Global Finance with Electronic Banking Compendium PDF

Global Finance with Electronic Banking Based on the 9th Edition of the book International Financial Management by Cheol S. Eun, Bruce G. Resnick, and Tuugi Chuluun, 2020; and E-Banking Management: Issues, Solutions, and Strategies by Mahmood Shah and Steve Clarke, 2009 DYCBAGff413 BSBA 4th Year | 1st Semester 2023-2024 AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION CONTENTS  Topic 1 – Globalization and the Multinational Firm  Topic 2 – International Monetary System  Topic 3 – Corporate Governance Around the World  Topic 4 – Management of Foreign Exchange Transaction Exposure  Topic 5 – Management of Foreign Exchange Economic Exposure  Topic 6 – Balance of Payments  Topic 7 – International Banking and Money Market  Topic 8 – Foreign Direct Investment and Cross-Border Acquisitions  Topic 9 – Multinational Cash Management  Topic 10 – International Trade Finance  Topic 11 – Introduction to E-Banking Management  Topic 12 – Delivery of Retail Banking Services  Topic 13 – A Managerial View of E-Banking  Topic 14 – Human Involvement and E-Banking AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION TOPIC 1: GLOBALIZATION AND THE MULTINATIONAL FIRM Learning Outcomes Once you are done with this lesson you should be able to:  Describe, in general, what international finance is.  Explain how global events affect the financial markets.  Understand the role of multinational corporations in global finance. As Finance students, you already learned and know that financial management’s main concern is to optimally make various corporate financial decisions, such as those pertaining to investment, financing, dividend policy, and working capital management. In a corporation, such decision-making points should be guided by the company’s set objectives. Maximizing shareholder wealth is generally considered the most important corporate objective. Shareholder wealth maximization means that the firm makes all business decisions and investments with an eye toward making the owners of the firm—the shareholders—better off financially, or wealthier, than they were before. International Finance In its simplest sense international finance is financial management in an international setting. We study international financial management because we are now living in a highly globalized and integrated world economy. To a large extent, this has happened as a result of multinational corporations’ (MNCs) relentless efforts to source inputs and locate production anywhere in the world where costs are lower, and profits are higher. In addition, financial markets have also become highly integrated. This development allows investors to diversify their investment portfolios internationally. Undoubtedly, we are now living in a world where all the major economic functions—consumption, production, and investment—are highly globalized. It is thus essential for financial managers to fully understand vital international dimensions of financial management. Three major dimensions set international finance apart from domestic finance. Foreign Exchange and Political Risks In integrated financial markets, individuals or households may also be seriously exposed to uncertain exchange rates. When firms and individuals are engaged in cross-border transactions, they are potentially exposed to foreign exchange risk that they would not normally encounter in purely domestic transactions. Exchange rate uncertainty will have a pervasive influence on all the major economic functions, including consumption, production, and investment. Another risk that firms and individuals may encounter in an international setting is political risk. Political risk ranges from unexpected changes in tax rules to outright expropriation of assets held by foreigners. Political risk arises from the fact that a sovereign country can change the “rules of the game” and the affected parties may not have effective option. Multinational firms and investors should be particularly aware of political risk when they invest in those countries without a tradition of the rule of law. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Market Imperfections A variety of barriers still hamper free movements of people, goods, services, and capital across national boundaries. These barriers include legal restrictions, excessive transaction and transportation costs, information asymmetry, and discriminatory taxation. The world markets are thus highly imperfect. Market imperfections, which represent various frictions and impediments preventing markets from functioning perfectly, play an important role in motivating MNCs to locate production overseas. Imperfections in the world financial markets tend to restrict the extent to which investors can diversify their portfolios. Expanded Opportunity Set When firms venture into the arena of global markets, they can benefit from an expanded opportunity set. They can gain from greater economies of scale when their tangible and intangible assets are deployed on a global basis. Individual investors can also benefit greatly if they invest internationally rather than domestically. If you diversify internationally, the resulting international portfolio may have a lower risk or a higher return (or both) than a purely domestic portfolio. This can happen mainly because stock returns tend to covary less across countries than within a given country. Once you are aware of overseas investment opportunities and are willing to diversify internationally, you face a much expanded opportunity set and you can benefit from it. Globalization of the World Economy To have better overview of international finance, we look at several key trends and developments of the world economy. Emergence of Globalized Financial Markets The momentum for globalized financial markets initially came from the governments of major countries that had begun to deregulate their foreign exchange and capital markets. For example, in 1980 Japan deregulated its foreign exchange market, and in 1985 the Tokyo