INTERNATIONAL FINANCIAL MANAGEMENT 41338 Essay Example

changes in exchange rates between when a transaction is recorded and when actual cash is received or paid (Solt ; Lee, 2001). To mitigate transaction exposure and eliminate its impact on a firm's value, futures and forwards can be utilized due to their short-term nature (Solt & Lee, 2001). In contrast, economic exposure pertains to the long-term consequences of exchange rate changes on future cash flows and stock returns (Solt & Lee, 2001).

Below is a summary of the various types of exchange rate risk that firms face:

Comparison of translation, transaction, and operating exposure

Translation exposure relates to the potential impact of fluctuations in currency exchange rates on a company's financial statements when it operates in multiple countries. This specifically involves converting the financial statements from one currency to another.

On the other hand, operating exposure refers to the risk that a company encounters due to changes in exchange rates which can affect its operating income and cash flows. It includes factors such as modifications in sales revenue, production costs, and competitive position across different markets.

Exchange rate fluctuations cause fluctuations in income statement items and book values of balance sheet assets and liabilities. These fluctuations only reflect nominal gains and losses, as determined by accounting rules. The measurement of accounting exposure is retrospective, applying to prior period accounts and impacting existing liabilities and assets.

On the other hand, fluctuations in exchange rates result in movements in the amount of future operating cash flows. Subsequent exchange translation gains and losses are influenced by changes in the firm's future competitive position and are considered real. The measurement of operating exposure is prospective, focusing on future periods unlike the retrospective measurement used

for translation exposure.

Compared to translation exposure, operating exposure has more serious impacts as it affects revenues and costs associated with future sales.

Taken from Shapiro's (2003) source.

Please note that the table does not mention transaction exposure because it is applicable to both translation and operating exposure.

Measuring Foreign Exchange Exposure

Shapiro explores four methods for measuring currency translation gains and losses, or translation exposure: the current/concurrent method, monetary/nonmonetary method, temporal method, and current rate method.

The method used to classify assets and liabilities on a company's balance sheet is the current/non-current method. This involves dividing assets and liabilities into two groups: current and non-current.

The translation process currently involves converting all assets and liabilities of a foreign subsidiary into the home country's currency using the current exchange rate. However, non-current assets and liabilities are translated using their historical exchange rates, which were the rates at the time they were acquired or incurred. The income statement translation uses the average exchange rate for the period, except for revenue and expense items related to non-current assets and liabilities.

Shapiro (2003) states that the historical exchange rate of an asset's corresponding balance sheet is used to translate depreciation expenses. Consequently, income statement items with identical expiration dates may be translated at varying exchange rates.

The Non-Monetary/Monetary Method is utilized.

The process involves categorizing different items into groups, including monetary and non-monetary assets. Certain assets like cash and accounts receivable, as well as liabilities like accounts payable and long-term debt (Shapiro, 2003), are classified separately. Non-monetary assets encompass trading stock, long-term investments, and fixed assets such as land property, plant, and equipment (PPE). Monetary assets are converted using the current rate while historical rates are utilized for

converting non-monetary assets.

The income statement items are translated by using the average exchange rate, except for revenue and expense items associated with monetary assets and liabilities. Monetary items are translated using the previously mentioned current rate (Shapiro, 2003).

The Temporal Method

According to Shapiro (2003), when using the monetary/non-monetary method to translate balance sheet and income statement items, the same procedures are followed. The only variation is that inventory, typically translated at historical cost, can be translated at the current rate if it is displayed on the balance sheet at market values.

Current Rate Method

The current rate method is used to convert all income statement and balance sheet items by using the current exchange rate. If a company has more assets in foreign currency than liabilities, a decrease in the value of the home currency will lead to a loss, while an increase will generate a gain.

Management of transaction and economic exposure.

Transaction exposure can be effectively managed by implementing well-structured hedging strategies, which involve establishing an opposing currency position to secure a fixed value in the home currency. This strategy eliminates the risk associated with currency fluctuations and ensures certainty regarding the future amount that will be received or paid in foreign currency.

To illustrate this, let's consider a scenario where a US citizen anticipates receiving 10 million pounds in three months. Currently, the exchange rate stands at 2 US dollars per pound, resulting in a current home currency value of 20 million dollars for this future receivable. However, due to uncertainty surrounding the exchange rate in three months, there is foreign exchange risk involved.

