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International Financial Management
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Question 1

Part A

The twin agency problem creates a divide between the headquarters of a multinational corporation (MNC) and its subsidiary operations in other places, which makes it more difficult for the MNC to globalise its operations.

While the parent company might place a higher priority on maximising profits, the subsidiary might give more weight to regional concerns and requirements. This could result in competing aims, making it challenging for the MNE to satisfy the requirements of both parties at the same time.

The following are a few different approaches that can be taken to address the problem of dual agency:

Education that Bridges Cultures: Training for employees to assist them understand and appreciate one other's cultural backgrounds can contribute to the growth of mutual understanding and regard for diverse cultural perspectives (Zhang et al., 2021).

Local Decision-Making Authority: It is possible to make the administration of local problems and demands more manageable by delegating decision-making authority to subsidiary businesses.

Performance Criteria and Evaluation: It is possible to help ensure that all parties are working toward the same objective by establishing clear performance criteria that take into account the requirements of both the headquarters and the subsidiary.

Improved Communication: It is absolutely necessary for the parent company and its subsidiaries to have open and forthright communication. By doing so, it is possible to ensure that all parties are aware of the concerns and concerns of the other side.

Aligned incentives: Incentives that are aligned It is important for the parent company and the subsidiary to have incentives that are aligned with one another.

The parent business might, for example, provide the subsidiary with performance-based bonuses, which are awarded in accordance with the subsidiary's achievements in relation to the goals of the parent firm.

Joint-Decision Making: Participation in shared decision-making processes can help to ensure that a parent company and its subsidiaries are pursuing the same objectives.

The parent company might, for example, choose to involve the subsidiary in significant strategic decisions or might choose to give decision-making authority to the subsidiary, albeit subject to specific constraints.

Independent monitoring: It is one way to help ensure that the interests of the parent company as well as those of the subsidiary companies are considered.

For example, a third party could be hired to monitor the activities of the subsidiary and report their findings back to the main company.

Part B

An Australian company purchases policies from a U.S.-based insurance company- Capital and Financial Account

An Australian company acquires 100% of corporate bonds issued by a U.S. firm-Capital and Financial Account

A Japanese student residing in Australia buys a laptop manufactured in the U.S. from an Australian retailer- Current Account

An Indian company imports milk powder from an Australian firm- Current Account

An Australian investor receives dividends for investments into a Chinese company- Capital and Financial Account

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Question 2

Answer A

The interest rate parity theory is a fundamental concept in international finance that states that the difference in interest rates between two countries should be equal to the expected change in exchange rates.

According to the interest rate parity theory, the expected change in exchange rates should be equal to the expected change in interest rates. This theory has implications for both multinational corporations and individual investors.

The interest rate parity theory allows investors to profit from arbitrage opportunities involving a variety of different currencies. If the expected change in exchange rates is greater than the difference in interest rates, investors can borrow in the lower-interest-rate currency and invest in the higher-interest-rate currency to profit from the difference in interest rates and exchange rates.

If the expected change in exchange rates is less than the interest rate differential, investors must borrow in the currency with the lower interest rate.

This type of arbitrage trading contributes to the preservation of an exchange rate within a predetermined range, as well as the preservation of an interest rate differential between two countries that is relatively close to the anticipated change in exchange rates (Estefania-Flores et al., 2022).

The interest rate parity theory is beneficial to international businesses because it helps to maintain stable exchange rates. This is advantageous in terms of international trade and investment.

The existence of a stable exchange rate allows businesses to predict the future costs of their goods and services more accurately, which can be useful in decision-making.

Furthermore, a stable exchange rate reduces the risk of losses due to exchange rate fluctuations. This is particularly important for businesses that rely heavily on international trade.

In general, interest rate parity theory is a critical concept in international finance. This is because it helps to keep exchange rates stable, which benefits both international investors and businesses operating on a global scale.

Answer B

Nations may decide to embrace dollarization or a currency board structure in order to maintain a steady exchange rate and reduce the risk of unfavourable consequences caused by changes in the value of other currencies.

Dollarization is the process of exchanging a country's currency for the US dollar, whereas a currency board arrangement is the process of pegging a country's currency to a foreign currency, such as the US dollar, at a fixed exchange rate. Dollarization is another term for dollarization.

There is evidence that both of these tactics can be helpful in terms of delivering currency rate stability, as long as the country's economic fundamentals are sound.

Hong Kong and Bulgaria are two examples of countries that have effectively used currency boards in their economies. These countries have been successful in maintaining the status quo of their currency exchange rates, resulting in a rise in foreign investment.

However, if not appropriately managed, these solutions have the potential to pose additional risks. For example, a country may become unduly reliant on a foreign currency, resulting in the country's incapacity to successfully control its own monetary policy.

Furthermore, if the value of the foreign currency to which it is tied falls significantly, the value of the local currency may suffer. The value of the local currency is linked to the value of the foreign currency.

