International financial management

International Financial Management MBA Second Year (Financial Management) School of Distance Education Bharathiar University, Coimbatore - 641 046 Author: Madhu Vij Copyright © 2008, Bharathiar University All Rights Reserved Produced and Printed by EXCEL BOOKS PRIVATE LIMITED A-45, Naraina, Phase-I, New Delhi-110028 for SCHOOL OF DISTANCE EDUCATION Bharathiar University Coimbatore-641046 CONTENTS Page No UNIT I Lesson IFM – Nature and Scope Lesson Balance of Payments 22 UNIT II Lesson International Monetary System 45 Lesson Purchasing Power Parity 71 UNIT III Lesson Foreign Exchange Market 83 Lesson Arbitrage and Speculation in Foreign 94 UNIT IV Lesson Foreign Exchange Exposure 117 Lesson Techniques for Covering the Foreign Exchange Risk 161 UNIT V Lesson International Financial Market Instruments 175 Lesson 10 Foreign Bond and Euro Bond 206 Model Question Paper 227 INTERNATIONAL FINANCIAL MANAGEMENT SYLLABUS UNIT I IFM- Nature and Scope, IFM and Domestic financial management- Balance of paymentssignificance- preparation of BOP statement - Link between BOP and the economy UNIT II International Monetary System - Gold standard - IMF and World Bank Exchange Rate mechanism - factors influencing exchange rate - Purchasing power parity and Interest Rate parity theorems UNIT III Foreign Exchange Market - Transactions - Spot, Forward, Futures, Options and SwapsArbitrage and speculation in Foreign exchange market.- Exchange arithmetic, Spread, premium and Discount UNIT IV Foreign Exchange Exposure - managing transaction, translation and operating ExposureTechniques for covering the foreign exchange risk - Internal and external techniques of risk UNIT V International financial market instruments - International Equities - ADR and GDR Foreign Bond and euro-bond- Short-term and medium term instruments UNIT I LESSON IFM – NATURE AND SCOPE CONTENTS 1.0 Aims and Objectives 1.1 Introduction 1.2 Nature and Scope of International Finance 1.2.1 Global Links 1.2.2 Objective of the MNCs 1.2.3 Agency Problem 1.2.4 Distinguishing Features of International Finance 1.3 IFM and Domestic Financial Management 1.3.1 Foreign Direct Investment 1.3.2 Portfolio Investment 1.3.3 Other Non-debt Flows 1.3.4 Changes in the BOP System of Recording 1.3.5 International Business Methods 1.3.6 Field of International Business 1.3.7 Motivations for International Business 1.4 Let us Sum up 1.5 Lesson End Activity 1.6 Keywords 1.7 Questions for Discussion 1.8 Suggested Readings 1.0 AIMS AND OBJECTIVES After studying this lesson, you will be able to: l Understand the meanings and definitions of International Financial Management l Have a knowledge of the Nature and Scope of International Financial Management l Distinguish between the International Financial Management and Domestic Financial Management International Financial Management 1.1 INTRODUCTION In this lesson on International Financial Management, we first discuss the objective of an MNC and then identify the distinguishing features of International Finance that set it apart from other fields of study The lesson then identifies the major factors that motivate firms to pursue international business and also discusses the methods by which firms conduct International Business The lesson concludes with a discussion of a few solved problems in the area of International Finance 1.2 NATURE AND SCOPE OF 1.2 INTERNATIONAL FINANCE A Multinational Corporation (MNC) is a company involved in producing and selling goods and services in more than one country It usually consists of a parent company located in its home country with numerous foreign subsidiaries As business expands, the awareness of opportunities in foreign markets also increases This, ultimately, evolves into some of them becoming MNCs so that they can enjoy the benefits of international business opportunities A knowledge of International Finance is crucial for MNCs in two important ways First, it helps the companies and financial managers to decide how international events will affect the firm and what steps can be taken to gain from positive developments and insulate from harmful ones Second, it helps the companies to recognise how the firm will be affected by movements in exchange rates, interest rates, inflation rates and asset values The consequences of events affecting the stock markets and interest rates of one country immediately show up around the world This is due to the integrated and interdependent financial environment which exists around the world Also, their have been close links between money and capital markets All this makes it necessary for every MNC and aspiring manager to take a close look at the ever changing and dynamic field of International Finance 1.2.1 Global Links Globalisation increases the ability of firms to business across national boundaries The barriers to crossing those boundaries are coming down gradually What once took days now takes hours and what once took hours now takes minutes, or even seconds All this is opening new opportunities for everyone everywhere; but Globalisation is not really risk-free Globalisation is a phenomenon that no development agenda can afford to ignore National governments generally face frustrations in dealing with Globalisation and these frustrations are magnified for small developing countries But such countries stand to gain more from international trade and finance than their large counterparts since they face tighter resource and market size constraints Foreign trade has grown more quickly than the world economy in recent years, a trend that is likely to continue For developing countries, trade is the primary vehicle for realising the benefits of Globalisation Figure 1.1 shows that trade is growing much faster than national income in developing countries The past half century has brought unprecedented prosperity and better living standards to most parts of the world World GNP has risen from $1.3 trillion in 1960 to $29 trillion in 1997 Between 1987 and 1997, world trade has nearly doubled and the ratio of trade to GDP in purchasing power parity dollars has risen from 20.6 to 29.6 per cent Trade in services has grown even faster, aided by the revolution in telecommunications and computers 1.2.2 Objective of the MNCs An objective is necessary so that all decisions of the organisation contribute towards the fulfillment of this purpose The usually accepted objective of an MNC is to maximise shareholders wealth This is the objective which a domestic firm also accepts and tries to fulfil Trade (Percentage of GDP) 50 45 Industrial countries 40 35 Developing countries 30 25 20 1981 1983 1985 1987 1989 1991 1993 1995 1997 Source: World Bank, World Development Indicators, 1999 Note: Trade is the sum of exports and imports of goods and services Figure 1.1: Trade is growing much faster than national income in developing countries In the context of a MNC, the objective of maximising shareholders’ wealth must be analysed in a much wider context, with a much wider range of opportunities, taking into account the worldwide market share This makes the MNCs task much more complex than that of the domestic firms If the managers of MNCs are to achieve their objective of maximising the value of their firms or the rate of return from foreign