Sum of all transactions, under double-entry, should add up to zero:

BOP = current account + capital account + official reserves = zero.
 However, given the amount of bad data, smuggling, etc., it usually doesn’t sum to zero.
 We add in a Statistical Discrepancy. This “fudge factor” is added to the the three BOP
items to get a zero sum.
 Cont.

 Current Account: Ethiopian shows Deficit

1) Merchandise (trade balance): We imported more than we exported:
2) Services (invisibles): Investment income (dividends and interest), travel and tourism,
fees for financial services, insurance premiums, etc.
3) Unilateral Transfers: pensions, gifts, foreign aid, (free and paid for) military aid.
 Capital Account: surplus (foreigners have been investing more in Ethiopian than
Ethiopian have been investing overseas.
 Cont.

 Capital Account: Two Types of Classifications:

1) Short-term Debt: Potentially the "hot money”. Ex., trade credit, Certificates of Deposit of
one year or less.
2) Portfolio Investments: Stocks and Long-term Debt. Affected by the country's economy,
inflation outlook, political climate.
3) Direct Investment: Owner has control of asset. Or 50+% control of a company's stock.
 Cont.

1) Investment overseas: If our investors are going overseas to purchase foreign

investments, it is a debit, if money is returning from an earlier investment (disinvestment)
it is a credit.
2) Foreign Investment in country .: If dollars are coming in from overseas to purchase
Ethiopian investments, it is a credit. Dollars leaving the Ethiopia (disinvestment by
foreigners) is a debit.
 Chapter Two : Foreign Exchange Risk

2.1. Exchange rate

- Exchange rate is the rate at which one country’s currency can be traded in exchange for
another country’s currency.
- The spot rate is the exchange rate currently offered on a particular currency for immediate
delivery.
 A forward rate is an exchange rate set now for currencies to be exchanged at a future date.
 Every traded currency has many exchange rates( exchange rates with every other traded
currency on the foreign exchange markets.
 Foreign exchange dealers profit emanates from by buying it for less than they sell it.
 Cont.

 Rates change continually because there is a huge volume of transactions daily in the
foreign exchange (FX) markets globally.
2.2 Foreign Exchange Demand
 Importer pays a foreign supplier in a foreign currency.
 E.g., An Ethiopian bank’s customer , a trading company , has imported goods for which it
must now pay 10,000 dollars.
 The company will now ask the bank to sell it 10,000 dollars. Company = buyer , bank=
seller
 Cont.

 The bank agreed to sell to the company and tells the company the spot rate of exchange
for the transaction. The banks’ selling rate = offer rate or ask rate is 0.034 dollar per 1
birr ( $1 =29.41 birr)
The bank’s charge = 10,000/0.034 = 294,118 Birr
 An Ethiopian exporter is paid 10,000 dollars . The company is the seller and the bank is
the buyer at bid price of 0.037 dollar per 1 birr ($1= 27.03 birr)
The bank’s payment= 10,000/0.037= 270,270
 The banks profit comes from buying at low and selling at high.
 Cont.

 Calculate how much an Ethiopian Exporter would receive or pay , ignoring the banks
commission , in each of the following situations.
(a) An Ethiopian exporter receives a payment from a Danish customer of $150,000.
(b) An Ethiopian importer buys goods from a Japanese supplier and pays 1 million dollars
Spot rate are as follows
Bank sells ( offer ) Bank buys ( bid)
During export per birr 0.034 0.036
During Export per birr 0.033 0.035
 Cont.

(a) 150,000/ 0.036= 4,166,667

(b) 1,000,000/0.033= 30,303,030
2.3. Foreign Exchange (FX) Markets
 Mainly banks buy and sell currency to exporting and importing firms, governments and
between themselves.
 International trade involves foreign currency for either the buyer , the seller or both.
 Most foreign exchange rates are not allowed to vary ( rates are continually changing)
 Cont.

 Each bank offers new rates according to how its dealers judge the market situation.
2.4. Foreign Currency Risk
 It is the risk of changes in an exchange rate or in the foreign exchange value of a
currency. It is a two-way risk.
 Currency risk occurs in three forms :
 transaction exposure: effects on short-term cash flows
 economic exposure : effect on present value of long-term cash flows
 translation exposure: gain or losses in the value of foreign currency assets or labilities.
 Cont.