Stock Exchange admitted as members a limited number of foreign brokerage firms. Additionally, the London Stock Exchange (LSE) began admitting foreign firms as full members in February 1986. Deregulated financial markets and heightened competition in financial services provided a natural environment for financial innovations that resulted in the introduction of various instruments. Examples of these innovative instruments include currency futures and options, multicurrency bonds, international mutual funds, country funds, exchange-traded funds (ETFs), and foreign stock index futures and options. Corporations also played an active role in integrating the world financial markets by listing their shares across borders. Such cross-border listings of stocks allow investors to buy and sell foreign shares as if they were domestic shares, facilitating international investments. Emergence of the Euro as a Global Currency The introduction of the euro at the start of 1999 represents a momentous event in the history of the world financial system. Currently, more than 300 million Europeans in 19 countries are using the common currency on a daily basis. Once a country adopts the common currency, it obviously cannot have its own monetary policy. The common monetary policy for the euro zone is now formulated by the European Central Bank (ECB). AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Since its inception in 1999, the euro has already brought about revolutionary changes in European finance. For instance, by redenominating corporate and government bonds and stocks from many different currencies into the common currency, the euro has caused the emergence of continentwide capital markets in Europe that are comparable to U.S. markets in depth and liquidity. Companies all over the world can benefit from this development as they can raise capital more easily on favorable terms in Europe. Europe’s Sovereign Debt Crisis of 2010 The euro’s emergence as a global currency, however, was dealt a serious setback in the midst of Europe’s sovereign debt crisis. The crisis started in December 2009 when the new Greek government revealed that its budget deficit for the year would be 12.7 percent of GDP, not the 3.7 percent previously forecast. This news surprised financial markets and prompted investors, who became worried about sovereign default, to sell off Greek government bonds. The Greek predicament is attributable to excessive borrowing and spending, with wages and prices rising faster than productivity. With the adoption of the euro, Greece can no longer use the traditional means of restoring competitiveness, that is, depreciation of the national currency. The panic spread to other weak European economies, especially Ireland, Portugal, and Spain. In the spring of 2010, both Standard & Poor’s and Moody’s, credit rating agencies, downgraded the government bonds of the affected countries, making borrowing and refinancing more costly. In particular, the Greek government bond was downgraded to “junk,” ineligible for institutional investment. These sovereign defaults led to a sharp fall of the euro’s exchange value in currency markets. The sovereign debt crisis in Greece quickly escalated to a Europe-wide debt crisis, threatening the recovery of the world economy from the severe global financial crisis of 2008–2009. Facing the spreading crisis, the European Union (EU) countries, led by France and Germany, jointly with the International Monetary Fund (IMF), put together a massive €750 billion package to bail out Greece and other weak economies. Note that Europe’s sovereign-debt crisis of 2010 revealed a profound weakness of the euro as the common currency: Euro-zone countries have achieved monetary integration by adopting the euro, but without fiscal integration. While euro-zone countries share the common monetary policy, fiscal policies governing taxation, spending, and borrowing firmly remain under the control of national governments. Trade Liberalization and Economic Integration International trade, which has been the traditional link between national economies, has continued to expand. As data sourced from various issues of World Financial Market, JPMorgan; World Development Indicators, The World Bank; and International Trade Statistics and International Financial Statistics, IMF show, the ratio of goods exports to GDP for the world has increased from 7.0 percent in 1950 to 22.1 percent in 2017. This implies that, over the same time period, international trade increased nearly three times as fast as world GDP. The principal argument for international trade is based on the theory of comparative advantage, which was advanced by David Ricardo in his seminal book, Principles of Political Economy (1817). According to Ricardo, it is mutually beneficial for countries if they specialize in the production of those goods they can produce most efficiently and trade those goods among them. Ricardo’s theory has a clear policy implication: Liberalization of international trade will enhance the welfare of the world’s citizens. In other words, international trade is not a “zero-sum” game in which one country benefits at the expense of another country. Rather, international trade could be an “increasing-sum” game at which all players become winners. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Privatization The economic integration and globalization that began in the 1980s picked up speed in the 1990s via privatization. Through privatization, a country divests itself of the ownership and operation of a business venture by turning it over to the free market system. Privatization can be viewed in many ways. In one sense it is a denationalization process. When a national government divests itself of a state-run business, it gives up part of its national identity. Moreover, if the new owners are foreign, the country may simultaneously be importing a cultural influence that did not previously exist. One benefit of privatization for many less-developed countries is that the sale of state-owned businesses brings to the national treasury hard-currency foreign reserves. The sale proceeds are often used to pay down sovereign debt that has weighed heavily on the economy. Additionally, privatization is often seen as a cure for bureaucratic inefficiency and waste; some economists estimate that privatization improves efficiency and reduces operating costs by as much as 20 percent. Global Financial Crisis of 2008–2009 The defining moment of the crisis came on September 14, 2008, when Lehman Brothers, a major U.S. investment bank with a global presence, went bankrupt. The unexpected failure of an iconic U.S. bank touched off a major crisis of confidence in financial markets and institutions around the world. Stock prices fell dramatically. Output fell and unemployment rose sharply. At the same time, international trade has been shrinking rapidly. Several factors have likely contributed to the crisis. First, households and financial institutions borrowed too much and took too much risk. Second, the crisis was amplified and transmitted globally by securitization. Securitization allows loan originators to avoid bearing the default risk, which leads to a compromised lending standard and increased moral hazard. Also, financial engineers designed complex mortgage-based securities that could be used for excessive risk-taking. These securities were traded infrequently and were often difficult to value. Third, the “invisible hands” of free markets apparently failed to self-regulate its excesses, contributing to the banking crisis. At the same time, “light touch” regulations by government agencies, such as the Securities and Exchange Commission (SEC) and the Federal Reserve, led to a failure to detect the rising risk in the financial system and to take regulatory actions in a timely fashion to prevent the crisis. Fourth, international financial markets are highly interconnected and integrated nowadays. Brexit Recently, the process of global and regional economic integration was dealt a major setback when the majority of Britons voted to leave the EU, the event known as Brexit. Brexit is likely to weaken the United Kingdom and the European Union, both economically and politically. Also, London’s position as the dominant center of European finance may deteriorate if the U.K. loses unrestricted access to Europe’s single market. It can be said that Brexit stems from the resentment of the majority against the urban elites who are seen as disproportionately benefiting from globalization and the fear of losing the British national identity. Brexit thus revealed some of the serious difficulties associated with free trade and global integration that espouse free movements of goods, services, capital, and people across countries. Although international trade contributes a great deal to economic growth, lifting tens of millions of people from poverty around the world, it also produces clear winners and losers. As a result, unless losers are compensated by transfer payment and retraining for good jobs, free trade is likely to encounter political resistance. It is thus important for countries to promote and pursue “shared growth” to continue to benefit from free trade and economic integration. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Multinational Corporations In addition to international trade, foreign direct investment by MNCs is a major force driving globalization of the world economy. A multinational corporation (MNC) is a business firm incorporated in one country that has production and sales operations in many other countries. The term suggests a firm obtaining raw materials from one national market and financial capital from another, producing goods with labor and capital equipment in a third country, and selling the finished product in yet other national markets. MNCs obtain financing from major money centers around the world in many different currencies to finance their operations. Global operations force the treasurer’s office to establish international banking relationships, place short-term funds in several currency denominations, and effectively manage foreign exchange risk. MNCs may gain from their global presence in a variety of ways. First of all, MNCs can benefit from the economy of scale by:  spreading R&D expenditures and advertising costs over their global sales  pooling global purchasing power over suppliers  utilizing their technological and managerial know-how globally with minimum additional costs Furthermore, MNCs can use their global presence to take advantage of underpriced labor services available in certain developing countries, and gain access to special R&D capabilities residing in advanced foreign countries. MNCs can indeed leverage their global presence to boost their profit margins and create shareholder value. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION TOPIC 2: INTERNATIONAL MONETARY SYSTEM Learning Outcomes Once you are done with this lesson you should be able to:  Understand the arrangements and workings of the international monetary system.  Contemplate on the future prospects of the international monetary system.  Compare and contrast the alternative exchange rate systems. Evolution of the International Monetary System The international monetary system defines the overall financial environment in which multinational corporations and international investors operate. Corporations nowadays are operating in an environment in which exchange rate changes may adversely affect their competitive positions in the marketplace. Similarly, international investors face the problem of fluctuating exchange rates affecting their portfolio returns. The international monetary system can be defined as the institutional framework within which international payments are made, movements of capital are accommodated, and exchange rates among currencies are determined. It is a complex whole of agreements, rules, institutions, mechanisms, and policies regarding exchange rates, international payments, and the flow of capital. Bimetallism: Before 1875 