operations, they have to understand the environment in which they function The environment consists of: The international financial system consists of two segments: the official part represented by the accepted code of behaviour by governments comprising the International Monetary System and the private part which consists of international banks and other multinational financial institutions that participate in the international money and capital markets The foreign exchange market consists of international banking, foreign exchange dealers and 24 hour trading at organised exchanges around the world where currency future options and derivatives are regularly traded The host country’s environment consists of such aspects as the political and socioeconomic systems and people’s cultural values and aspirations Understanding of the host country’s environment is crucial for successful operation and assessment of the political risk IFM – Nature and Scope 10 International Financial Management Further, the manager of a MNC must take into account the fact that the presence of his firm in a number of countries presents challenges as well as opportunities The basic challenges are the multiplicity of currency and the associated unique risks a manager of a MNC has to face Another important challenge is the multiplicity and complexity of the taxation system which has an impact on the MNC’s operations and profitability But the manager can use the taxation tool to reduce the firm’s overall tax burden through transfer of funds from high to low tax affiliates and by using tax havens In addition, due to the multiplicity of sources of funds, the finance manager has to worry about the foreign exchange and political risk in positioning funds and in modifying cash resources The MNC can reduce its cost of capital and, at the same time, maximise the return on its excess cash resources by taking advantage of the fact that financial resources have been raised from different capital markets Thus, a well diversified MNC can actually reduce risks and fluctuations in earnings and cash flows by making the diversity in geography and currency work in its favour A successful manager of an MNC will take into account the various challenges of operating his firm in a number of countries so that he can make the diversity and complexity of the environment work for the total benefit of the firm 1.2.3 Agency Problem Financial executives in multinational corporations many times have to make decisions that conflict with the objective of maximising shareholders wealth It has been observed that as foreign operations of a firm expand and diversify, managers of these foreign operations become more concerned with their respective subsidiary and are tempted to make decisions that maximise the value of their respective subsidiaries These managers tend to operate independently of the MNC parent and view their subsidiary as single, separate units The decisions that these managers take will not necessarily coincide with the overall objectives of the parent MNC There is less concern, here, for how the entity can contribute to the overall value of the parent MNC Thus when a conflict of goals occurs between the managers and shareholders, it is referred to as the 'Agency Problem' MNCs use various strategies to prevent this conflict from occurring One simple solution here is to reward the financial managers according to their contribution to the MNC as a whole on a regular basis Still another alternative may be to fire managers who not take into account the goal of the parent company or probably give them less compensation/ rewards The ultimate aim here is to motivate the financial managers to maximize the value of the overall MNC rather than the value of their respective subsidiaries 1.2.4 Distinguishing Features of International Finance International Finance is a distinct field of study and certain features set it apart from other fields The important distinguishing features of international finance are discussed below: Foreign exchange risk: An understanding of foreign exchange risk is essential for managers and investors in the modern day environment of unforeseen changes in foreign exchange rates In a domestic economy this risk is generally ignored because a single national currency serves as the main medium of exchange within a country When different national currencies are exchanged for each other, there is a definite risk of volatility in foreign exchange rates The present International Monetary System set up is characterised by a mix of floating and managed exchange rate policies adopted by each nation keeping in view its interests In fact, this variability of exchange rates is widely regarded as the most serious international financial problem facing corporate managers and policy-makers At present, the exchange rates among some major currencies such as the US dollar, British pound, Japanese yen and the euro fluctuate in a totally unpredictable manner Exchange rates have fluctuated since the 1970s after the fixed exchange rates were abandoned Exchange rate variation affect the profitability of firms and all firms must understand foreign exchange risks in order to anticipate increased competition from imports or to value increased opportunities for exports Political risk: Another risk that firms may encounter in international finance is political risk Political risk ranges from the risk of loss (or gain) from unforeseen government actions or other events of a political character such as acts of terrorism to outright expropriation of assets held by foreigners MNCs must assess the political risk not only in countries where it is currently doing business but also where it expects to establish subsidiaries The extreme form of political risk is when the sovereign country changes the “rules of the game” and the affected parties have no alternatives open to them For example, in 1992, Enron Development Corporation, a subsidiary of a Houston based energy company, signed a contract to build India’s longest power plant Unfortunately, the project got cancelled in 1995 by the politicians in Maharashtra who argued that India did not require the power plant The company had spent nearly $300 million on the project The Enron episode highlights the problems involved in enforcing contracts in foreign countries Thus, political risk associated with international operations is generally greater than that associated with domestic operations and is generally more complicated Expanded opportunity sets: When firms go global, they also tend to benefit from expanded opportunities which are available now They can raise funds in capital markets where cost of capital is the lowest In addition, firms can also gain from greater economies of scale when they operate on a global basis Market imperfections: The final feature of international finance that distinguishes it from domestic finance is that world markets today are highly imperfect There are profound differences among nations’ laws, tax systems, business practices and general cultural environments Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolio Though there are risks and costs in coping with these market imperfections, they also offer managers of international firms abundant opportunities Thus, the job of the