U6-ch15 - only what is important are in the notes PDF

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UNIT 6 CHAPTER15 CONSOLIDATION The process of translating SUBSIDIARY results and aggregating them into 1 financial report CURRENT RATE METHOD An approach in foreign currency translation in which assets and liabilities are valued at current spot rates TEMPORAL METHOD An approach in foreign currency t...

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UNIT 6 – CHAPTER15

CONSOLIDATION The process of translating SUBSIDIARY results and aggregating them into  1 financial report

CURRENT RATE METHOD An approach in foreign currency translation in which assets and liabilities are valued at current spot rates

TEMPORAL METHOD An approach in foreign currency translation in which monetary accounts are valued at the spot rate and accounts carried at historical cost are  translated @ their historic exchange rates FUNCTIONAL CURRENCY The PRIMARY currency of a business

OFF-SHORE FINANCIAL CENTERS are locations that specialize in facing nonresidents, w/  low taxes and  few banking regulations

FRONTING LOAN A loan made through an intermediary,

usually a bank, from parent company to subsidiary TRANSFER PRICING Pricing that is established for transactions between members of the enterprise

AMERICAN DEPOSITORY RECEIPTS (ADRS) Foreign shares held by a custodian, usually a U.S. bank, in the issuer's home market and traded in dollars on the U.S. exchange

HEDGE To hold assets (to take a position) in one market in order to offset exposure to price changes in an OPPOSITE POSITION MULTILATERAL NETTING Strategy in which subsidiaries transfer net intracompany cash flows through a centralized clearing center reduces transactions costs reduces FX costs allows firm to benefit from investment of idle funds (opportunity costs)

LEADING AND LAGGING Timing payments  early (lead) or

 late (lag), depending on anticipated currency movements, so that they have the most favorable impact for the company

LEAD APPROACH: collect receivables EARLY when the foreign currency is expected to weaken and fund payables EARLY when the foreign currency is expected to strengthen

LAG APPROACH: collect receivables LATE when the currency is expected to strengthen and fund payables late when the currency is expected to weaken

RISK: When an International Company operates in different currencies, there is a risk that foreign exchange movements may affect the Company adversely

FOREIGN EXCHANGE EXPOSURE: 1.Transaction exposure 2.Translation exposure

3.Economic exposure

TRANSACTION EXPOSURE  Occurs when the firm has transactions denominated in a foreign currency and the exchange rate changes between  the time the commitment is made and the  time it is payable  E.g. Suppose you bought equipment from Belgium and you have to pay €1 million in 90 days  If the spot rate is €1/ZAR15, what will happen if the forward rate is €1/ZAR18?

6 WAYS TO HEDGE AGAINST TRANSACTION EXPOSURE forex risk management techniques / forex exposure hedging technique

Change in the value of a financial position created by foreign currency changes between  the establishment and  the settlement of a contract

1. By leading or lagging Leading payment when foreign currency expected to appreciate, and vice versa

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Timing payments early (lead) or late (lag), depending on anticipated currency movements

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DEPRICIATE • Leading receivables • lagging payables when foreign currency is expected to depreciate 

APPRECIATE • Lagging receivables • leading payables when the foreign currency is expected to appreciate

 E.g. lead payables because the € is expected to appreciate / ZAR will depreciate

2. Exposure netting To be exposed to currencies that move in opposite directions  Running a centralized clearing account • that matches and • nets out foreign exchange exposures

across currencies or across currency families  In other words, to be exposed to currencies that move in opposite directions • E.g. you would enter into transactions where the foreign currency is expected to depreciate (against the € which is appreciating)

3.Forward market hedge Foreign currency contract sold or bought forward to protect against foreign currency movement – locking the exchange rate (buy Euros now at a more favourable exchange rate) 

Foreign currency contract sold or bought forward (from a bank or other financial institution) to protect against foreign currency movement – locking the exchange rate  e.g. You buy a forward contract to receive €1 mln in exchange for ZAR15 mln in 90 days’ time – you have worked out a way to exchange €1 mln at the spot rate of €1/ZAR15

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But you need to honour the forward contract; the exchange of currencies needs to happen

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Fees are applicable

4. CURRENCY OPTION HEDGE 

An option to buy or sell a specific amount of foreign currency @ a specific time in order to protect against foreign currency RISK

Call option when foreign currency expected to appreciate 

An option to  buy (“call option”) or  sell (“put option”) a specific amount of foreign currency at a specific time in order to protect against foreign currency risk 

Call option when you owe in foreign currency

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Put option when you will receive foreign currency  E.g. buy a call option to buy €1 mln in exchange for ZAR15 mln in 90 days’ time

 N.B.!!! You have an option: you can refrain from exercising the option should the foreign currency fluctuate in the OPPOSITE DIRECTION

 E.g. the forward rate turns out to be €1/ZAR13, so you’d rather not exercise the option and pay €1 mln in exchange for ZAR13 mln 

