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International Finance Paper For the past twenty years, financial markets throughout the world have become more and more interconnected. Globalization of finances has brought considerable benefits to different economies and to investors and changed the composition of markets. It has created new risks and challenges for market members and policymakers. The worldwide marketplace continues to present opportunities for companies. But change is constant and prudent so companies must work to minimize their risks while maximizing their opportunities. The International marketplace can offer considerable financial returns to companies conducting business but there are risks that have to be considered such as trade, foreign exchange, cash management, cross border financing, investment, and multi currency requirements.
In conducting business overseas, there is need to deal with multi currency financial flows, fluctuating market conditions, and exchange risks. Risk management internationally has always been a critical issue, due to financial deregulation and innovations. The unpredictability in the financial market has increased tremendously. Instability in exchange rates due to floating exchange rates, unstable interest rates both with domestic and foreign assets has exposed all the financial mangers to a greater uncertainty in achieving companies financial objectives. Rapid advances in corporations and governments having to rely more heavily on national and international capital markets to finance their activities have heightened the emphasis on money management performance. At the same time, cross-border financial activity has increased.
Investors that manage a growing share of global financial wealth are trying to enhance their risk adjusted returns by diversifying their portfolios internationally and are seeking out the best investment opportunities from a wider range of industries, countries, and currencies. Also non-bank financial institutions are competing sometimes aggressively with banks for national and international markets, driving down the prices of financial instruments. A significant portion of many companies business is conducted outside the United States. For the years ending December 31, 2001, 2000 and 1999, approximately 60 %, of United States based companies revenues were generated from customers outside of the United States. (PanAmSat) This made them vulnerable to be harmed financially and operationally by changes in foreign regulations and telecommunications standards, tariffs or taxes and other trade barriers. Although almost all of their contracts with foreign customers require payment in U. S.
dollars, customers in developing countries could have difficulty in obtaining the U. S. dollars they owe these companies, including as a result of exchange controls. Exchange rate fluctuations may adversely affect the ability of their customers to pay us in U. S. dollars.
If these companies ever need to pursue legal remedies against their foreign business partners or customers, they may have to sue abroad, where it could be hard for them to enforce their rights. (PanAmSat) Banks have an integral part in the international chain, and their contributions can have a direct impact on a U. S. companys success and profitability. A number of market factors are creating an opportunity for banks to significantly enhance the value they add to their customers cross border risk mitigation efforts. The first factor is what method is available to measure currency exposure, secondly, based on the nature of the exposure and the companys ability to forecast currencies, what exchange risk strategy should the firm utilize. Lastly, which tool or techniques of the foreign exchange market should be utilized that will take into consideration the risks attached with each market to prevent the likelihood of a transaction not going through smoothly.
The exchange rates are influenced by many factors, with the most significant ones being the interest rates and inflation rates. The exchange rate, interest rates and inflation rates are linked to one another through a set of relationships which have import for the nature of corporate foreign exchange risk. (Giddy) This relationship follows the pattern that inflation affects supply and demand for currency, which impacts international trade, where as the interest rates affects investment in foreign securities. Unexpected changes in either or both of these factors can cause fluctuations of the exchange rate setting up for a potential gain or loss in currencies. The exchange rate risk is the danger that an unexpected change in the exchange rate between the dollar and the currency in which a projects cash flows are denominated can reduce the market value of that projects cash flow. (Financial Analysis) Although a projects initial investment can usually be predicted with some certainty, the dollar value of future cash inflows can be dramatically altered if the local currency depreciates against the dollar. In the short term, specific cash flows can be hedged by using financial instruments such as currency futures and options. Long term exchange rate risk can best be minimized by financing the project, in whole or in part, in local currency. (Financial Analysis) There are also a number of factors that may influence the rate of exchange between currencies, exchange rates may be quoted direct or indirect exchange rates also may differ depending on whether they are a buying or selling rate.
Present and future rates are known as spot and forward rates respectively. Forward exchange rates apply to the exchange of currencies at a future point in time. The agreement to exchange currencies at a future date is generally a forward contract. The forward contract specifies the forward rate of exchange and the forward date. The difference between a forward rate and the current spot rate represents a premium or a discount and is explained in part by interest differentials. In the situation of foreign currency transactions, hedging may be used to offset or protect against risk when undertaking a forward contract.
Hedging against foreign currency exchange risk is designed to manage the risk or uncertainty associated with possible changes in exchange rates. Complications in hedging can occur when a forward contract expires before or after contract date causing a rollover contract, which means the future rate is unfixed. Another complication is when a forward contract amount is different than a transaction amount. If the amount is less than the transaction amount it causes partial hedge, if greater than transaction amount you have a part speculative hedge. Hedge on identifiable foreign currency commitment is used to fix or establish the basis of a FC transaction based on exchange rates at the commitment date versus the transaction date. It involves market prices which have been previously determined at the time of the commitment.
The commitment is a fair value hedge and must meet specific criteria for special accounting treatment. Bibliography: Financial Analysis for Managers Vol. II International Risk Consideration pp. 213. University of Phoenix, 1999 Giddy, I. , Due, G.
The Handbook of International Accounting. The Management of Foreign Exchange Risk, 1992 < web > PanAmSat. Risk Factors, 2003 < web >
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Research essay sample on U S Dollars Exchange Rates