If the pound weakens below 2 US dollars per pound, there will be

a loss equivalent to 10 million multiplied by the decrease in value. Conversely, if the pound strengthens above 2 US dollars per pound, there will be a gain.

To mitigate this risk, one option available to the US citizen is entering into a forwards contract that provides a forward price of 1.9 US dollars per pound. By selling their pound receivables forward at this price, they effectively lock in a minimum value of 19 million US dollars (in their home currency) that will be received after three months.According to Shapiro (2003), fluctuations in the exchange rate will not impact the future receivable of a company. However, managing Economic Exposure can still be challenging but can be effectively handled through marketing management, pricing strategy, and production management.

Arcelor Mittal is a global company.

Forecasted Income Statements for Arcelor Mittal Under Different Scenarios

Scenario 1

Forecasted Income Statement for Arcelor Mittal (NZ$=US$0.48)

US$ NZ$ US$ NZ$

The domestic sales amount is 600,000,000.00.

The revenue in the United States is 100,000,000.00 and 208,333,333.33.

The total revenue in New Zealand is 808,333,333.33 NZ$.

The sales cost of NZ Materials totaled $100,000,000.00.

The cost of sales for US materials is $200,000,000.00 or 416,666,666.67.

Total Cost of Sales 516,666,666.67

Variable operating expenses amount to 161,666,666.67.

The total fixed operating expenses amount to $30,000,000.00 and $62,500,000.00.

Interest Expense 20,000,000.00 41,666,666.67

Income before tax is 25,833,333.33.

Scenario 2

Forecasted Income Statement for Arcelor Mittal (NZ$=US$0.50)

US$ NZ$ US$ NZ$

Domestic sales totaled 600,000,000.00.

US Revenue $105,000,000.00 $210,000,000.00

Total Revenue (NZ$) 810,000,000.00

Cost of sales (N Z Materials) 100,000,000.00

Cost of sales for US Materials is $200,000,000.00 and $400,000,000.00*

Total cost of sales is 500,000,000.00

Variable operating expenses total $162,000,000.00.

The range for fixed operating expenses is from $30,000,000.00 to $60,000,000.00.

Interest Expense: 20,000,000.00

Interest Expense: 40,000,000.00

The interest expense is $20,000,000.00 and

$40,000,000.00 respectively.

Income before tax is 48,000,000.00.

Scenario 3

Forecasted Income Statement for Arcelor Mittal (NZ$=US$0.54)

US$ NZ$ US$ NZ$

Domestic sales amount to $600,000,000.00.

US Revenue: $110,000,000.00 and ˆ203,703,703.70

Total revenue is NZ$803,703,703.70.

The cost of sales for materials in New Zealand is 100,000,000.00 dollars.

The cost of sales for US materials is $200,000,000.00, which equals 370,370,370.37 units.

Total cost of sales is 470,370,370.37.

The variable operating expenses amount to 160,740,740.74.

The fixed operating expenses total $30,000,000.00 or $55,555,555.56.

Interest Expense $20,000,000.00 $37,037,037.04

Income before tax: 80,000,000.00

The income before tax rises as the exchange rates fluctuate from 0.48 to 0.50 to 0.54 US dollars per New Zealand dollar. In scenario 1, the income before taxes is N$25,833,333.33; in scenario 2, it is N$48,000,000.00; and in scenario 3, it is N$80,000,000.00. The increase in profit can be attributed to Arcelor Mittal's liabilities being denominated in US dollars.

For example, the company expects costs of goods sold totaling $200 million and fixed operating expenses amounting to $30 million along with interest expense of $20 million on existing US loans (without any New Zealand loans). These combined expenses add up to $250 million which exceeds their receipts in dollars: $100 million for scenario 1, $105 million for scenario 2, and $110 million for scenario 3 respectively.

As the New Zealand dollar strengthens against the US dollar, fewer New Zealand dollars are needed to settle their liabilities denominated in US dollars resulting in increased profitability. Additionally, revenue generated from their US business increases when the value of the dollar decreases thereby offsetting some potential loss from foreign currency receipts.

c) To navigate the impact of the depreciation of the US dollar, Arcelor Mittal has various options for restructuring its operations. These options include increasing expenses

in US dollars, such as by invoicing purchases from the United States in US dollars and obtaining more loans in US dollars. Additionally, Arcelor Mittal can decrease receipts in US dollars by invoicing exports to the United States in New Zealand dollars. Another possibility is transferring some operations to the United States, where lower labor and raw material costs resulting from the depreciation of the US dollar can be taken advantage of. In summary, Arcelor Mittal should aim to increase liabilities in US dollars while reducing assets denominated in that currency.