Fees are applicable

5. MONEY MARKET HEDGE A method to hedge foreign currency exposure by  BORROWING AND  LENDING in the

fluctuate in opposite direction  an irregular rising and falling in number or amount; a variation.

 domestic money market  foreign money markets another way of = locking the exchange rate,  but w/out forward market hedge fee  Borrowing and lending in the domestic and foreign money markets so as to match the amount of the sale with a liability/investment in the same currency – locking the exchange rate e.g. (assuming no interest rates):  [Borrow ZAR15 mln from a bank]  Exchange ZAR15 mln for €1 mln  Invest €1 mln with a bank  At the time you need to pay the European supplier, withdraw the €1 mln investment and make the payment  [Repay the ZAR15 mln loan from your reserves] o

N.B.!!! This changes according to whether you have

 receivable  payables o

No fees, but in reality  interest rate on the loan could be higher than the interest rate on the investment… more convenient?

6. Swap contract An agreement to exchange currencies at  specified rates and  on a specified date or  sequence of dates

 with a partner (bank, another multinational or an institutional investor) 

E.g. you find a SA exporter (“partner”) who, in 90 days, will receive €1 mln and who would like ZAR15 mln in exchange – you agree to exchange the two amounts: you will swap ZAR15 mln for €1 mln

TRANSLATION EXPOSURE Potential change in the value of a company’s financial position due to exposure created during the consolidation process  Potential change in the value of a company’s financial position o due to exposure created during the consolidation process  When foreign subsidiaries draw financial reports in a foreign currency BUT  financial reports are then consolidated in the parent company’s currency o Any exchange rate movement will affect the value of the consolidated results o Typically, not hedged because:  Translation gains and losses do not represent cash flows 

Hedging against translation exposure entails a foreign exchange transaction (e.g. taking a loan denominated in foreign currency), hence creating transaction exposure

ECONOMIC EXPOSURE 

The potential for the value of future cash flows to be affected by unanticipated exchange rate movements

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More firm-wide and long term

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E.g. the impact on exports of exchange rate fluctuations  The potential for the value of future cash flows to be affected by unanticipated exchange rate movements  More firm-wide and long term  More operational  More difficult to hedge, but it can be done using the same forex exposure hedging techniques seen before

TAXATION INVERSION acquisition of foreign company in order to move legal HQ to reduce taxes

VALUE ADDED TAX (VAT) is an indirect tax, in that the tax authority collects it from  the person or firm that adds value during the production and marketing process, NOT from the owner of the item taxed. The ultimate user of the product pays the full amount of tax, which is rebated to the others in the value chain.

INCOME TAX Direct tax levied on earnings

VALUE-ADDED TAX (VAT) Indirect tax collected from the parties as they add value to the product

BRANCH  

Legal extension of the parent company In this case, the parent company can deduct the losses of the branch from its taxable income

SUBSIDIARY 

Separate legal entity owned by the parent company

 MINORITY STAKE: income is taxed only when it is remitted to the parent company  MAJORITY (>50%) STAKE: active income is taxed when remitted to the parent company, but its passive income (royalties, licensing fees, dividends, service fees) is taxed as it occurs

INTERNATIONAL FINANCIAL MANAGEMENT: CAPITAL STRUCTURE The accounting terms for these functions are  disclosure practices and  accounting measurement. Gray's study, summarized in Figure classifies countries on two dimensions,

1. secrecy–transparency and 2. optimism–conservatism.

Cultural Differences in Measurement and Disclosure for Accounting Systems

The dimension of Secrecy–Transparency  measures the degree to which companies disclose information to the public. Germany, Japan, and Switzerland are countries that tend to value secrecy/privacy over transparency. In the United Kingdom and the United States, there is  more disclosure and less privacy.

The dimension of Optimism–Conservatism  Gray's second dimension o measures the degree to which a company is cautious in its  valuing of assets and  measuring of income. CONSERVATISM

Accounting reports in countries with conservative asset-valuing approaches  tend to understate assets and income while OPTIMISM those in countries whose asset-valuing approach is more optimistic  tend toward overstatement. In France, Germany, and Japan, we find a  conservative approach to asset-valuing. In these countries, public companies' capital structure tends to depend more on debt than on equity, w/ banks being a major source of that debt. Banks are concerned with liquidity.  A conservative statement of profits may reduce tax exposure and dividend payouts, contributing to cash reserves that can be tapped for debt service.  On the optimism measure, in the United States and in a more restrained way in the United Kingdom, companies want to show impressive earnings  that will attract investors and  raise the share value = sooner rather than later.

Firms raise capital from two sources  Internal sources, retained earnings  External sources, equity or debt

 Increasing use of foreign stock markets (equity) o Firms issue stock on foreign exchanges directly o Control by foreigners is a concern, especially in sensitive industries

 Increasing use of foreign debt markets o Trend is to tap local markets first o Offshore financial centres (Hong Kong, Switzerland, the Cayman Islands, and the Bahamas) may also be a source of capital 

Offshore financial centres are locations that specialise in financing nonresidents, with low taxes and few banking regulations...