manager of a MNC is both challenging and risky The key to such management is to make the diversity and complexity of the environment work for the benefit of the firm Check Your Progress State whether the following statements are True or False: When firms go global, they also tend to benefit from expanded opportunities which are available now The features of international financial management that distinguishes it from domestic finance is that world markets today are highly imperfect Imperfections in the world financial markets tend to restrict the extent to which the investors can diversify their portfolio The job of the manager of an MNC is neither challenging nor risky 11 IFM – Nature and Scope Simultaneously, the firm is also exposed to an interest rate risk This is because the firm’s liability depends on the interest rate which may vary from time to time once the borrowing has been done In India, most of the ECBs are pegged to the 6-month LIBOR (denoted as 6-month LIBOR plus a spread) and any variation (particularly an increase) in the LIBOR at the reset dates (dates on which the prevailing LIBOR is used to compute the liability) enhances the firm’s cost Even otherwise, since the rate of interest is uncertain, it carries an element of risk with it that the firms have to bear in the absence of any cover The movement of the LIBOR is not only difficult to predict but also is not related in any way to the operations of the company Thus, an opposite movement between the two, i.e., LIBOR increasing and simultaneously recessionary trends in the country which decrease the company’s revenues, raises the cost of capital for the company at a time when it is least prepared to meet it If the floating rate is pegged to a base which is more reflective of the economic conditions prevailing in India, then it will reduce the risk to an extent (but not remove it totally) To protect itself against the risk, the firm has to incur a cost associated with hedging against the exposure 10.3.5 Managing Exposure Arising from ECBs A company raising an ECB exposes itself to primarily two kinds of risks: exchange rate risk and interest rate risk To safeguard its position, the company has to incur a cost so that it is protected from the effects of any adverse movement of the exchange rate or the interest rate In order to that, a firm may enter into separate arrangements to hedge against each of these exposures, e.g., a firm that has raised an ECB and has therefore exposed itself to both interest rate and exchange rate movements can adopt the following strategy It can buy the required dollars in the forward market and enter into an interest rate swap that assures to it the requisite number of rupees required to buy the dollars on the due date This arrangement may provide the necessary hedge to the firm against both the interest rate and the exchange rate movements but it necessitates two different contracts, more documentation and a greater default risk, since dealing with two parties and also default by either can incur huge damages to the company’s interests Moreover, it depends on the company’s ability to enter into forward agreements for all maturities Since this may not be possible because of regulations to enter into forwards of all maturities, this provides an insufficient hedge especially if the tenure of the loan is long It can, however, enter into a single contract such as an interest-currency swap whereby at the due dates of interest/principal payment, it gets the required number of dollars against the periodic payment of a fixed rupee liability Entering into a single such arrangement provides the company a perfect hedge against movements of both the exchange rate and the interest rates but such a contract may prove to be costlier than entering into two single contracts Financial engineering today provides a company the opportunity to get itself a tailormade cover to meet all its needs, albeit at a cost The derivatives markets have come out with innovative products, both standardised and customised, tradable as well as nontradable In nascent markets such as India, the cost of hedge may turn out to be quite high and is an important consideration before any specific arrangements are made As of now, the significant difference in the ECB and the domestic market coupon rates (about 250–300 basis point after providing for hedge) does give the corporates sufficient breathing space while deciding their hedging strategy, but once this large interest rate differential narrows down, the minimisation of costs associated with hedging might become a paramount consideration Moreover, with the widening and the deepening of the derivatives markets in countries like ours, it is expected that the costs associated with hedging will come down significantly Companies that have export incomes in currencies of the denomination of the borrowing or have subsidiaries remitting profits to them in these currencies enjoy some distinct 213 Foreign Bond and Euro Bond 214 International Financial Management advantage First, owing to the similarity in denomination of the assets (receivables, remittances) and the liabilities (interests/principal repayments), the companies are protected from providing for the currency cover in part or in full Not only this, the export incomes and the remittances are also protected against currency volatility either in totality (if the total receivables are used in meeting the liabilities) or partly (if the liabilities are only a part of the assets or vice versa), thus reducing the hedging requirements (and the costs associated) for inflows This saving in costs should also be incorporated while evaluating the costs-benefits accruing from the ECB Thus, it makes a lot more sense for eligible export units as well as parent corporates in India, to borrow in the Euromarkets Over a period of time the Government has allowed corporates/banks, etc., a lot more freedom in raising/managing an ECB The banks are allowed to provide for cover in a more liberal manner as well as to introduce more instruments Swaps are also a recent phenomenon in the country It has also allowed corporates, who not have an exposure, because of their operating activities, to assume an exposure and generate cost savings through better exposure management Companies that have in their books, huge volumes of high cost, domestic debt see this as a great opportunity to pre-pay their high cost debt and replace it with low cost debt from ECBs, thus gaining a reduction in the interest costs As more and more firms adopt this route, exposure management will receive greater and greater emphasis 10.3.6 Policy Changes for Encouraging External Commercial Borrowings (ECBs) The ECB policies have been liberalised with respect to the end use of the funds ECB funds can now be used to fund certain categories of the Rupee expenditure Net commercial borrowings in the year 1996-97 amounted to US$ 1.009 billion against the total of US $1.275 billion in the previous year Although the net borrowing was lower, the disbursement was higher at US $5.732 billion against a total of US $4.252 billion in the previous year The amortisation was also higher at US $4.732 billion due to the repayment of the India Development Bonds In April 1998, the ECB policy has been further revised