Globalization.
Meaning:
By the term globalisation we mean opening up of the economy for world market
by attaining international competitiveness. Thus the globalisation of the
economy simply indicates interaction of the country relating to production,
trading and financial transactions with the developed industrialized countries of
the world.
Accordingly, the term globalisation has four parameters:
(a) Permitting free flow of goods by removing or reducing trade barriers between
the countries,
(b) Creating environment for flow of capital between the countries,
(c) Allowing free flow in technology transfer and
(d) Creating environment for free movement of labour between the countries of
the world. Thus taking the entire world as global village, all the four components
are equally important for attaining a smooth path for globalisation.
The concept of Globalisation by integrating nation states within the frame work
of World Trade Organisation (WTO) is an alternative version of the Theory of
Comparative Cost Advantage propagated by the classical economists for
assuming unrestricted flow of goods between the countries for mutual benefit,
especially from Great Britain to other less developed countries or to their
colonies.
In this way, the imperialist nations gained much at the cost of the colonial
countries who had to suffer from the scar of stagnation and poverty. But the
advocates of the policy of globalisation argue that globalisation would help the
underdeveloped and developing countries to improve their competitive strength
and attain higher growth rates. Now it is to be seen how far the developing
countries would gain by adopting the path of globalisation in future.
In the mean time, various countries of the world have adopted the policy of
globalisation. Following the same path India had also adopted the same policy
since 1991 and started the process of dismantling trade barriers along with
abolishing quantitative restrictions (QRs) phase-wise.
Accordingly, the Government of India has been reducing the peak rate of
customs duty in its subsequent budgets and removed QRs on the remaining 715
items in the EXIM Policy 2001-2002. All these have resulted open access to new
markets and new technology for the country.
Advantages of Globalisation:
(i) Globalisation paves the way for redistribution of economic power at the world
level leading to domination by economically powerful nations over the poor
nations.
(ii) Globalisation usually results greater increase in imports than increase in
exports leading to growing trade deficit and balance of payments problem.
(iii) Although globalisation promote the idea that technological change and
increase in productivity would lead to more jobs and higher wages but during the
last few years, such technological changes occurring in some developing
countries have resulted more loss of jobs than they have created leading to fall
in employment growth rates.
(iv) Globalisation has alerted the village and small scale industries and sounded
death-knell to it as they cannot withstand the competition arising from well
organized MNCs.
(v) Globalisation has been showing down the process to poverty reduction in
some developing and underdeveloped countries of the world and thereby
enhances the problem of inequality.
(vi) Globalisation is also posing as a threat to agriculture in developing and
underdeveloped countries of the world. As with the WTO trading provisions,
agricultural commodities market of poor and developing countries will be flooded
farm goods from countries at a rate much lower than that indigenous farm
products leading to a death-blow to many farmers.
(vii) Implementation of globalisation principle becoming harder in many
industrially developed democratic countries to ask its people to bear the pains
and uncertainties of structural adjustment with the hope of getting benefits in
future.
2 In foreign exchange market many types of transactions take place. Discuss the
meaning and role of forward, future and options market.
The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading
of currencies. This includes all aspects of buying, selling and exchanging currencies at current or determined
prices. In terms of volume of trading, it is by far the largest market in the world.[1] The main participants in this
market are the larger international banks. Financial centres around the world function as anchors of trading
between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends.
The foreign exchange market does not determine the relative values of different currencies, but sets the current
market price of the value of one currency as demanded against another.
The foreign exchange market works through financial institutions, and it operates on several levels. Behind the
scenes banks turn to a smaller number of financial firms known as dealers, who are actively involved in large
quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes
market is sometimes called the interbank market, although a few insurance companies and other kinds of
financial firms are involved. Trades between foreign exchange dealers can be very large, involving hundreds of
millions of dollars. Because of the sovereignty issue when involving two currencies, forex has little (if any)
supervisory entity regulating its actions.
The foreign exchange market assists international trade and investments by enabling currency conversion. For
example, it permits a business in the United States to import goods from European Union member states,
especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also
supports direct speculation and evaluation relative to the value of currencies, and the carry trade, speculation
based on the interest rate differential between two currencies.[2]
In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some
quantity of another currency. The modern foreign exchange market began forming during the 1970s after three
decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary
management established the rules for commercial and financial relations among the world's major industrial
states after World War II), when countries gradually switched to floating exchange rates from the
previous exchange rate regime, which remained fixed as per the Bretton Woods system.