The international monetary system before the 1870s can be characterized as “bimetallism” in the sense that both gold and silver were used as international means of payment and that the exchange rates among currencies were determined by either their gold or silver contents. Countries that were on the bimetallic standard often experienced the well-known phenomenon referred to as Gresham’s law. Since the exchange ratio between the two metals was fixed officially, only the abundant metal was used as money, driving more scarce metal out of circulation. Classical Gold Standard: 1875–1914 An international gold standard can be said to exist when, in most major countries:  gold alone is assured of unrestricted coinage,  there is two-way convertibility between gold and national currencies at a stable ratio, and  gold may be freely exported or imported. In order to support unrestricted convertibility into gold, bank-notes need to be backed by a gold reserve of a minimum stated ratio. In addition, the domestic money stock should rise and fall as gold flows in and out of the country. Under the gold standard, the exchange rate between any two currencies will be determined by their gold contents. Here, misalignment of the exchange rate will be automatically corrected by cross- border flows of gold. In addition, international imbalances of payment will also be corrected automatically. The gold standard, however, has a few key shortcomings. First of all, the supply of newly minted gold is so restricted that the growth of world trade and investment can be seriously hampered for the lack of sufficient monetary reserves. The world economy can face deflationary pressures. Second, whenever the government finds it politically necessary to pursue national objectives that are inconsistent with maintaining the gold standard, it can abandon the gold standard. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Interwar Period: 1915–1944 As major countries began to recover from the war and stabilize their economies, they attempted to restore the gold standard. The United States, which replaced Great Britain as the dominant financial power, spearheaded efforts to restore the gold standard. The international gold standard of the late 1920s, however, was not much more than a front. Most major countries gave priority to the stabilization of domestic economies and systematically followed a policy of sterilization of gold by matching inflows and outflows of gold respectively with reductions and increases in domestic money and credit. In another word, countries lacked the political will to abide by the “rules of the game,” and so the automatic adjustment mechanism of the gold standard was unable to work. In September 1931, the British government suspended gold payments and let the pound float. As Great Britain got off gold, countries such as Canada, Sweden, Austria, and Japan followed suit by the end of 1931. The United States got off gold in April 1933 after experiencing a series of bank failures and outflows of gold. Lastly, France abandoned the gold standard in 1936. Paper standards came into being when the gold standard was abandoned. In sum, the interwar period was characterized by economic nationalism, halfhearted attempts and failure to restore the gold standard, economic and political instabilities, bank failures, and panicky flights of capital across borders. No coherent international monetary system prevailed during this period, with profoundly detrimental effects on international trade and investment. It is during this period that the U.S. dollar emerged as the dominant world currency, gradually replacing the British pound for the role. Bretton Woods System: 1945–1972 In July 1944, representatives of 44 nations gathered at Bretton Woods, New Hampshire, to discuss and design the postwar international monetary system. After lengthy discussions and bargains, representatives succeeded in drafting and signing the Articles of Agreement of the International Monetary Fund (IMF), which constitutes the core of the Bretton Woods system. The agreement was subsequently ratified by the majority of countries to launch the IMF in 1945. The IMF embodied an explicit set of rules about the conduct of international monetary policies and was responsible for enforcing these rules. Delegates also created a sister institution, the International Bank for Reconstruction and Development (IBRD), better known as the World Bank, that was chiefly responsible for financing individual development projects. Under the Bretton Woods system, each country established a par value in relation to the U.S. dollar. Here, the U.S. dollar was the only currency that was fully convertible to gold; other currencies were not directly convertible to gold. Countries held U.S. dollars, as well as gold, for use as an international means of payment. Because of these arrangements, the Bretton Woods system can be described as a dollar-based gold-exchange standard. Under the gold-exchange system, the reserve-currency country should run balance of payments deficits to supply reserves, but if such deficits are large and persistent, they can lead to a crisis of confidence in the reserve currency itself, causing the downfall of the system. This dilemma, known as the Triffin paradox, was indeed responsible for the eventual collapse of the dollar-based gold- exchange system in the early 1970s. The Flexible Exchange Rate Regime: 1973–Present The flexible exchange rate regime that followed the demise of the Bretton Woods system was ratified after the fact in January 1976 when the IMF members met in Jamaica and agreed to a new set of rules for the international monetary system. The key elements of the Jamaica Agreement include: 1. Flexible exchange rates were declared acceptable to the IMF members, and central banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION 2. Gold was officially abandoned (i.e., demonetized) as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold, with the proceeds to be used to help poor nations. 