in the wake of the SE Asian crisis and the impact on the international markets The requirements of having a longer maturity for larger borrowings, caps on the borrowing costs and the restrictions on the end use of the ECB have been relaxed in the wake of the changed market conditions Modifications have also been made to the ECB policy to provide for easier access to external funds by the Indian industry to support investment and economic activity, and to increase transparency in the procedures Greater priority will now be given to projects in the infrastructure segment, the core sector and the export promotion Table 10.1: Status of the ECB Approvals Sector Power Telecom Shipping Civil Aviation Petroleum and Natural Gas Railways FIs Ports, Roads Others Total 1996-97 1875 289 146 46 783 144 1502 3797 8582 1997-98 3014 1493 210 373 230 179 795 62 2358 8714 Thus, it can be seen that to hedge a risk arising out of an interest liability, a firm can employ a number of strategies The basic and elementary concept of Swaps is manipulated so as to give a number of ways in which the risk can be hedged The great number of players in the market ensures that practically no innovation is left unoffered Straddles, strangles, collars, are only a few strategies that exist and are listed In the particular exposure illustrated, the company RXY was offered as many as 40 strategies and these were offered by as many as seven banks But the fact remains that the sheer number of variants possible make it almost impossible to classify them separately For example, a plain vanilla swap can also be classified as a collar, with the rate payable to the bank being the floor and the cap rate It thus becomes absolutely essential that treasurers of the hedging firm understand the markets very well if they want to get the best deal from the bank It is this understanding which will help these treasury managers in negotiating with the banks the best deal for their firm In fact, in most cases, it is observed, that it is the negotiating skills of the hedging firm’s managers that gets them the deal most suitable External Commercial Borrowing (ECB—1998-01) Gross aggregate disbursements under external commercial borrowings amounted to US $ 3187 million in 1999-2000 In aggregate terms, this was much lower than US$ 7226 million disbursed in 1998-99 However it may be mentioned that aggregate disbursements for the year 1998-99 include proceeds from Resurgent India Bonds ( (RIBs) worth US $ 4231 million Exchange RIB accruals, disbursements for 1998-99 are estimated at US $ 2995 million On a comparative basis, disbursements, therefore, were marginally higher in 1999-2000 Repayments for both years were more or less identical figuring US $2864 million in 1998-99 and US $ 2874 million in 1999-2000 Exchange RIB proceeds, net disbursements at US $ 313 million were higher in 1999-2000, compared to US $ 131 million in 1998-99 In the first-half of the current year (April-september,2000), repayments (US $ 2465 million) have exceeded disbursements (US $ 2360 million), resulting in net repayments of US $ 105 million The comparative estimate for April - September, 1999 was net disbursement of US$ 80 million Though disbursements in the current year (US$2360 million ) are higher than the comparable period of the previous year (US$ 1387 million ), the repayments in the current year are above those in the same period of the previous year (US$1307 million) As a result there has been a net repayment in the first-half of 2000-01 as against net disbursement during the corresponding period of 1999-2000 Despite a marginal improvement in the volume of disbursement in the current year, ECB accruals continue to be low The reasons behind the low mobilisation can be traced, inter alia, to hardening of international interest rates (particularly US dollar denominated) and the relatively sluggish demand of domestic industry industry for investment ECB approvals are also exhibiting a declining trend in the current year As in the previous years, the power sector has received the highest ECB approvals during the current year Petroleum and natural gas, shipping and financial institutions have been the other major recipients The amounts raised by Indian corporates under the "structured obligation window" is higher during the first three (quarters) of the current year (2000-01) as compared to the total approvals given under this window during 1999-2000 While total approvals under the window during 1992 amounted to US$ million, during the current financial year (as on December 31, 2000), total approvals have amounted to approximately US$ 1090 million 215 Foreign Bond and Euro Bond Table 10.2: Status of ECB Approvals 216 International Financial Management (US$ million) Sector 1998-99 Power 1999-2000 2000-01* 3998 2267 375 Telecom 75 0 Shipping 37 27 144 0 Petroleum & Natural Gas 40 218 150 Railways 15 0 150 125 70 80 885 129 60 Approval given by RBI 552 602 Amount raised under auto-route facility 0 318 Civil Aviation Financial Institution Ports, Roads etc Others (including exporters) Total 5200 3398 1719 * As on 31-12-2000 A series of policy liberalisations have been effected for further facilitating the use of External commercial borrowings as a window for resource mobilisation Some of these measures are as mentioned : l Fresh ECB approvals up to US $50 million and all refinancing of existing ECBs have been placed under the automatic route Under this arrangement, any corporate being a legal entity, registered under the Companies Act, Societies Registration Act, Cooperative Societies Act, including proprietorship/partnership concerns, will henceforth be eligible to enter into loan agreement with overseas lender for raising fresh ECB for an amount up to US and 50 million, or for refinancing an existing ECB, provided it is in compliance with the ECB guidelines The corporates would not be required to obtain prior approvals for raising ECBs up to US $ 50 million or for refinancing of existing ECBs l The RBI has been delegated the authority to sanction fresh ECB approvals up to US $ 100 million l RBI has also been delegated the power to approve prepayment as per the prevailing guidelines l The existing all-in cost ceilings for normal projects, infrastructure project and longterm ECBs are now 300,400 and 450 basis points over months LIBOR, for the respective currency in which the loan was to be raised, or applicable bench marks as the case may be l The average maturity for the purpose of ECB guidelines has been declared to be the weighted average of all disbursements, taking each disbursement individually and its period of retention by borrowers l Corporates, having underlying exposures in respect of crude and petroleum products, have been permitted to hedge commodity price risk subject to detailed guidelines of the RBI 10.3.7 Euro Debt External Commercial Borrowings (ECBs) are defined to include: Commercial bank loans Buyer’s credit Supplier’s credit Credit from official export credit agencies Securitised instruments such as fixed rate notes and floating rate bonds Commercial borrowings from the private sector window of multilateral financial institutions such as IFC, ADB, AFIC, CDC, etc Various forms of Euro bonds and Syndicated loans Here we will only analyse the long-term sources