The foreign exchange market is unique because of the following characteristics:
its huge trading volume representing the largest asset class in the world leading to high liquidity;
its continuous operation: 24 hours a day except weekends, i.e., trading from 22:00 GMT on Sunday
(Sydney) until 22:00 GMT Friday (New York);
the low margins of relative profit compared with other markets of fixed income; and
the use of leverage to enhance profit and loss margins and with respect to account size.
As such, it has been referred to as the market closest to the ideal of perfect competition,
notwithstanding currency intervention by central banks.
According to the Bank for International Settlements,[3] the preliminary global results from the 2013 Triennial
Central Bank Survey of Foreign Exchange and OTC Derivatives Markets Activity show that trading in foreign
exchange markets averaged $5.3 trillion per day in April 2013. This is up from $4.0 trillion in April 2010 and $3.3
trillion in April 2007.
.
These companies' selling point is usually that they will offer better exchange rates or cheaper payments than
the customer's bank.[70] These companies differ from Money Transfer/Remittance Companies in that they
generally offer higher-value services.
Money transfer/remittance companies and bureaux de change
Money transfer companies/remittance companies perform high-volume low-value transfers generally by
economic migrants back to their home country. In 2007, the Aite Group estimated that there were $369 billion of
remittances (an increase of 8% on the previous year). The four largest markets (India, China, Mexico and
the Philippines) receive $95 billion. The largest and best known provider isWestern Union with 345,000 agents
globally followed by UAE Exchange
Bureaux de change or currency transfer companies provide low value foreign exchange services for travelers.
These are typically located at airports and stations or at tourist locations and allow physical notes to be
exchanged from one currency to another. They access the foreign exchange markets via banks or non bank
foreign exchange companies.
The most popular types of swaps are plain vanilla interest rate swaps. They allow
two parties to exchange fixed and floating cash flows on an interest-bearing
investment or loan.
Businesses or individuals take loans from the markets in which they have an
advantage in order to secure a cost-effective loan. However, their selected
market may not offer their preferred loan or loan structure. For instance, an
investor may get cheaper loan in a floating rate market, but he prefers a fixed
rate. Interest rate swaps enable the investor to switch the cash flows, as desired.
Currency Swaps
Commodity Swaps
Commodity swaps are common among people or companies that use raw
material to produce goods or finished products. Profit from a finished product
may take a hit if the commodity prices vary, as output prices may not
necessarily change in sync with the commodity prices. A commodity swap allows
receipt of payment linked to the commodity price against a fixed rate.
Assume two parties get into a commodity swap over one million barrels of crude
oil. One party agrees to make six-monthly payments at a fixed price of $60 per
barrel and receive the existing (floating) price. The other party will receive the
fixed and pay the floating.
Benefits: The first party has locked in the price of commodity using a currency
swap, achieving a price hedge. Commodity swaps are effective hedging tools
against variations in commodity prices or against variation in spreads between
the final product and the raw material prices.
Another popular type of swap, the credit default swap, offers insurance in case of
default on part of a third-party borrower. Assume Peter bought a 15-year long
bond issued by ABC, Inc. The bond is worth $1,000 and pays annual interest of
$50 (i.e., 5% coupon rate). Peter worries that ABC, Inc. may default, so he gets
into a credit default swap contract with Paul. Under the swap agreement, Peter
(CDS buyer) agrees to pay $15 per year to Paul (CDS seller). Paul trusts ABC, Inc.
and is ready to take the default risk on its behalf. For the $15 receipt per year,
Paul will offer insurance to Peter for his investment and returns. In case ABC, Inc.
defaults, Paul will pay Peter $1,000 plus any remaining interest payments. In
case ABC, Inc. does not default throughout the 15-year long bond duration, Paul
benefits by keeping the $15 per year without any payables to Peter.
