Question

Your firm has just landed a large client contract in Germany and secured an even larger supplier contract from Mexico. You are in the automobile stereo sound system business with the Detroit Auto Show, your signature event (product, advertising, etc.), and a potential deal with the Chinese and Brazilians projected to be signed and sourced in March and July 2016, respectively. What do you recommend your C-Suite consider and your risk management group do, if anything, about this increasingly international exposure? What financial instruments, if any, would be of help to your firm? Why is your firm even having this discussion?

Answer 1

The scanario mentioned above is a typical example of International Finance. Decision aking becomes complicated when multiple curencies are involved and with different legal environment, accounting practices and expectations of customers/suppliers.

There are various factors involved while dealing with International business, namely:

• Foreign currency could appreciate/depreciate - Appreciation means more nmber of local currency are needed to buy same number of foreign currency. Depreciation is vice-versa.
• Inflation & Exchange rate - Suppose, there is inflation in USA, then price of American items would rise to foreign items. Foreign people would buy less American items. This would lead to decrease in supply of forign currencies.
• Interest rate: Suppose, interest rate in USA increase, foreign invvestore would invest in USA market, so supply of foreign currencies increase, Dollar appreciates.

In Foreign exchange markets (OTC), currency rates are negotiated between 2 parties and is majorly dominated by transactions amongst banks. Since in the above case, supplier is from Mexico and client is from Germany, foreign currencies would be Mexican Peso and Euro respectively. To avoid risks involved due to currency fluctuations, forward contracts can be used.

Forward contracts asthe name sugggests are the ones in which foreign currency can be bought/sold on a future date with rates determined now. They serve as hedging mechanism in International business.

There are various risks involved, namely:

• Trasaction Exposure - This occurs when contracts are denominated in foreign currency and are already entered, but not settled. This can have impact on Cash Flow of the organization. To avoid such risks, there is a concept called "Hedging". It ensures stability to cash flows. But because of hedging, thre could be a possibility of less profit, however with hedging adverse risks can beavoided.

To manage such risks strategically, risk can be shifted to counter party or risk can be shared. Best way is to get money and pay money in local currency. This would aveoffsetting effect and hence netted. Other option is to share the risk so that neither party is at extreme loss.

• Economic Exposure - When risk is involved due to exchange rate fluctuations, there would be impact in Cash flow. Strategic way to manage this kind of risk is to diversify ie; spread geographically. This can reduce volatility of aggregate cash flows. Product differentiation would be great use as it can help in combating competition. Uncertainty can be avoided by cultivating good relationship with local vendors and reduce dependency on foreign vendors, Long-term contracts can be signed with suppliers.
• Translation Exposure - Also known as Balance sheet or Acounting exposure, occurs when financial statements are translated to domestic currency from foreign currency. To avoid this risk, 4 methods are used - Current/Non current method, Monetary/Non-monetary method, Temporal and all Current.
  • Current/Non current method: Assets & liabilities are categorized on the basis of maturities and based on that applcable exchange rates are determined.
  • Monetary/Non-monetary method: Categorized on the basis of Monetary/Non-monetary. Monetary items are receivable/payable and non-monetary items include physical assets/liablities.
  • Temporal method: Variant of Monetary/Non-Monetary method. In this method, same type of echangerate re used for carrying items in balance sheet.
  • All current method: Only currrent rates are used except equity or which historical rate is used.