of finance and hence will concentrate only on the last mode Check Your Progress State whether the following statements are True or False: The underdeveloped and the developing economies require external assistance due to the shortage of capital within the country The scarcity of domestic capital resources hinders a high rate of capital formation The rate of savings is low because the income levels are at a low level and whatever small savings are possible, they are very difficult to mobilize A company raising an ECB exposes itself to primarily two kinds of risks: exchange rate risk and interest rate risk 10.3.8 Foreign Currency Convertible Bonds (FCCBs) The instrument floated by the Indian companies are commonly referred to as Foreign Currency Bonds (FCCBs) FCCBs are basically equity linked debt securities, which are converted to equity or Depository Receipts after a specific period In India, conversion of a Fully Convertible Debenture of a Partially Convertible Debenture is forced, since the conversion date and price are fixed in advance However, in case of FCCBs, the holder has the option of converting them into equity (normally at a predetermined exchange rate), or retaining the bond Because of this facility, FCCBs carry a lower rate of interest than the rate on any other similar non-convertible debt instrument FCCBs are freely tradable and the issuer has no control over the transfer mechanism, since, like GDRs, they are bearer securities, with no registration of owners However, Convertible Bonds issuance is concentrated only in a few currencies Of the major currencies, the US dollar accounts for more than half the issuance of FCCBs The British pound sterling, French franc and Japanese yen together account for around a quarter of the current outstandings in global markets, but they are primarily for domestic markets and attract very little international interest The Swiss franc is an important niche market, accounting for more than 10 per cent of the outstanding issuance and offers low coupon structures, especially for relatively small amounts and for Asian issuers 217 Foreign Bond and Euro Bond 218 International Financial Management Convertibles are more beneficial for the issuer than a GDR because of the following characteristics: i They have a lower coupon than straight debt ii They provide a broader investor base, i.e., both, those who invest in debt as well as in equity iii They allow a higher premium to the issuer than a GDR iv Dilution of equity is not immediate, but deferred The disadvantages of convertibles when compared to GDRs are the need for debt servicing in foreign currency and the exchange risks associated with it and to leverage before conversion Pure Euro Debt Pure Euro Debt is generally raised through Syndicated Loans or Private Placements Very few Indian companies have issued Euro debt to the general public The reasons for this are the higher cost of raising funds (when compared to Syndicated Loans or Private Placement) as well as servicing the debt and the exchange risk associated with the payments Also, very few investors would be interested in investing in an Indian company, which would be graded very low, in spite of the higher coupon offered to them In Syndicated Loans, the company which wishes to raise funds, appoints a Lead Manager and it is the responsibility of the Lead Manager to form a syndicate of banks and/or other Financial Institutions (FIs) who combine to raise the amount needed by the company For instance, The Tata Iron and Steel Company (TISCO) raised a loan of $150 million recently in March, 1997, wherein the Lead Managers were State Bank of India, ANZ Grindlays Bank and HSBC Markets, who, among themselves contributed only $6.5 million and the rest was contributed by a syndicate of 21 other banks, which was formed by the managers Syndicated Loans are usually given at a floating rate of interest, where the or months LIBOR is taken as the benchmark and the interest is fixed at certain basis points above this rate The tenors can extend up to 10 years and repayment is fixed in any profile bullet or amortising No listing is required The loan may be secured or unsecured These loans are typically given by banks and are not traded in the capital markets The various types of bonds for the general public, which have evolved over time, are listed below: i Deep Discount Convertibles: These are also known as Zero Coupon Convertible Bonds They are issued at a discount to the par value and mature at par value Thus, they have no or very low interest payments ii Bunny Bonds: These bonds permit investors to reinvest their interest income into more such bonds with the same terms and conditions, thus compounding their earnings iii Bulldog Bonds: These are denominated in pounds sterling for UK investors by a non-UK entity iv Yankee Bonds: These are dollar denominated issues, aimed at US investors, floated by a non-US entity v Samurai Bonds: These are long-term domestic yen debt issues targeted at Japanese investors by non-Japanese companies vi Dragon Bonds: These are issued in dollars, yen and other currencies, to lure Asian investors Apart from these, issuers can make their offerings more attractive through additional sweeteners in the form of equity warrants, options, etc Each new combination can be termed as a new instrument Indian companies are, however, not permitted to issue warrants along with their Euro issues Characteristics of Euro Debt The pricing of ECB loans is like the U-curve For small loans (up to $3 million) the interest rates are high This is because of the high proportion of fixed costs towards clearing the loan proposal As the size of the loan increases to $15 to $18 million, the interest rates decline In case of big loans, they rise again due to the higher risk perception of the lender and larger syndication cost So, in case of small loans, the interest is fixed at about 50–100 basis points above LIBOR, while for medium-size loans, they fall to 35– 45 basis points above LIBOR, and rise again for large loans to more than 100 basis points above LIBOR 10.3.9 Advantages of Euro Issues (i) (ii) Advantages in Holding Global Depository Receipts: GDRs offer the following advantages to an investor over direct investment: GDRs are bought and sold in international stock exchanges Hence, the investor can utilise the services of international settlement systems instead of the home country’s, which might be outmoded and inefficient Dividends are paid in dollars instead of the home country’s currency, which might be weak GDRs listed on internationally recognised stock exchanges may facilitate investment even by those investors who may be restricted from holding such securities on minor exchanges Use of GDRs sometimes permits investments by non-resident investors in jurisdictions which restrict foreign investment in local shares Rights issues and other corporate actions, voting at shareholder meetings, dividend disbursements, etc., are handled by the depository bank The GDR certificates are in bearer form; hence the holder need not declare his name, which is mandatory in case of domestic shareholding Advantages to the Issuer: The main advantage to the issuer is that he does not assume any exchange risk, though he does enjoy the benefit of foreign exchange collected