Overall, dollarization and currency board arrangements have the potential to be advantageous in that they can efficiently give stability to a country's exchange rate; yet they can also present hazards if not properly handled.

Before deciding to put such plans into effect, governments must do a thorough examination of the potential disadvantages as well as the potential benefits.

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Question 3

Answer A

Currency risk refers to exchange rate volatility. Variations in these rates may have a negative impact on organisations that are susceptible to exposure, necessitating the distribution or mitigation of these risks.

Currency risk hedging is a strategy that helps investors manage the risks associated with overseas investments by seeking to compensate for fluctuations in currency value. It involves taking positions in a derivative that correspond to the current position.

Using exchange-traded funds for hedging

Purchasing and selling period risk analysis can mitigate currency exposure risk. In an exchange-traded fund, long-term purchases and sales are computed. Buying on a long-term basis serves to stabilise and disperse exchange rates, whereas selling is determined by the convenience of the present rate (gain or loss). This helps to decrease exposure (Alfaro et al., 2021).

In favour of argument

ETF hedging is essential for portfolio exposure management and risk protection. Its supply of inverse returns on currencies against the daily performance of the others provides a risk management method. Investors in portfolios are safeguarded in this case by long-term original assets against short-term depreciation. Returns are inverse to fluctuations in this case, protecting against the loss associated with buying and selling assets.

Contrary argument

ETF hedging can be costly and ineffective in terms of risk management. Risk mitigation necessitates a great deal of experience and understanding. For example, hedging incurs a 1% legal charge, which may cut into profits, particularly in the event of a risk occurrence. Similarly, where the risk of funds mechanics divergence is foregone in currency matching, EFT does not account for all of the hazards involved.

Hedging with futures and forward contracts

Currency forwards arrangements entail two parties agreeing and presetting (fixing) the exchange rates at which they will trade (buy/sell) in the future. The layout also includes a time frame. This hedging encourages trade by providing assurance and guarantee provision.

In favour of argument

Future contract hedging is an important risk management strategy since it encourages trade by assuring predictable profits. Future gains can be secured by locking in exchange rates. Similarly, the costs and losses associated with foreign exchange market evaluation and portfolio modifications can be avoided, improving profits.

Contrary argument

Future contract hedging is a business limiting factor. Mutually locked rates are frequently calculated at a low level to ensure that neither side has an unfair advantage over the other. As a result, this patch foregoes a number of aspects that could have served as leverage. Similarly, fixed rates limit the party's ability to profit from advantageous situations.

Personal viewpoint

Hedging is an important part in ensuring a company's success. As an investor, I would think about hedging as a way to provide certainty. Investors and shareholders are incentivized to invest more when risk is handled since rewards are guaranteed. Massive investment also has a number of advantages, including economies of scale and profit maximisation. As a result, hedging can play an important role in increasing the value of a corporation in order to generate earnings.

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Answer B

The price of the item will be determined in the currency that is used by the business that is selling it. If the company that is buying has a weaker currency than the company that is selling, the company that is buying will have to pay more in its base currency to fulfill the contract price if the currency of the company that is selling is stronger.

In other words, for a number of reasons, multinational companies usually have a lower cost of capital than companies that only do business in their own country. First, because they are bigger, multinational companies can borrow money at lower interest rates.

Capital structure is how much debt and equity a company is willing and able to keep on its balance sheet without being too leveraged (Boudoukh et al., 2019).

The proceeds from a trade will always be denominated in the investor's base currency, regardless of whether or not the trade resulted in a profit or loss for the investor.

Depending on how the currency exchange rate fluctuates, the result of this conversion can be significantly less than anticipated. Hedging methods can help mitigate foreign exchange risk for businesses that are exposed to it and are vulnerable to it.

In most cases, this is accomplished through the use of forward contracts, options, and many other unusual financial products. This can shield the organization from undesirable shifts in the value of the currency exchange market if it is executed correctly.

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Question 4

Nationalist policies and currency controls

As a result of the pandemic's effects, Australia is experiencing a financial crisis and is running out of foreign reserves, just like every other nation. The government will very certainly be compelled to enforce a series of currency controls in order to support the economy.

Due to the restrictions, MNEs with offshore accounts, such as deposit accounts, that must make trade payables or loan repayments may experience financial entrapment. Similarly, epidemic frustrations may culminate in a nationalist response.

Due to the nationalist inclination, the government may consider imposing restrictions on foreign ownership, exports, and imports, which could have an impact on MNEs.

Uncertainty in Politics

It is possible that the government will be unable to address the demands of the people because it is too busy dealing with the aftermath of a pandemic and getting ready for elections.

It is possible that this pressure will result in civil unrest and protests as a means of redressing the political discontent of governments. Inappropriate behaviour in a commercial setting, especially on the part of multinational corporations, includes acts such as looting and damage of property.