According to Shapiro (2003), a firm can manage its operating exposure through production management, marketing management, or financial management. The firm should consider its input mix, shift production among plants, determine plant location, increase productivity, and plan for exchange rate changes. Shapiro (2003) suggests that the company can be more flexible by changing the input mix and purchasing more components from abroad. Another solution is to shift production among plants. This involves increasing production in a country with a devalued currency and reducing production in a country with an appreciated currency (Shapiro, 2003). Therefore, Arcelor Mittal can resolve its issue by increasing production in the United States of America. Shapiro (2003) highlights that under marketing management, pricing strategy and market selection are crucial.

Arcelor Mittal can restructure its operations by increasing its sourcing of inputs from the United States, with payment in US dollars, and arranging for sales to the United States to be invoiced in New Zealand dollars. Furthermore, it should strengthen its obligations, such as accounts payable and long-term debt, denominated in US dollars.

Currency fluctuations have a substantial impact on multinational companies' profitability and

macro-economic uncertainty (Muller et al, 2006). These fluctuations can also influence the cash flows and overall value of multinational firms (Fraser and Pantzalis, 2004). Due to operating in multiple countries, multinational companies are exposed to various currencies, resulting in foreign exchange exposure. This exposure can be categorized as either translation or economic, each having different effects on the firm. Translation exposure primarily affects balance sheet items that have already been recorded, therefore having limited impact. In contrast, economic exposure significantly impacts both cash flows and profits. For instance, Toyota, a leading global automaker, operates with the Japanese yen as its functional currency while sourcing inputs from countries like the United States, United Kingdom, Europe, and Australia. Additionally, Toyota generates sales in the United States, Europe, and other regions. These factors subject Toyota's consolidated financial statements to exchange rate movements.According to the Toyota Annual Report of 2006, Toyota is affected by the fluctuations of various currencies, including the US dollar, the British pound, the Euro, the Australian dollar, as well as the Swedish krona, the Danish krona, and the Norwegian krona. These currency movements have an impact on both the pricing of Toyota's products and its inputs. An increase in the value of the yen compared to the US dollar would particularly influence Toyota's operating results.

Arcelor Mittal is known for its effective hedging strategies.

a. The cost of a one yen call option is 0.015 cents.

Thus, 125,000,000 yen will amount to $US18,750, considering that 1 yen is equivalent to US$0.00015.

If the yen settles below the minimum price (out-of-the-money), Arcelor Mittal will choose not to exercise the option. Conversely, if the yen settles above the maximum price (in-the-money),

then Arcelor Mittal will exercise the option and earn.

(0.0084-0.00800) x 125,000,000 = US$50,000.

Thus, the net profit he will receive from exercising the option can be determined as follows:

Net profit is equal to US$31,250, which is calculated by subtracting US$18,750 from US$50,000.

Assuming Arcelor Mittal uses a futures contract, they can secure a price of $0.00794 per unit. The total cost would be $992,500 for 125,000,000 units.

If the yen ends at its minimum value of US$0.007500, she will suffer a loss equal to US$0.007500 - US$0.007940 = (US$0.000440/?). Hence, her total loss on the 125,000,000? purchase will amount to 0.000440 X 125,000,000 = US$55,000.

Assuming that the yen settles at its maximum value, Arcelor Mittal will generate a profit, as follows:

The net profit in yen is equal to US$0.008400 minus US$0.007940, resulting in US$0.000460 per unit.

US$57,500 will be the total profit on ?125,000,000, which is calculated as US$0.000460 per ?125,000,000.

The following table displays the cash outflows and inflows of the futures and options positions, along with the profit/loss positions. The subsequent graphs depict Arcelor Mittal's profit/loss on both the options and futures positions.

Table displaying the profit/loss of Acerlor Mittal's Option and Futures Position.

Yen price 0.007500 0.007940 0.008150 0.008400

Option inflow: 1,018,750 1,050,000

Option premium: -18,750 -18,750 -18,750 -18,750

Exercise cost 1000,000 or 1,000,000

Profit from option is -18,750, with a difference of -18,750 and a sum of 0 and 31,250.

Futures inflow 937,500, 992,500, 1,000,000, and 1,050,000

Futures outflow remains constant at -992,500 for each period.