by way of issue proceeds The dividend outflow from the company is only in rupee terms, since it is the responsibility of the overseas depository bank to convert this into dollars and pay to the ultimate investors, after deducting a withholding tax of 10% GDRs enable an issuing company to place its equity in a foreign market, thereby “internationalising” the profits of its company in the investor base, and at the same time expanding its name recognition GDRs can also be used as a vehicle for corporate acquisition Moreover, one of the major benefits of a GDR issue to the issuer company is the ability to raise funds at a lower cost The cost of raising funds in the Euro market is approximately 3–5% of the issue amount (depending upon the size of the issue); as against this, domestic issues cost anywhere between 8-14% of the issue size A Euro issue can be priced at par or at a slight premium to the domestic price, unlike domestic issues, where justification of the premium demanded has to be mandatorily given in the issue prospectus 219 Foreign Bond and Euro Bond 220 International Financial Management Advantages of Euro Debt The major benefit of a Euro loan for a company is the availability of foreign exchange at a reasonable cost Low cost of funds is one of the major benefits of a Euro loan for a company Average coupon rates on convertibles of five years maturity range from 2.5 to 4%, as against the domestic rates of above 15% per annum In the case of pure debt, most deals are stuck between 50–200 basis points above LIBOR As the LIBOR for the US dollar stands at around 6%, interest cost works out to between 6.5–8% To be added to this is the exchange risk cost for the depreciation of the Indian rupee vis-á-vis the US dollar In the worst case, this would amount to 6–7% per annum This implies a total cost of 12.5–15% per annum (in a worst case scenario), which is still lower than the minimum rate of about 16% charged by Indian FIs In most cases, companies are exempted from paying withholding taxes (@10% of interest amount), thereby saving a further 1.25–1.5% on interest costs The “$3 million scheme” enables corporates to borrow their entire funds requirement from one banker only, thereby saving syndication expenses on the loan Euro loans enable a company to raise funds from a foreign market, thereby “internationalising” the profile of the company in the investor base, and at the same time, expanding its name recognition In India, term-lending institutions impose severe restrictions in the loan agreements which restrict managerial authority of the company to a large extent Lenders in the Euromarkets offer an opportunity to the companies to raise loans without any significant loss of managerial discretionary powers, except for the negative lien which companies have to mandatorily offer Exporters can look for borrowing in the international markets as a natural hedge against their outstanding positions Thus, they can issue bonds denominated in a currency in which they would gain their export earnings, and offset their exchange risk External finance is generally provided for longer tenors, and can flexibly be structured to suit the convenience of the borrower and/or the lender It is a significant alternative mode of financing when local debt is unavailable (especially in case of a liquidity crunch as experienced by the Indian economy in the past few years) Advantages of Euro Convertibles Convertible Bonds enjoy the advantages of both debt and equity, since they are treated as debt before conversion and equity afterwards Thus, they enjoy the advantages of Euro loans before conversion and the advantages of GDRs afterwards Common Benefits to All Issuers of Euro Paper Apart from the above, there are certain benefits which accrue to companies which raise funds from global offerings through any of the following ways—be it equity, debt or convertibles These are listed below: An issuer company has the benefits of getting its name internationally recognised and enlarge its reach to the global markets International listings and trading and settlement systems provide easy liquidity, thus endearing them to buyers International investors get an opportunity to diversify their risk by investing in companies from different countries Investment by local individuals and institutions helps the company in mobilising the support of local political authorities for setting up joint ventures, subsidiaries, manufacturing bases and export bases, etc., in those countries, through strong ties with its local investors 10.3.10 Performance of Indian Euro Issues From May 1992 onwards, Indian companies have been issuing Global Depository Receipts (GDRs) and Foreign Currency Convertible Bonds/Euro Currency Bonds (FCCBs/ECBs) on the Euro market on a large scale Up to March 1996, Indian companies had raised US $5,180 million through 64 issues of GDRs and ECBs The first GDRs were issued by Reliance Industries Limited (RIL) in May, 1992 with an issue size of US $150 million at an issue price of US $16.35, thus issuing 9.2 million GDRs, each of which represented underlying equity shares of the company At that time, the market for Indian issues was so underdeveloped that RIL had to give GDRs at a discount of up to 17%, in order to get the issue fully subscribed The first FCCB was raised by Essar Steel in July, 1993 The amount raised was US $75 million at a coupon rate of 5.5% at a price of US $ 100 per bond These bonds were to be converted into 50.43 equity shares per bond This is the highest coupon paid by any Indian issuer till date It was necessary for Essar to pay this rate in order to get full subscription However, Indian paper could not attract many investors in the beginning This trend continued in 1992 and the first-half of 1993 However, later, as the economy opened up and more companies came out with issues for the global markets, more and more investors looked at India as an alternative investment avenue among developing countries and the market for Indian Euro issues picked up This was helped by the fact that Lead Managers got larger commissions on the sale of Indian paper, since India was seen as a high risk investment The first major success among Indian Euro issues was the Shipping Credit and Investment Corporation of India (SCICI) $100 million FCCB issue in October, 1993, which was priced at par (without any discount) and still got over subscribed by 10 times There was no stopping the Indian corporates after that, as many more issues hit the Euromarkets The total amount of money raised by Indian companies through the GDR route equalled US $ 5,425.9 million, while that through the ECB route US $ 1,035.5 million till the end of financial year 1995-96 Most of these securities are listed in Luxembourg The following table traces the development of Euro issues in India, since inception: Euro Issues (US$ Million) GDRs 1992-93 1993-94 1994-95 1995-96 240 1597 2050 1152 ECBs - 896 102 - Total 240 2493 2152 1152 Guidelines issued by the Finance Ministry in October, 1994, had specified that proceeds of Euro issues of Indian companies should be kept abroad till they were ready to be deployed for specific projects This was done in order to curtail the supply of dollars, which was appreciating the Indian rupee, consequently hurting