2.4.1 The nature of foreign exchange risk

 Is also called currency risk or FX risk , is the risk arising from unforeseen changes in an
exchange rate or the value of a currency.
 Business decisions may be made now but the profits or the returns from those decisions
may depend on exchange rates in the future.
 Is a two way risk – exchange rate movements can be favorable as well as adverse , so the
term ‘risk’ can be misleading.
 E.g. an Ethiopian company buys goods from UK supplier costing 100,000 GBP, for
settlement in three months. If the current spot rate of exchange is 0.028 GBP per Birr the
expected cost of the goods would be 100,000/0.028 = 3,571, 429 birr
 Cont.

 The company does nothing to protect itself against the risk of exchange rate movement
and the spot rate after three month is 0.027
= 100,000/0.027= 3,703,704 birr , cost of goods by = 3,703,704-3,571,429= 132,275 than
expected.
- If the spot exchange is 0.029 , the cost of goods will be 3, 448, 276, which is Birr 123,153
less than expected.
 Cont.

 The Ethiopian company should consider the seriousness of the risk and the potential
movements in the exchange rate.
 Risk seriousness depends on expectation of future movements in the dollar-birr spot
exchange rate.
2.4.2 Translation risk
 is the risk that the organization will make exchange losses when the accounting results of
it foreign branches or subsidiaries are translated into home currency.
 E.g re-stating the BV of a foreign subsidiary assets at the exchange rate on the statement
of financial position date.
 TR effect is to create gain or loss in he reported financial results of the parent company
but they do not create cash flow gain or losses
 Cont.

2.4.3. Transaction Risk

 the risk of adverse exchange rate movements occurring in the course of normal international
trading transaction.
 Arises when :
 the prices of imports or exports are fixed in foreign currency terms
 And there is movement in the exchange rate between the date when the price is agreed and the
date when the cash is paid or received in settlement.
E.g., an Ethiopian Company buys goods from a US supplier for an agreed price of $,1,000,000,
with payments in two months’ time.
 the greater danger is in the movement in exchange rates
 Cont.

 This risk is faced by exporters who invoice in a foreign currency and importers who pay
in a foreign currency.
 Bigcat Ltd , an Ethiopian Co, buys goods from Redland which costs 100,000 Reds (local
currency). The goods are sold in Ethiopia for Birr 32,000. At the time of the import
purchase the exchange rate is Red 3.5650-Red 3.5800 per 1 Br.
Required
(a) What is the expected profit on the resale ?
(b) What would the actual profit be if the spot rate at the time when the currency is received
has moved to ;
i) Red 3.0800-Red 3.0950 per Br?
ii) Red 4.0650-Red 4.0800 per Br ?
 Cont.

(a) - Revenue from resale of goods…………………Br 32,000.00

- Less cost of 100,00 reds in birr(÷3.5650) 28,050.49
Expected profit 3,949.51
(b) I - if the actual spot rate is 3.0800
Revenue from resale of goods…………………Br 32,000.00
- Less cost of 100,00 reds in birr(÷3.0800) 32,467.53
loss (467.53)
II- if the actual spot rate is 4.0650
 Cont.

Revenue from resale of goods…………………Br 32,000.00

Less cost of 100,00 reds in birr(÷4.0650) 24,600.25
Expected profit 7,399.75
2.4.4 Economic Risk
 refers to the effect of exchange rate movements on the international competitiveness of a company
and refers to the effect of on the present value of longer-term cash flows.
 It is the risk that over time a currency will depreciate or appreciate in value against other
currencies , so that a country’s economy becomes more or less competitive.
E.g. Import local currency depreciate against foreign currency – dollar
Export local currency strengthens against foreign currency – Euro
 Cont.

 Difficult to avoid
 Diversification of the supplier and customer base across different countries will reduce
this kind of exposure to risk.
2.5. The cause of exchange rate fluctuations
1) Currency supply and demand
 Fx rate , the buying and selling rates , both spot and forward – is primarily determined by
supply and demand in the foreign exchange markets.
 Supply and demand for currencies are in turn influenced by
 Cont.