Profit: -55,000, 0, 7,500, 57,500

If the yen settles at US$0.007900, which is its most likely value, Acerlor Mittal will not exercise her call option and will suffer a loss of US$18,750 as the call premium.

However, if

Acerlor Mittal decides to establish a hedge position using futures, she will need to purchase yen at an exchange rate of US$0.007940 when the current spot price is priced at US$0.0079.

So, Acerlor Mittal will lose US$5,000, which is the result of (0.007900-0.007940) x 125,000,000.

b. The break-even future spot price on the option contract is equal to the exercise price plus the call premium.

The exercise price is $0.0080.

The cost of an option premium is $0.00015.

The futures contract's break-even point is at 0.007940, as it represents the level at which Arcelor neither experiences a loss nor a gain.

So, the break-even future price is equal to US$0.0080 plus US$0.00015, which equals US$0.00815

c. The mirror image of Arcelor Mittal’s position will be reflected in the profit/loss position and break-even prices of the sellers on the futures and options contracts. The break-even price for the futures sellers is 0.007940, while for the options sellers, it is $0.008150. In the event that the yen settles at its minimum value, the options sellers will earn a profit of $18,750, whereas the futures sellers will earn a profit of $55,000. Conversely, if the yen settles at its maximum value, the options sellers will experience a loss of $31,250, while the futures sellers will incur a loss of $57,500. The diagrams below provide further visual representation.

4.

According to the interest rate parity theorem stated by Shapiro (2003), the currency of the country with a lower interest rate should have a forward premium compared to the currency of the country with a higher interest rate. To exemplify this, let's take the UK pound and the UK dollar. If we denote the

current exchange rate between these two countries as E0, meaning that E0 dollars are required to purchase 1 pound, and let F0 be the agreed upon forward price for buying one pound at time T in the future. The theorem holds that the appropriate relationship between F0 and E0 is determined by the risk-free rate in both the United States and the United Kingdom.

(Bodie et al, 2002)

Therefore if the value is $1.13

The price is $1.10.

If the interest rate parity (IRP) condition is true, then the value of the dollar should decrease and there should be a forward premium, while the value of the euro should decrease at a different rate.

By substituting the values into equation 1 and taking into account a one-year time frame, we obtain:

The value of $1.10 is equal to $1.10.

Hence, the principle of IRP is valid.

According to Shapiro (2003), purchasing power parity (PPP) suggests that price levels should be equal worldwide. This means that a unit of home currency (HC) should have the same purchasing power around the world. The inflation rates in the home and foreign currency are represented by "i" and "i*" respectively. Additionally, the dollar value of the euro at the beginning of the period is denoted as "E" and the spot exchange rate in period t is represented as "S".

(Shapiro, 2003).

If condition (2) is true, then

Therefore, for,

c. According to Shapiro (2003), the International Fisher Effect suggests that currencies with lower interest rates are likely to increase in value compared to currencies with higher interest rates, as expressed mathematically.

When we substitute the interest rates, we receive

-3.39 =

The value is negative at -$2.26.

The discrepancy can be resolved

by acknowledging that IFE is not a reliable indicator of the forward rate for short timeframes. It is likely to be unreliable in this situation since we are only predicting one year in the future. Typically, the margin of error for shorter prediction periods is quite significant, and therefore IFE is not accurate for these shorter timeframes. However, over longer periods of time, prediction errors tend to balance out as we make predictions over time. (Shapiro, 2003).

There have been five major crises in East Asia.

Investors in these countries regarded high interest rates as compensation for the associated risk, as they were risk-averse (Bodie et al, 2002). According to the capital asset pricing model, investors expect compensation for time value of money and a risk premium (Bodie et al, 2002). Therefore, they are willing to take on high risk if adequately compensated. In the case of Southeast Asian investors, they became risk-averse and took on the risk despite interest rates reflecting inflation levels. The International Fisher Effect may have failed due to time varying exchange risk premiums that compensate for risk resulting from changing exchange rates (Shapiro, 2003).