India’s export competitiveness However, during January, 1995, the RBI stated that these proceeds could be deposited in foreign branches of Indian companies or foreign banks, which are 221 Foreign Bond and Euro Bond 222 International Financial Management rated for short-term obligations The fund could also be invested in treasury bills, or high quality commercial paper, having a maturity of less than one year This provided the much-needed fillip to the Euro issue market, which was then languishing due to regulatory restrictions combined with a sluggish domestic capital market 10.4 SHORT-TERM INSTRUMENTS Short-term instruments in international financial market include: The trade in short-term, low-risk securities, such as certificates of deposit and U.S Treasury notes A mutual fund that sells its shares in order to purchase short-term securities, the income from which is distributed among shareholders in the form of additional shares in the fund Also called money market fund Short-term ("money market") negotiable debt securities such as T-Bills (issued by governments), Commercial Paper (issued by companies) or Bankers Acceptances These are much like bonds, differing mainly in their maturity "Short-term” is usually defined as being up to year in maturity "Medium-term" is commonly taken to mean from to years in maturity, and "Long-term" anything above that Treasury Bills: Short-term zero coupon US government obligations, generally issued with various maturities of up to one year Also known as T-Bills Short-term Income Funds: These schemes invest in short-term money market instruments and corporate bonds The objective of these schemes is to provide a higher current income than liquid funds but without compromising the liquidity The ideal investment horizon is month to months Check Your Progress State whether the following statements are True or False: More and more Indian corporates are finding the route of raising money through ECBs very attractive A dual currency bond is a Euro bond dominated in one country, but the interest is payable in another currency A floating rate Eurocurrency note is a note which carries a coupon rare which is linked to a benchmark and which is adjusted periodically The term Eurodollar does not refer to US dollars accumulated over the years by European banks and other banks outside the United States The floating feature in effect, splits the interest rate risk between the borrowers and the investors 10.5 MEDIUM TERM INSTRUMENTS A Medium Term Note (MTN) is a debt note that usually matures (is paid back) in 5-10 years, but the term may be as short as one year They're normally issued on a floating basis such as Euribor +/- basic points When they are issued in euro they are "Euro Medium Term Notes" Serial Bond: A bond issue in which a portion of the bonds are scheduled to be retired at regular intervals over a period of years Serial bonds are issued when the underlying security for the bonds depreciates through use or obsolescence The maturities of the bonds are scheduled so that at any time, the bonds still outstanding will not exceed the declining value of the security Medium-Term Income Funds: These schemes invest in medium-term treasury bills and corporate bonds The objective of these schemes is to provide a higher current income than short-term income funds with reasonable liquidity The ideal investment horizon is months to months Stripped Mortgage Backed Securities: Mortgage pass-through securities in which the cash flow from the underlying mortgages is separated All principal is diverted into securities that pay only principal back to the investors, while all interest is diverted into securities that pay only interest The interest-only (IO) and principal-only (PO) securities are used as hedging tools to provide greater stability for mortgage portfolios during periods of fluctuating interest rates Municipal Bonds: A tax exempt debt obligation issued by a state or local government agency to raise funds for the public good, such as building low-income housing, improving streets or building bridges The bonds are redeemed with interest and are backed by the government's taxing authority Treasury Bonds: Long-term (more than ten years) obligations of the US government that pay interest semiannually until they mature, at which time the principal and the final interest payment is paid to the investor Also known as T-Bonds Treasury Notes: Same as Treasury Bonds except that Treasury Notes are mediumterm (more than one year but not more than ten years) Structured Notes: Non-mortgage-backed debt securities, whose cash flow characteristics depend on one or more indices and/or have embedded forwards or options Bootstrapping: In finance, bootstrapping refers to the procedure used to calculate the zero coupon yield curve, solving for the maturities where no instruments are available The method uses interpolation to complete the yield curve, using available zero coupon securities with varying maturities Swap: A financial contractual agreement between two parties to exchange (swap) a set of payments that one party owns for a set of payments owned by the other party Two kinds of swaps are, currency swaps and interest-rate swaps Securitized Bond: Bonds, whose interest and principal payments are backed by the cash flows from a portfolio or pool of other assets, are called securitized bonds Securitization allows for an organization (such as a bank) transfer risk from its own balance sheet to the debt capital markets through the sale of bonds For example, a mortgage bank might use the cash inflows on its current mortgage book, to issue bonds The cash raised from the sale of these bonds would then be used to issue new mortgages This process is cyclic allowing the mortgage bank to increase its operational leverage This type of securitization is known as a Mortgage Backed Security (MBS) Bid Bond: A type of surety bond wherein the surety company guarantees the bidder will enter into a contract and furnish the required payment and performance bonds Basket: A basket is an economic term for a group of several securities created for the purpose of simultaneous buying or selling Baskets are frequently used for program trading Baby Bonds: A name given to the Series A-1935 savings bond, but carried over to Series B-1936, C-1937 & 1938, and D-1939, 1940, & 1941 (through April) savings bonds Bilateral Investment Treaty: A Bilateral Investment Treaty (BIT) is an agreement establishing the terms and conditions for private investment by nationals and companies of one state in the state of the other This type of investment is called Foreign Direct Investment (FDI) 223 Foreign Bond and Euro Bond 224 International Financial Management Swift: The Society for Worldwide Interbank Financial Telecommunication ('SWIFT') runs a worldwide network by which messages concerning financial transactions are exchanged among banks and other financial institutions As of December 2001 it linked over 7,000 financial institutions in 194 countries and estimates that it carries payment messages averaging more than six trillion US dollars per day Bearer Instrument: A bearer instrument is a document that indicates that the bearer of the document has title to property, such as shares or bonds Bearer instruments differ from normal