Risk-Mitigation Strategies

Protection against political perils

In such uncertain times, multinational corporations demand political risk insurance. If a loss occurs, political insurance will give reimbursement. This risk may involve coverage for government acts, inconvertibility of cash, and contract discontent (Cho et al., 2020).

A Decline in fixed investment

As a result of looting or property destruction, political risks such as civil unrest and demonstrations may have an effect on the fixed capital of multinational corporations. In order to minimize risk, multinational corporations should limit their fixed assets in order to reduce their risk exposure and resultant losses.

Avoid making investments.

Avoidance is the simplest risk management method. Prior to constructing the MNE, it is required to conduct a risk assessment; if the risks are deemed to be significant, investment is foregone.

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Practical Questions

Question 1

Answer A

Purchase price/Spot rate

=40/0.67

=59

Answer B

Spot-Forward/Forward x 360/n x 100%
=0.67/0.66*360/12*100%
=7%

Question 2

1)Current price = price in yen/ exchange rate = 250000000/91.04 = 2746045.69

2) New price = current price *(1+AU inflation%)/(1+yen inflation%)

New price=  2746045.69*(1+2.8%)/(1+2.2%) 

New price=  2762167.29

price 100% pass through=current+increase*passthrough
price 100% pass through= 2746045.69+(2762167.29- 2746045.69)*100%= 2762167.29

3)  price 95% pass through= 2746045.69+(2762167.29- 2746045.69)*95%= 2761361.21

Question 3

Answer A

Put option will provide gain if price go below strike price. Therefore break even price is price which recovers its premium cost.
Break even price = Strike price - Premium
Break even price= 1.2040 - 0.00038 = $1.20362/€

Answer B

When spot rate is $1.2404/€, it is not profitable to sell the stock. Put option is only in the money when the spot price is lower than the strike price. When the spot is equal to strike, the option is at-the-money, when the spot price is greater than the strike price then the option is out-of-the-money.

Answer C

If spot rate is 1.2770/€ then option will exercise and pay off will be price difference i.e.  1.2040 - 1.2770 = $0.073/€
Net profit = Pay off - premium = 0.073 - 0.00038 = $0.07262/€

Answer D

Hedging using put option
Minimum receivable amount under put option = 1000000 * 1.2040 = $1,204,000
Premium cost = 1000000 * 0.00038 = $380
Cost of capital on premium = 380 * 15% * 6/12 = $2850
Therefore, net receipt under put option (Minimum) = 1,204,000 - 380 - 2850 = $1,200,770

Question 4

k_e=k_rf+(k_m-k_rf)β

k_(d ("After Tax)" )=k_d (1-t)

k_d=k_rf+"credit risk premium" 

WACC=(k_e  E/V)+(k_d (1-t)D/V) =35%*8+65%*11 =10%

Amount of transaction 20,00,000
Spot 1.0292
6 month forward 1.0356
Forward contract  
Total received            20,71,200
Money market hedge  
CHF borrowing rate 0.022
US$ investing rate 0.023
Amount to be borrowed            19,56,947
Translated            20,14,090
Total received            20,60,414
Futures-WACC-10 percent  
June futures rate 1.0369
Size of contract 1,20,000
Number of contracts 16
Number of contracts rounded 98
Predicted futures rate - basis 1.0358
Futures receipts         1,26,88,550
Amount unhedged -       1,00,50,000
Hedged at forward rate -       1,00,14,900
Total received            20,73,650
Options  
Exercise price 1.0375
Size of contract 1,25,000
Number of contracts rounded 98
Options  receipts         1,17,09,375
Amount unhedged -       1,00,50,000
Hedged at forward rate -       1,06,14,900
Premium -            1,05,350
Total received            12,19,125
 

References

Alfaro, L., Calani, M. and Varela, L., 2021. Currency hedging: Managing cash flow exposure (No. w28910). National Bureau of Economic Research.

Boudoukh, J., Richardson, M., Thapar, A. and Wang, F., 2019. Optimal currency hedging for international equity portfolios. Financial Analysts Journal, 75(4), pp.65-83.

Cho, J.B., Min, H.G. and McDonald, J.A., 2020. Volatility and dynamic currency hedging. Journal of International Financial Markets, Institutions and Money, 64, p.101163.

Ciorciari, J.D. and Haacke, J., 2019. Hedging in international relations: an introduction. International Relations of the Asia-Pacific, 19(3), pp.367-374.

Estefania-Flores, J., Furceri, D., Hannan, M. S. A., Ostry, M. J. D., & Rose, M. A. K. (2022). A Measurement of Aggregate Trade Restrictions and Their Economic Effects (No. 16919). International Monetary Fund.

Zhang, J., Deng, T., Jiang, H., Chen, H., Qin, S., & Ding, G. (2021). Bi-level dynamic scheduling architecture based on service unit digital twin agents. Journal of Manufacturing Systems, 60, 59-79.

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