According to the International Fisher Effect, the increasing interest rates in Southeast Asian countries indicate expectations of inflation, leading to a decline in the value of their currencies. It is clear that no investor would choose to hold bonds, stocks, or other securities denominated in a currency that is expected to lose value in the future, if they were aware of this fact. Therefore, even with high interest rates, investors would not have been interested in investing in Southeast Asian countries if they knew that these rates were a

reflection of inflation levels and subsequent devaluation or depreciation of their currencies.

a. Theoretical factors that determine the exchange rate are as follows:

Relative inflation rates

Relative interest rates

Relative economic growth rates

Political risk and economic risk

Relative inflation rates

The excessive supply of money compared to its demand is known as inflation, which results in an increase in the prices of goods and services (Shapiro, 2003). For example, if there is an excess supply of dollars in the United States, the prices of US products will increase relative to European goods and services. As a consequence, European consumers will purchase fewer US products and opt for European alternatives. This shift will lead to a decrease in the number of euros available at each exchange rate between the euro and the dollar. As depicted in the figure below, this will cause the euro supply curve to shift from S to S?. Similarly, US consumers will start substituting European imports with domestic products, creating an increased demand for euros, depicted as D'. In summary, both Europeans and Americans seek the best global deals and adjust their purchases accordingly (Shapiro, 2003).

When inflation is higher in the United States compared to Europe, it will result in an increase in European exports to the US and a decrease in US exports to Europe. This scenario will cause the US dollar to depreciate in relation to the euro (Shapiro, 2003). Similarly, if inflation is higher in Europe than in the United States, there will be an increase in demand for US goods in Europe and a decrease in demand for European goods in the US, leading to a depreciation of the euro relative to the dollar

(Shapiro, 2003). Generally, a country with higher inflation rates will experience a decline in the value of its currency compared to countries with lower levels of inflation.

Interest rates that are relative.

Differences in interests also impact the equilibrium exchange rate between two countries' currencies. If European interest rates remain unchanged while US interest rates increase, investors from both countries will shift their portfolios from euro-denominated assets to dollar-denominated assets in order to benefit from the rising interest rates. As a result, the euro's value decreases relative to the dollar. It is worth noting that the interest rates mentioned are real interest rates, which means they are calculated by subtracting the inflation rate from the nominal interest rate. If the difference in interest rates reflects nominal interest rates instead, the outcome would be a weaker dollar.

Relative Economic Growth

A country that has a higher economic growth has the ability to attract foreign direct investment, leading to increased demand for its currency. Conversely, a country with economic stagnation, as indicated by low growth in per capita GDP, will experience capital flights and their currency will depreciate (Shapiro, 2003).

Political and Economic Risk

The equilibrium exchange rates between currencies of different countries can be affected by political and economic risk. Investors tend to prefer low-risk currencies over high-risk ones. As a result, high-risk currencies may experience depreciation as investors are not willing to hold assets denominated in those currencies. On the other hand, low-risk currencies may appreciate as investors are willing to shift their portfolios into assets denominated in those currencies.

Government action determines exchange rates in practice. If a government restricts investors to purchasing bonds issued only in the country, interest rate

parity is not held. Therefore, the exchange rate depends on the government's chosen regime, whether it is a free-floating exchange rate or a fixed exchange rate. Under a fixed exchange rate regime, government actions greatly influence exchange rates, whereas market forces determine exchange rates in a free-floating regime. (Economic Report of the President)

REFERENCES

Bodie Z., Kane A., Markus A. J. (1999). Investments. Fifth International Edition. McGraw-Hill Irwin.

< p > Fraser S. P., Pantzalis C. (2004). Journal of Multinational Financial Management Vol. 14, pp 261-281. Foreign exchange rate exposure of US multinational corporations: a firm-specific approach. < /p >The article "Asymmetric foreign exchange risk exposure: Evidence from U.S. multinational firms" by Mullem A., Willem F.C., and Verschoor (2005) is published in the Journal of Empirical Finance. It can be found in the Volume 13 of the journal on pages 495-518.

Economic Report of the President, which can be downloaded from Currency Markets and Exchange Rates.

http://www.whitehouse.gov/cea/ch7-erp07.pdf

Faff R., Iorio A. (2001). A study was conducted to test the stability of exchange rate risk in the Australian equities market. The findings were published in the Global Finance Journal, Volume 12, pages 179-203.

The book "Multinational Financial Management" by Shapiro A.C. was published in 2003 by Wiley and Sons Inc., in its seventh edition.

Solt M. E. and Lee W. Y. (2001) conducted a study on the economic exposure and hysteresis, which was published in the Global Finance Journal. The study focused on analyzing the stock returns from Germany, Japan, and the United States. The article can be found on pages 217 to 235.

Toyota Annual Report (2006) on Risk Factors can be found on the following Link:

The following website contains the

annual report for Toyota in 2006: http://www.toyota.co.jp/en/ir/library/annual/pdf/2006/p44_45.pdf.