Summary International Finance
Lecture 1 Transaction Exposure 3
Chapter 14/8 Management of Transaction Exposure 3
Three Types of Exposure 3
Forward Market Hedge 4
Money Market Hedge 5
Option Market Hedge 6
Hedging Foreign Currency Payables 7
Cross-Hedging Minor Currency Exposure 7
Hedging Contingent Exposure 7
Hedging Recurrent Exposure with Swap Contracts 8
Hedging through Invoice Currency 8
Hedging via Lead and Lag 8
Exposure Netting 8
Should the Firm Hedge? 9
Lecture 2 Management of Economic Exposure 10
Chapter 9/15 Management of Economic Exposure 10
How to Measure Economic Exposure 10
Operating Exposure: Definition 12
Illustration of Operating Exposure 12
Determinants of Operating Exposure 13
Managing Operating Exposure 14
Lecture 3 Management of Translation Exposure 17
Chapter 10/16 Management of Translation Exposure 17
Translation Methods 17
Financial Accounting Standards Broad Statement 8 19
Accounting Standards Board Statement 52 19
International Accounting Standards 20
Lecture 4 Foreign Direct Investment & International Capital Structure and Cost of Capital 22
Chapter 11/17 Foreign Direct Investment and Cross-Border Acquisitions 22
Global Trends in FDI 22
Why Do Firms Invest Overseas? 22
Cross-Border Mergers and Acquisitions 24
Political Risk and FDI 25
Chapter 18 International Capital Structure and the Cost of Capital 27
Cost of Capital 27
Cost of Capital in Segmented versus Integrated Markets 28
Does the Cost of Capital Differ among Countries? 29
Cross-Border Listing of Stocks 29
The Effect of Foreign Equity Ownership Restrictions 30
The Financial Structure of Subsidiaries 31
Beau Maria Ruiter, University of Twente, International Business Administration, M7 FENSI (2020/2021) 1
,Lecture 5 Adjusted Present Value Model; Capital Budgeting form the Parent Firm’s perspective; risk adjustments &
Purchase Power Parity Assumption 33
Chapter 19/18 International Capital Budgeting 33
Review of Domestic Capital Budgeting 33
The Adjusted Present Value Model 34
Capital Budgeting from the Parent’s Firm Perspective 36
Risk Adjustment in the Capital Budgeting Analysis 38
Sensitivity Analysis 38
Purchasing Power Parity Assumption 39
Real Options 39
Lecture 6? 41
Chapter 20 Multinational Cash Management 41
The Management of International Cash Balances 41
More in Dept: Reduction in Precautionary Cash Balances 42
Cash Management Systems in Practice 42
Beau Maria Ruiter, University of Twente, International Business Administration, M7 FENSI (2020/2021) 2
,Lecture 1 Transaction Exposure
Chapter 14/8 Management of Transaction Exposure
Chapter 14/8 Management of Transaction Exposure
Three Types of Exposure
- Three types of foreign currency exposures
● Transaction exposure: the sensitivity of “realized” domestic currency values of the firm’s contractual
cash flows denominated in foreign currencies to unexpected exchange rate changes
(potential change in the value of financial position due to changes in the exchange rate)
➔ Occurs when the firm has foreign-currency-dominated receivables or payables and their
settlements are likely to affect the firm’s cash flow position
➔ Settlement of these contractual cash flows affect the firm’s domestic currency cash flows →
transaction exposure is sometimes regarded as a short-term economic exposure
➔ Arises from fixed-price contracting in a world where exchange rates are changing randomly
➔ The magnitude of transaction exposure is the amount of foreign currency that is receivable or
payable
● Economic exposure: the extent to which the value of the firm would be affected by unanticipated
changes in exchange rates
(potential change in the value of the firm due to change in exchange rate)
➔ Any anticipated changes in exchange rates would have been already discounted and reflected
in the firm’s value
➔ Changes in the exchange rates can have a profound effect on the firm’s competitive position
in the world market and thus on its cash flows and market value
● Translation exposure: the potential that the firm’s consolidated financial statements can be affected
by changes in exchange rates
(potential change in the consolidated balance sheet due to exchange rate fluctuations)
➔ Consolidation involves translation of subsidiaries’ financial statements from local currencies
to the home currency
➔ Resultant translation gains and losses represent the accounting system’s attempt to measure
economic exposure ex post
- The firm is subject to transaction exposure when it faces contractual cash flows that are fixed in foreign
currencies
- If the firm does nothing about the exposure, it is effectively speculating on the future course of the exchange
rate
- Whenever the firm has foreign-currency-denominated receivables or payables, it is subject to transaction
exposure, and their settlements are likely to affect the firm’s cash flow position
- In view of the fact that firms are now more frequently entering into commercial and financial contracts
denominated in foreign currencies, judicious (= oordeelkundig) management of transactions exposure has
become an important function of international financial management
- Transaction exposure is well-defined: the magnitude of transaction exposure is the same as the amount of
foreign currency that is receivable or payable
- Chapter will focus on alternative ways of hedging transaction exposure using various financial contract and
operational techniques
● Financial contracts
➔ Forward market hedge
➔ Money market hedge
➔ Option market hedge
➔ Swap market hedge
Beau Maria Ruiter, University of Twente, International Business Administration, M7 FENSI (2020/2021) 3
, ● Operational techniques
➔ Choice of the invoice currency
➔ Lead/lag strategy
➔ Exposure netting
Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk
of any adverse price movements. Put another way, investors hedge one investment by making a trade in another. ... A
reduction in risk, therefore, always means a reduction in potential profits.