 The rate of inflation , compared with the rate of inflation on other countries
 Interest rates , compared with interest rate in other countries
 Balance of payment in goods and services
 Transactions of a capital nature , such as inward or outward foreign investment
 Sentiment of foreign exchange market participants regarding economic prospects
 Speculation
 Government policy on intervention to influence the exchange rate
 Cont.

2) Interest rate parity

 Is a method of predicting foreign exchange rates based on the hypothesis that the
difference between the interest rate in two countries should offset the difference between
the spot rates and the forward foreign exchange rate over the same period.
 Expected birr return in birr deposits is equal to the expected birr return on foreign
deposits
 Investors holding the currency with the lower interest rates would switch to other
currency ( arbitrage ) – fixing the forward rate
 Forces of supply and demand will lead to a change in the forward rate to prevent such
risk-free making
 Cont.

 The principle links to foreign markets an the international money markets and capital markets.
 The principle can be stated as follows :
F0= S0* (1+ic)
(1+ib )
Where F0= forward rate
S0= current spot rate
ic= interest rate in the country C ( the overseas country) up to the future date
ib= interest rate in the country B ( the base country) up to the future date
 Cont.

 If there are two countries , C and B, then country C’s interest rate will be the numerator
when the exchange rate are expressed as the quantity of the currency of C required to
purchase one unit of the currency B.
 E.g. Exchange rate between two currencies , birr and dollar , are listed in the financial
press as follows:
Spot rate $1= 35.7413
1Br=0.028 dollar
 Cont.

 90- days forward rates = 33.3333 Br per 1 dollar

0.030 dollars per 1 Birr
 The money market interest rate for 90-day deposits in Ethiopia is 7.5% annualized. What
is implied about the interest rates in US? Assume a 365-day year.
Ethiopian interest rate on 90-day deposit = 7.5% *90/365= 1.85%
US interest rate on 90-day deposit = ic
90-day forward exchange rate = F0= 0.030
Spot Exchange rate = S0 = 0.028
 Cont.

 0.030= 0.028 * (1+ic) = 0.03056=0.028+0.028ic = 0.00256=0.028ic

(1+0.0185)
= 0.091 or 9.1%
Annualized , this is 0.091*365/90=7.71%
E.g. An Ethiopian company is expecting is expecting Kuwati dinars in one years time. The
spot rate is ETB 60 per 1 dinar. The Company could borrow in dinars at 9% or in ETB at
14%. There is no forward rate in one year’s time. Predict what the exchange rate is likely to
be in one year?
 Cont.

 Using the interest rate parity , the ETB is the numerator and the Kuwaiti dinar is the
denominator. So the expected future exchange rate dollar/dinar is given by:
60.000*1.14 = 62.7523
1.09
 This prediction is subject to great inaccuracy, but note that the company could ‘lock into’
this exchange rate, working a money market hedge by borrowing today in dinars at 9% ,
converting the cash to ETB at spot and repaying any 14% ETB
 Con.

3. Purchasing Power Parity

• Purchasing power parity states that the exchange rate between two currencies is the same
in equilibrium when the purchasing power of currency is the same in each country.
• S1= S0* (1+hc)
(1+hb )
• Where S1= expected spot rate
S0= current spot rate
hc= expected inflation rate in country c ( a foreign country)
hb= expected inflation rate in country b ( the investor’s county)
 Cont.

 PPP predicts the future spot rate and interest power parity predicts the forward rate.
 The expected future rate will not necessarily coincide with the ‘forward exchange rate’
currently quoted.
 E.g. The spot exchange rate between UK Sterling and the Dansh krone is £1=8.00 kroner.
Assuming there is now purchasing power parity, an amount of commodity costing £110 in
the UK will cost 880 kroner in Denmark. Over the next year, price inflation in Denmark is
expected to be 5% while inflation in the UK is expected to be 8%. What is the ‘expected
spot exchange rate’ at the end of the year?
 Cont.