Benefits: CDS work as insurance to protect the lenders and bondholders from
borrowers default risk. (Related: Credit Default Swaps: An Introduction)
Zero Coupon Swaps (ZCS)
Similar to the interest rate swap, the zero coupon swap offers flexibility to one of
the parties in the swap transaction. In a fixed-to-floating zero coupon swap, the
fixed rate cash flows are not paid periodically, but only once at the end of the
maturity of the swap contract. The other party paying floating rate keeps paying
regular periodic payments following the standard swap payment schedule.
A fixed-fixed zero coupon swap is also available, wherein one party does not
make any interim payments, but the other party keeps paying fixed payments as
per the schedule.
Benefits: Such zero coupon swaps are primarily used for hedging. ZCS are often
entered into by businesses to hedge a loan in which the interest is to be paid at
maturity, or by banks that issue bonds with end-of-maturity interest payments.
Total Return Swaps (TRS)
A total return swap allows an investor all the benefits of owning a security,
without actually owning it. A TRS is a contract between a total return payer and
total return receiver. The payer usually pays the total return of an agreed
security to the receiver, and receives a fixed/floating rate payment in exchange.
The agreed (or referenced) security can be a bond, index, equity, loan, or
commodity. The total return will include all generated income and capital
appreciation.
4 Explain in detail the types of exposure and measuring economic exposure
In the present era of increasing globalization and heightened currency volatility, changes in exchange rates have
a substantial influence on companies operations and profitability. Exchange rate volatility affects not just
multinationals and large corporations, but small and medium-sized enterprises as well, even those who only
operate in their home country. While understanding and managing exchange rate risk is a subject of obvious
importance to business owners, investors should be familiar with it as well because of the huge impact it can
have on their investments.
Economic or Operating Exposure
Companies are exposed to three types of risk caused by currency volatility:
Transaction exposure This arises from the effect that exchange rate fluctuations have on a companys
obligations to make or receive payments denominated in foreign currency in future. This type of
exposure is short-term to medium-term in nature.
Translation exposure This exposure arises from the effect of currency fluctuations on a companys
consolidated financial statements, particularly when it has foreign subsidiaries. This type of exposure is
medium-term to long-term.
Economic (or operating) exposure This is lesser known than the previous two, but is a significant risk
nevertheless. It is caused by the effect of unexpected currency fluctuations on a companys future cash
flows and market value, and is long-term in nature. The impact can be substantial, as unanticipated
exchange rate changes can greatly affect a companys competitive position, even if it does not operate
or sell overseas. For example, a U.S. furniture manufacturer who only sells locally still has to contend
with imports from Asia and Europe, which may get cheaper and thus more competitive if the dollar
strengthens markedly.
Note that economic exposure deals with unexpected changes in exchange rates - which by definition are
impossible to predict - since a companys management base their budgets and forecasts on certain exchange
rate assumptions, which represents their expected change in currency rates. In addition, while transaction and
translation exposure can be accurately estimated and therefore hedged, economic exposure is difficult to quantify
precisely and as a result is challenging to hedge.
In this example, we have used a 50-50 possibility (of a stronger or weaker euro) for the sake of simplicity.
However, different probabilities can also be used, in which case the calculations would be a weighted average of
these probabilities.
Managing operating exposure
The risks of operating or economic exposure can be alleviated either through operational strategies or currency
risk mitigation strategies.
Operational strategies
Diversifying production facilities and markets for products: Diversification would mitigate the risk
inherent in having production facilities or sales concentrated in one or two markets. However, the
drawback here is that the company may have to forgo economies of scale.
Sourcing flexibility: Having alternative sources for key inputs makes strategic sense, in case exchange
rate moves make inputs too expensive from one region.
Diversifying financing: Having access to capital markets in several major nations gives a company the
flexibility to raise capital in the market with the cheapest cost of funds.
Matching currency flows: This is a simple concept that requires foreign currency inflows and outflows to
be matched. For example, if a U.S. company has significant inflows in euros and is looking to raise debt,
it should consider borrowing in euros.
Currency risk-sharing agreements: This is a contractual arrangement in which the two parties involved in
a sales or purchase contract agree to share the risk arising from exchange rate fluctuations. It involves a
price adjustment clause, such that the base price of the transaction is adjusted if the rate fluctuates
beyond a specified neutral band.