When people decide to hedge, they are insuring themselves against a negative event's impact on their finances. This
doesn't prevent all negative events from happening. However, if a negative event does happen and you're properly
hedged, the impact of the event is reduced.
Spot exchange rate: the current price level in the market to directly exchange one currency for another, for delivery
on the earliest possible value date
Forward exchange rate: the exchange rate at which a bank agrees to exchange one currency for another at a future
date when it enters into a forward contract with an investor
Forward Market Hedge
- The most direct and popular way of hedging
transaction exposure is by currency forward
contracts
- The firms may sell (buy) its foreign currency
receivables (payables) forward to eliminate its
exchange risk exposure
- The dollar proceeds under the forward hedge
will be higher than those under the unhedged
position if the future spot exchange rate turns
out to be less than the forward rate, and the
opposite would hold if the future spot rate
becomes higher than the forwarded rate
- The gain will be positive as long as the forward
exchange rate (F) is greater than the spot rate
on the maturity date (𝑆𝑇), that is, 𝐹 > 𝑆𝑇, , and the gain will be negative if the opposite holds
- The firm must decide whether to hedge or not ex ante (= before the event) → to help firm decide, it is useful to
consider the following three alternative scenarios
1. 𝑆𝑇 ≈ 𝐹
● The firm’s expected future spot exchange rate is about the same as the forward rate, the
expected gains or losses are approximately zero
● But forward hedging eliminates exchange exposure → firm can eliminate foreign exchange
exposure without sacrificing any expected dollar proceeds from the foreign sale
● Under this scenario the firm would be inclined to hedge as long as it is averse to risk
● This scenario becomes valid when the forward exchange rate is an unbiased predictor of the
future spot rate
2. 𝑆𝑇 < 𝐹
● The firm’s expected future spot exchange rate is less than the forward rate, the firm expects a
positive gain from forward hedging
● Since the firm expects to increase the dollar proceeds while eliminating exchange exposure, it
would be even more inclined to hedge under this scenario than under the first scenario
Beau Maria Ruiter, University of Twente, International Business Administration, M7 FENSI (2020/2021) 4
Lecture 1 Transaction Exposure 3
Chapter 14/8 Management of Transaction Exposure 3
Three Types of Exposure 3
Forward Market Hedge 4
Money Market Hedge 5
Option Market Hedge 6
Hedging Foreign Currency Payables 7
Cross-Hedging Minor Currency Exposure 7
Hedging Contingent Exposure 7
Hedging Recurrent Exposure with Swap Contracts 8
Hedging through Invoice Currency 8
Hedging via Lead and Lag 8
Exposure Netting 8
Should the Firm Hedge? 9
Lecture 2 Management of Economic Exposure 10
Chapter 9/15 Management of Economic Exposure 10
How to Measure Economic Exposure 10
Operating Exposure: Definition 12
Illustration of Operating Exposure 12
Determinants of Operating Exposure 13
Managing Operating Exposure 14
Lecture 3 Management of Translation Exposure 17
Chapter 10/16 Management of Translation Exposure 17
Translation Methods 17
Financial Accounting Standards Broad Statement 8 19
Accounting Standards Board Statement 52 19
International Accounting Standards 20
Lecture 4 Foreign Direct Investment & International Capital Structure and Cost of Capital 22
Chapter 11/17 Foreign Direct Investment and Cross-Border Acquisitions 22
Global Trends in FDI 22
Why Do Firms Invest Overseas? 22
Cross-Border Mergers and Acquisitions 24
Political Risk and FDI 25
Chapter 18 International Capital Structure and the Cost of Capital 27
Cost of Capital 27
Cost of Capital in Segmented versus Integrated Markets 28
Does the Cost of Capital Differ among Countries? 29
Cross-Border Listing of Stocks 29
The Effect of Foreign Equity Ownership Restrictions 30
The Financial Structure of Subsidiaries 31
Beau Maria Ruiter, University of Twente, International Business Administration, M7 FENSI (2020/2021) 1
,Lecture 5 Adjusted Present Value Model; Capital Budgeting form the Parent Firm’s perspective; risk adjustments &
Purchase Power Parity Assumption 33
Chapter 19/18 International Capital Budgeting 33
Review of Domestic Capital Budgeting 33
The Adjusted Present Value Model 34
Capital Budgeting from the Parent’s Firm Perspective 36
Risk Adjustment in the Capital Budgeting Analysis 38
Sensitivity Analysis 38
Purchasing Power Parity Assumption 39
Real Options 39
Lecture 6? 41
Chapter 20 Multinational Cash Management 41
The Management of International Cash Balances 41
More in Dept: Reduction in Precautionary Cash Balances 42
Cash Management Systems in Practice 42
Beau Maria Ruiter, University of Twente, International Business Administration, M7 FENSI (2020/2021) 2
,Lecture 1 Transaction Exposure
Chapter 14/8 Management of Transaction Exposure
Chapter 14/8 Management of Transaction Exposure
Three Types of Exposure
- Three types of foreign currency exposures
● Transaction exposure: the sensitivity of “realized” domestic currency values of the firm’s contractual
cash flows denominated in foreign currencies to unexpected exchange rate changes
(potential change in the value of financial position due to changes in the exchange rate)
➔ Occurs when the firm has foreign-currency-dominated receivables or payables and their