 Future spot rate= 8* 1.05 = 7.78

1.08
2.6. Foreign Currency risk management
 Currency of invoice
 Exporters invoice their foreign customers in their domestic currency, importers arrange
with their foreign supplier to be invoiced in their doemestic currency.
 Matching receipts and payments
- A company that expects to make payments and have receipts in the same foreign currency
should plan to offset its payments against its foreign receipts in the currency.
 Cont.

 Matching assets and liabilities

 a company which expects to receive a substantial amount of income in a foreign currency
will be concerned that this currency may weaken.
 It can hedge against this possibility by borrowing in the foreign currency and using the
foreign receipts to repay the loan. E.g. receivables in dollars can be hedged by taking out a
dollar overdraft. Similarly , dollar trade payables can be matched against a dollar bank
account which is used by the supplier.
 Leading and lagging
- Lead payments: payments in advance for goods purchased in a foreign currency.
- Lagged Payments: delaying payments beyond their due date for goods purchased in a foreign
currency.
 Cont.

 Netting
 Netting of intercompany transactions before arraigning payment to avoid transaction costs
 Forward Exchange market
 It is a contract made now for the purchase or sale of a quantity of currency in exchange
for another currency, for settlement at a future date and at the rate of exchange that is
fixed in the contract.
 A forward contract therefore fixes in advance the rate at which a specified quantity of
currency will be bought and sold.
 Are sometimes referred to as over-the-counter or OTC transctions.
 For example ,suppose that :
 The spot rate for dollar is 0.2341 – 0.2512 per ETB and
 The three –month forward rate is 0.2724-0.2822 per ETB
(a) A bank would sell 20,000 dollar :
(i) At the spot rate , now , for 20,000/0.2341= 80,433.57
(ii) Under a forward contract for settlement in three months’ time ,for (20,000/0.2724) ETB
73,421.44
(b) A bank would buy 20,000 dollar :
i) At the spot rate , for (20,000/0.2512) ETB 79,617.83
ii) Under forward contract for settlement in three months’ time , for (20,000/0.2822) ETB
70,871.72
 Cont.

- The current spot price is irrelevant to the outcome of a forward contract.

 Money Market Hedging
 Borrowing in one currency , converting the money borrowed into another currency and
putting the money on deposit until the time the transaction is completed , hoping to take
advantage of favorable exchange rate movement.
Setting up a money market hedge for a foreign currency payment.
 E.g. A us company owes a Danish supplier Kr 3,500,000 which is payable in three
months’ time. The spot exchange rate is Kr7.5590-Kr7.5548 per $1. The company can
borrow in dollars for three months time at 8.60% per annum and can deposit Kroner for
three months at 10% per annum.
SOLUTION
Interest rate are for three months are 2.15% (8.60%/4) to borrow dollar and 2.5%(=10%/4)
to deposit in kroner. The company needs to deposit enough kroner now so that the total
including the interest will be Kr3,500,000 in three months’ time. This mean depositing;
 Cont.

- Kr3,500,000/(1+0.025) = Kr3,414,634
 This Krona will cost $452,215( spot rate Kr7.5509=$1). The company must borrow this
amount and , with three months’ interest rate at 2.15%, will have to repay: $
452,215*(1+0.0215)= $461,938.
 effective forward rate which the company has ‘manufactured’ =
3,500,000/461,938= Kr 7.5768 per $1
Setting up a money Market hedge for a foreign currency receipt
E.g. a us company is owed CHF2,500,000 , receivable in three months’ time form a Swiss
company. The spot exchange rate is CHF 1.4498-CHF1.4510 per $1. The company can
deposit in dollars for three months at 8.00% per annum and can borrow Swiss francs for three
months at 7.00% per annum. What is the receipt in dollars with a money market hedge and
what effective forward rate would this represent?
Solution
the interest rate for three months are 2.00% to deposit in dollars and 1.75% to borrow in
Swiss francs. The company should borrow CHF 2,500,000/1.0175=CHF 2,457,002 today.
After three months , CHF 2,500,000 will be repayable , including interest/
 Cont.

 These Swiss francs will converted to $ at 2,457,002/1.4510= $ 1,693,316. The company

must deposit this amount for three months, when it will have increased in value with
interest (2% for three months) to : $ 1,693,316*1.02=$1,727,182
 The effective forward rate the company ‘manufactured’ = 2,500,000/1,727,182= CHF
1.4474=$1
- This effective forward rate show that the Swiss franc at a premium with the dollar because
the Swiss franc interest rate is lower than the dollar rate.
 Cont.