registered instruments, in that no records are kept of who owns the underlying property, or of the transactions involving transfer of ownership Whoever physically holds the bearer bond papers owns the property This is useful for investors and corporate officers who wish to retain anonymity, but ownership is extremely difficult to recover in event of loss or theft In general, the legal situs of the property is where the instrument is located Bearer instruments can be used in certain jurisdictions to avoid transfer taxes, although taxes may be charged when bearer instruments are issued Bankers Acceptance: A draft or bill of exchange accepted by a bank where the accepting institution guarantees payment Used extensively in foreign trade transactions 10.6 LET US SUM UP The Eurobond market has become popular and has flourished in the last few years due to several unique features that sets it apart from the domestic and foreign bond market More and more Indian corporates are finding the route of raising money through ECBs very attractive The existence of lower cost of funds in these markets in spite of the currency differential and the costs associated with hedging the exposure as compared to the high costs prevailing in the domestic market have made these markets the darling of eligible Indian companies Companies which meet the RBI guidelines raise funds in these markets more as a matter of rule rather than exception ECBs may be raised from any internationally recognised source such as banks, export credit agencies, foreign collaborator etc There are two kinds of risks involved in ECBs– interest rate risk and exchange rate risk Companies must manage the exposure arising due to adverse changes of exchange rates or the interest rates to safeguard their position Differentials in yields among Euro bonds denominated in different currencies have been known to exist beyond what can be reasonably explained by exchange rate expectations Moreover, these differentials, unlike differentials in money market yields, persist for long periods as they are not easily arbitragable as the latter The differentials are also due, in part, to such factors as political risk and capital market segmentation Nevertheless, market forces, if unobstructed, tend to produce an alignment, albeit less close than in the money market, between the yield on a Eurodollar bond and a dollar bond of the same grade risk and maturity The term Eurodollar refers to US dollars accumulated over the years by European banks and other banks outside the United States Since these dollars are outside the jurisdiction of the United States government, the European banks are free to deal in them without any restriction In addition to the US dollars acquired by banks with their own or foreign currency, Eurodollars also come into existence when a domestic or foreign holder of dollar-demanddeposits in the United States places them on deposit in a bank outside the United States 10.7 LESSON END ACTIVITY Write a note on Eurocurrency and Eurobond market 10.8 KEYWORDS Foreign Bonds: These are the bonds floated in a particular domestic capital market (and in the domestic currency of that market) by non-resident entities Euro Bond Market: Euro Bonds are unsecured debt securities issued and sold in markets outside the home country of the issuer (borrower) and denominated in a currency different from that of the home country of the issuer ECB: The governments, therefore, allow the corporate sector to access funds from abroad in the form of External Commercial Borrowings (ECB) Foreign Currency Convertible Bonds (FCCBs): The instrument floated by the Indian companies are commonly referred to as Foreign Currency Convertible Bonds (FCCBs) Deep Discount Convertibles: These are also known as Zero Coupon Convertible Bonds They are issued at a discount to the par value and mature at par value Thus, they have no or very low interest payments Bunny Bonds: These bonds permit investors to reinvest their interest income into more such bonds with the same terms and conditions, thus compounding their earnings Bulldog Bonds: These are denominated in pounds sterling for UK investors by a nonUK entity Yankee Bonds: These are dollar denominated issues, aimed at US investors, floated by a non-US entity Samurai Bonds: These are long-term domestic yen debt issues targeted at Japanese investors by non-Japanese companies Dragon Bonds: These are issued in dollars, yen and other currencies, to lure Asian investors 10.9 QUESTIONS FOR DISCUSSION What is meant by International Financial Markets? What are the reasons for the existence of the Eurodollar market? Can the Eurocurrency create money? What are the problems created by the existence of the Eurocurrency market? What are some of the important benefits that result from this market? What are the necessary conditions for the existence of a Euromarket? Do you expect the Eurodollar to exist 10 years from now? Why or why not? Briefly describe the characteristics of the Eurodollar market List the major advantages of Euro issues to Indian companies Has the performance of Indian Euro issues been satisfactory? Why or why not? What is the International Bond Market? Enumerate the important features of this market Why companies go in for External Commercial Borrowings (ECBs)? What are the risks involved in issuing ECBs? 225 Foreign Bond and Euro Bond 226 International Financial Management Check Your Progress: Model Answers CYP 1 True True True True CYP True True True False True 10.10 SUGGESTED READINGS Madhu Vij, International Financial Management, Excel Books, New Delhi, IInd Edition, 2003 V Sharan, International Financial Management, 4th Edition, Prentice Hall of India Alan C Shapiro, International Financial Management, PHI Levi, International Finance, McGraw Hill International Series Adrian Buckly, Multinational Finance, PHI MODEL QUESTION PAPER MBA Second Year Sub: International Financial Management Time: hours Total Marks: 100 Direction: There are total eight questions, each carrying 20 marks You have to attempt any five questions What factors cause some firms to become more internationalised than others? What are the implications and uses of the balance of payments statement? Explain how these exchange-rate systems function (a) gold standard (b) par value (c) crawling peg (d) wide band and (e) floating Explain the Purchasing Power Parity theory and the rationale behind it Distinguish between the spot market and the forward market Differentiate between speculation and hedging Also, discuss the appropriate role for each in the equity market Define transaction exposure How is it different from accounting exposure? What is exchange risk? How can it be managed ... International Financial Management l Have a knowledge of the Nature and Scope of International Financial Management l Distinguish between the International Financial Management and Domestic Financial. .. Financial Management and Domestic Financial Management International Financial Management 1.1 INTRODUCTION In this lesson on International Financial Management, we first discuss the objective... Madhu Vij, International Financial Management, Excel Books, New Delhi, IInd Edition, 2003 V Sharan, International Financial Management, 4th Edition, Prentice Hall of India Alan C Shapiro, International