Back-to-back loans: Also known as a credit swap, in this arrangement two companies located in different
countries arrange to borrow each others currency for a defined period, after which the borrowed
amounts are repaid. As each company makes a loan in its home currency and receives equivalent
collateral in a foreign currency, a back-to-back loan appears as both an asset and a liability on their
balance sheets.
Currency swaps: This is a popular strategy that is similar to a back-to-back loan but does not appear on
the balance sheet. In a currency swap, two firms borrow in the markets and currencies where each can
get the best rates, and then swap the proceeds.
If initially the exchange rate is given by $/1.00 and an American subsidiary is worth $500,000, then the UK parent company
will anticipate a balance sheet value of 500,000 for the subsidiary. A depreciation of the US dollar to $/2.00 would result in
only 250,000 being translated.
Unless managers believe that the company's share price will fall as a result of showing a translation exposure loss in the
company's accounts, translation exposure will not normally be hedged. The company's share price, in an efficient market,
should only react to exposure that is likely to have an impact on cash flows.
The forward market is where you can buy and sell a currency, at a fixed future date for a predetermined rate, i.e. the forward
rate of exchange. This effectively fixes the future rate.
Forward contracts can be explored in more detail here.
Money market hedges
The basic idea is to avoid future exchange rate uncertainty by making the exchange at today's spot rate instead. This is
achieved by depositing/borrowing the foreign currency until the actual commercial transaction cash flows occur. This effectively
fixes the future rate.
Money market hedges can be explored in more detail here.
Futures contracts
Futures contracts are standard sized, traded hedging instruments.
The aim of a currency futures contract is to fix an exchange rate at some future date, subject to basis risk.
Currency futures can be explored in more detail here.
Options
A currency option is a right, but not an obligation, to buy or sell a currency at an exercise price on a future date. If there is a
favourable movement in rates the company will allow the option to lapse, to take advantage of the favourable movement. The
right will only be exercised to protect against an adverse movement, i.e. the worst-case scenario.
A call option gives the holder the right to buy the underlying currency.
A put option gives the holder the right to sell the underlying currency.
Options are more expensive than the forward contracts and futures but result in an asymmetric risk exposure.
Currency options can be explored in further detail here.
Forex swaps
In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the
period at an agreed swap rate. The swap rate and amount of currency is agreed between the parties in advance. Thus it is
called a fixed rate/fixed rate swap.
The main objectives of a forex swap are:
To hedge against forex risk, possibly for a longer period than is possible on the forward market.
Access to capital markets, in which it may be impossible to borrow directly.
Forex swaps are especially useful when dealing with countries that have exchange controls and/or volatile exchange rates.
Forex swaps can be explored in further detail here.
Currency swaps
A currency swap allows the two counter parties to swap interest rate commitments on borrowings in different currencies.
In effect a currency swap has two elements:
An exchange of principal in different currencies, which are swapped back at the original spot rate - just like a forex swap.
An exchange of interest rates - the timing of these depends on the individual contract.
The swap of interest rates could be fixed for fixed or fixed for variable.
The method is to calculate the NPV of the project as if it is all-equity financed (so called base
case). Then the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit
is a tax shield resulted from tax deductibility of interest payments. Another benefit can be a
subsidized borrowing at sub-market rates. The APV method is especially effective when
a leveraged buyout case is considered since the company is loaded with an extreme amount of
debt, so the tax shield is substantial.
Technically, an APV valuation model looks similar to a standard DCF model. However, instead
of WACC, cash flows would be discounted at the unlevered cost of equity, and tax shields at either
the cost of debt (Myers) or following later academics also with the unlevered cost of equity.[1] . APV
and the standard DCF approaches should give the identical result if the capital structure remains
stable.
APV formula[edit]
APV = Unlevered NPV of Free Cash Flows and assumed Terminal Value + NPV of Interest Tax
Shield and assumed Terminal Value
The discount rate used in the first part is the return on assets or return on equity if unlevered. The
discount rate used in the second part is the cost of debt financing by period.
In detail:
EBIT
- Taxes on EBIT
Take Present Value (PV) of FCFs discounted by Return on Assets % (also Return on Unlevered
Equity %)
+ PV of terminal value
=Value of Unlevered Firm (i.e., firm value without financing effects or benefit of interest tax shield)
+ Present Value of Debt's Periodic Interest Tax Shield discounted by Cost of Debt Financing %
- Value of Debt