 Foreign Currency Derivatives

Currency futures
- Are standardized contracts for the sale, or purchase at a set future date of set quantity of
currency.
 Summary of the difference between currency futures and forward contracts
Currency Futures Forward Contract
Standard contract Bespoke Contracts

Exchange traded Traded over the counter

Flexible close out dates Fixed date of settlement

Underlying transactions take place at the spot rate and the difference Underlying transactions take place ate the forward rate
between spot rate and futures rate is settled between two parties
Cheaper than forwards Relatively high premium required
 Cont.

 Currency Options
 Is a right of an option holder to buy (call) or sell(put) a quantity of one currency in
exchange for another, at a specific exchange rate ( the exercise rate , exercise price or strike
price) on or before a future expiry date. If a buyer exercises the option , the option seller
must sell or buy at this rate. If an option is not exercised , it lapses at the expiry date.
 Companies can choose whether to buy :
(a) A tailor-made currency option from a bank , suited to the company’s specific needs. These
are OTC or negotiated options ; or
(b) A standard option , in certain currencies only, from an options exchange. Such options are
traded or exchange-traded options.
 Cont.

 Currency Swaps
 Effectively involve the exchange of debt from one currency to another.
 can provide a hedge against exchange rate movements for longer periods than forward
markets and can be a means of obtaining finance from new countries.
 E.g consider a UK company x with a subsidiary Y in France which owns vineyards.
Assume a spot rate of £=1.2 euros. Suppose the parent company X wishes to raise a loan
of 1.2 million euros for the purpose of buying another French wine company.
 Cont.

 At the same time , the French subsidiary Y wishes to raise £1 m to pay for new up to date
capital equipment imported form UK. The UK parent company X could borrow the £1 m
sterling and the French subsidiary Y could borrow the 1.2 million euros , each effectively
borrowing on the other's behalf. They could swap the currencies.
Chapter Three: Multinational Working capital
Management
3.1. Short-Term Financing Strategy
 The amount of money tied –up in working capital is equal to the value of raw materials ,
work in progress, finished goods and accounts receivables less accounts payable.
 Key Current assets and liabilities

Current Assets Current liabilities

Cash Trade accounts payable

Inventory of raw materials Taxation payable

Inventory of work in progress Dividend payments due

Inventory of finished goods Short-term loan

Amounts receivable from customers Long-term loans maturing within one year

Marketable securities Lease rentals due within one year

 Cont.

 Working capital investment policy

 Organizations must decide important risks related to working capital and whether to adopt
a conservative , aggressive or moderate approach to investment in working capital
Conservative Approach
 Reduce the risk of system break-down by holding high level of working capital
 customers are allowed generous credit –terms to stimulate demand
 Finished goods are high to ensure availability for customers
 Raw materials and WIP are high to minimize the risk of running out of inventory and
consequent downturn in the manufacturing process .
 However the cumulative effect of tis policy is the firm carries a high burden of
unproductive assets , resulting finance cost that can destroy profitability
An aggressive approach
 Seeks to reduce this financing costs and increase profitability by cutting inventories ,
speeding up collections from customers and delaying payments to suppliers
 Potential disadvantage of this policy is an increase in the chance of system breakdown
through running out of inventory or loss of good will with customers and suppliers.
- Modern manufacturing techniques JTI
 Cont.

A moderate approach
 Middle way between the aggressive and conservative approaches
 Working capital financing policy
- Different ways of funding current and non-current assets.
- Employ long- and short-term source of funding
 short-term sources are usually cheaper and more flexible than long-term ones but are
risker
Conservative Approach
 Cont.