settlements are likely to affect the firm’s cash flow position
➔ Settlement of these contractual cash flows affect the firm’s domestic currency cash flows →
transaction exposure is sometimes regarded as a short-term economic exposure
➔ Arises from fixed-price contracting in a world where exchange rates are changing randomly
➔ The magnitude of transaction exposure is the amount of foreign currency that is receivable or
payable
● Economic exposure: the extent to which the value of the firm would be affected by unanticipated
changes in exchange rates
(potential change in the value of the firm due to change in exchange rate)
➔ Any anticipated changes in exchange rates would have been already discounted and reflected
in the firm’s value
➔ Changes in the exchange rates can have a profound effect on the firm’s competitive position
in the world market and thus on its cash flows and market value
● Translation exposure: the potential that the firm’s consolidated financial statements can be affected
by changes in exchange rates
(potential change in the consolidated balance sheet due to exchange rate fluctuations)
➔ Consolidation involves translation of subsidiaries’ financial statements from local currencies
to the home currency
➔ Resultant translation gains and losses represent the accounting system’s attempt to measure
economic exposure ex post
- The firm is subject to transaction exposure when it faces contractual cash flows that are fixed in foreign
currencies
- If the firm does nothing about the exposure, it is effectively speculating on the future course of the exchange
rate
- Whenever the firm has foreign-currency-denominated receivables or payables, it is subject to transaction
exposure, and their settlements are likely to affect the firm’s cash flow position
- In view of the fact that firms are now more frequently entering into commercial and financial contracts
denominated in foreign currencies, judicious (= oordeelkundig) management of transactions exposure has
become an important function of international financial management
- Transaction exposure is well-defined: the magnitude of transaction exposure is the same as the amount of
foreign currency that is receivable or payable
- Chapter will focus on alternative ways of hedging transaction exposure using various financial contract and
operational techniques
● Financial contracts
➔ Forward market hedge
➔ Money market hedge
➔ Option market hedge
➔ Swap market hedge
Beau Maria Ruiter, University of Twente, International Business Administration, M7 FENSI (2020/2021) 3
, ● Operational techniques
➔ Choice of the invoice currency
➔ Lead/lag strategy
➔ Exposure netting
Hedging against investment risk means strategically using financial instruments or market strategies to offset the risk
of any adverse price movements. Put another way, investors hedge one investment by making a trade in another. ... A
reduction in risk, therefore, always means a reduction in potential profits.
When people decide to hedge, they are insuring themselves against a negative event's impact on their finances. This
doesn't prevent all negative events from happening. However, if a negative event does happen and you're properly
hedged, the impact of the event is reduced.
Spot exchange rate: the current price level in the market to directly exchange one currency for another, for delivery
on the earliest possible value date
Forward exchange rate: the exchange rate at which a bank agrees to exchange one currency for another at a future
date when it enters into a forward contract with an investor
Forward Market Hedge
- The most direct and popular way of hedging
transaction exposure is by currency forward
contracts
- The firms may sell (buy) its foreign currency
receivables (payables) forward to eliminate its
exchange risk exposure
- The dollar proceeds under the forward hedge
will be higher than those under the unhedged
position if the future spot exchange rate turns
out to be less than the forward rate, and the
opposite would hold if the future spot rate
becomes higher than the forwarded rate
- The gain will be positive as long as the forward
exchange rate (F) is greater than the spot rate
on the maturity date (𝑆𝑇), that is, 𝐹 > 𝑆𝑇, , and the gain will be negative if the opposite holds
- The firm must decide whether to hedge or not ex ante (= before the event) → to help firm decide, it is useful to
consider the following three alternative scenarios
1. 𝑆𝑇 ≈ 𝐹
● The firm’s expected future spot exchange rate is about the same as the forward rate, the
expected gains or losses are approximately zero
● But forward hedging eliminates exchange exposure → firm can eliminate foreign exchange
exposure without sacrificing any expected dollar proceeds from the foreign sale
● Under this scenario the firm would be inclined to hedge as long as it is averse to risk
● This scenario becomes valid when the forward exchange rate is an unbiased predictor of the
future spot rate
2. 𝑆𝑇 < 𝐹
● The firm’s expected future spot exchange rate is less than the forward rate, the firm expects a
positive gain from forward hedging
● Since the firm expects to increase the dollar proceeds while eliminating exchange exposure, it
would be even more inclined to hedge under this scenario than under the first scenario
Beau Maria Ruiter, University of Twente, International Business Administration, M7 FENSI (2020/2021) 4