 All non-current assets and permanent current assets , as well as part of the fluctuating
current asses are financed by long-term funding.
Non-current (fixed) assets are long-term assets from which an organization expects to
derive benefit over a number of periods ; for example , buildings or machinery.
Permanent current assets are the amount required to meet long-term minimum needs and
sustain normal trading activity ; for example, inventory and the average level of accounts
receivable.
Fluctuating Current assets are the current assets which vary according to normal
business activity ; for example , due to seasonal variations.
Aggressive approach
 All fluctuating current assets and some permanent current assets
 Represent increase level of risk of liquidity and cash flow problems
Moderate Approach
 Maturity matching
 Long –term funds finance permanent assets
 Short- term funds finance non-permanent assets
3.2. Financing Techniques in International
Trade
 Credit Insurance to overcome bad debts
Companies may be able to obtain credit insurance against certain approved debts going bad
through a specialist credit insurance firm.
 Factoring – an arrangement to have debts collected by a factor company , which advances
a proportion of the money it is due to collect.
 Without recourse
 With recourse
 Invoice Discounting
 The purchase ( by a provider of the discounting service) of trade debts at a discount.
Invoice discounting enables the company from which debts are purchased to raise
working capital.
 Documentary credits –L/C
 Forfaiting – is a methods of export finance whereby a bank purchases from a company a
number of sales invoices , usually obtaining a guarantee of payment of the invoice. They
can be sold at the money market as debt instruments
 Counter trade
- Goods are exchanged for other goods.
3.3.International cash, receivables and
Inventory management
 A business needs to have clear policies fro the management of each component of
working capital.
 What difference would there be in the working capital management polices for a
manufacturing company and a food retailer?
A manufacturing company invest in heavily in spare parts and extends generous credit
terms ( management of A/Rs which will need to reflect credit policies of its close competitors.

Food retailer will have a large amount of goods for resale but will have low/no accounts
receivable. It should be more concerned with inventory management
 Cont.

 The cash operating cycle ( working capital cycle , trading cycle or cash conversion cycle.
 Is the period of time which elapse between the point at which cash begins to be expended
on the production of a product and the collection of cash from a customer.
 The COC in a manufacturing business equls :
Months
The average time the raw materials remains in inventory ….x
Less the time taken to pay suppliers x
 Plus the time taken to produce the goods …………………..x
Plus the time taken by customers to pay for the goods…….x
Cash Cycle x
E.g. Wines Co busy raw materials from suppliers that allows wines 2.5 months’ credit. The
raw materials remain in inventory for one month, and it takes Wines two months to produce
the goods. The good are sold within a couple of days of production being completed and
customers take on average 1.5 months to pay.
Required : calculate the Wine’s COC
 We can ignore the time that finished goods are in inventory, as it is no more than a couple
of days.
The average time the raw materials remain in inventory…….1.0
Less time taken to pay suppliers ………………………………….(2.5)
The time taken to produce the goods……………………………2.0
The time taken by customers to pay for the goods……………..1.5
Cash Cycle………………………………………………………………2.0
 Cont.

 Over capitalization
 Excess inventories , accounts receivable and cash and very few accounts payable
 Over investment by the company in current assets.
Sales / working capital = low or falling ratio compared to previous years
Liquidity ratios
Turnover ratios = longer turnover periods for inventory and accounts receivable or short
credit period from suppliers
 Over trading
 When the business tries too do too much too quickly with too little long term capital
 Symptoms :
• rapid increase in sales revenue
• Rapid increase in the volume of current assets and possibly also non-current assets.
• Small increase in equity capital – most of the increase in assets is financed by credit ,
especially trade accounts payable and a bank over draft
 Some debt ratios and liquidity ratios alter dramatically
Group Assignment

The following topics are assigned for presentation and term paper submission for each one of five groups in the
course’s session. Topics are allotted equitably in light of reference materials availability and time required to
finish the assignment . The deadline to hand-in a print out of the term paper is August 17, 2019 and the
presentation the week after( August 24)
Topic Group
-Designing a Global Remittance Policy ( Ch 3) - 1
- Designing a Global financing strategy ( Ch 5)- 2
-Patterns of International Banking Activities ( Ch 6) 3
-Value creation in International Banking (Ch 6) 4
-Country Risk Analysis in International Banking( Ch 6) 5
 Cont.

 Valuation basis
Term- paper
 Relevance of contents (20%)
 Tendency to accommodate Ethiopian context ( 20%)
Presentation
 Ability to communicate what is on the term-paper ( 5%)
 Being able to answer question raised from anyone (5%)