3. Non-oil-exporting countries and less-developed countries were given greater access to IMF funds. The U.S. dollar, however, experienced a major appreciation throughout the first half of the 1980s because of the large-scale inflows of foreign capital caused by unusually high real interest rates available in the United States. To attract foreign investment to help finance the budget deficit, the United States had to offer high real interest rates. The heavy demand for dollars by foreign investors pushed up the value of the dollar in the exchange market. The value of the dollar reached its peak in February 1985 and then began a persistent downward drift until it stabilized in 1988. The downward trend was also reinforced by concerted government interventions. In September 1985, the so-called G-5 countries (France, Japan, Germany, the U.K., and the United States) met at the Plaza Hotel in New York and reached what became known as the Plaza Accord. They agreed that it would be desirable for the dollar to depreciate against most major currencies to solve the U.S. trade deficit problem and expressed their willingness to intervene in the exchange market to realize this objective. As the dollar continued its decline, the governments of the major industrial countries began to worry that the dollar may fall too far. To address the problem of exchange rate volatility and other related issues, the G-7 economic summit meeting was convened in Paris in 1987. The G-7 is composed of Canada, France, Japan, Germany, Italy, the U.K., and the United States. The meeting produced the Louvre Accord, according to which: 1. The G-7 countries would cooperate to achieve greater exchange rate stability. 2. The G-7 countries agreed to more closely consult and coordinate their macroeconomic policies. The Louvre Accord marked the inception of the managed-float system under which the G-7 countries would jointly intervene in the exchange market to correct over- or undervaluation of currencies. Following the Louvre Accord, exchange rates became relatively more stable for a while. During the period 1996–2001, however, the U.S. dollar generally appreciated, reflecting a robust performance of the U.S. economy fueled by the technology boom. During this period, foreigners invested heavily in the United States to participate in the booming U.S. economy and stock markets. This helped the dollar to appreciate. In 2001, however, the U.S. dollar began to depreciate due to a sharp stock market correction, the ballooning trade deficits, and the increased political uncertainty following the September 11 incident. The Current Exchange Rate Arrangements The IMF currently classifies exchange rate arrangements into 10 separate regimes. The system classifies exchange rate arrangements primarily based on the degree to which the exchange rate is determined by the market rather than by official government action, with market-determined rates generally being more flexible.  No separate legal tender: The currency of another country circulates as the sole legal tender. Adopting such an arrangement implies complete surrender of the monetary authorities’ control over the domestic monetary policy.  Currency board: A currency board arrangement is a monetary arrangement based on an explicit legislative commitment to exchange domestic currency for a specified foreign currency at a fixed exchange rate, combined with restrictions on the issuing authority to ensure the fulfillment of its legal obligation. This implies that domestic currency is usually fully backed by foreign assets, eliminating traditional central bank functions such as AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION monetary control and lender of last resort, and leaving little room for discretionary monetary policy.  Conventional peg: For this category the country formally (de jure) pegs its currency at a fixed rate to another currency or a basket of currencies, where the basket is formed, for example, from the currencies of major trading or financial partners and weights reflect the geographic distribution of trade, services, or capital flows. The anchor currency or basket weights are public or notified to the IMF. The country authorities stand ready to maintain the fixed parity through direct intervention or indirect intervention.  Stabilized arrangement: Classification as a stabilized arrangement entails a spot market exchange rate that remains within a margin of 2 percent for 6 months or more and is not floating. The required margin of stability can be met either with respect to a single currency or a basket of currencies, where the anchor currency or the basket is ascertained or confirmed using statistical techniques.  Crawling peg: Classification as a crawling peg involves the confirmation of the country authorities’ de jure exchange rate arrangement. The currency is adjusted in small amounts at a fixed rate or in response to changes in selected quantitative indicators, such as past inflation differentials vis-à-vis major trading partners or differentials between the inflation target and expected inflation in major trading partners.  Crawl-like arrangement: The exchange rate must remain within a narrow margin of 2 percent relative to a statistically identified trend for six months or more and the exchange rate arrangement cannot be considered as floating. Usually, a minimum rate of change greater than allowed under a stabilized (peg-like) arrangement is required.  Pegged exchange rate within horizontal bands: The value of the currency is maintained within certain margins of fluctuation of at least ±1 percent around a fixed central rate, or the margin between the maximum and minimum value of the exchange rate exceeds 2 percent. Tonga is the only example.  Other managed arrangement: This category is a residual, and is used when the exchange rate arrangement does not meet the criteria for any of the other categories. Arrangements characterized by frequent shifts in policies may fall into this category.  Floating: A floating exchange rate is largely market determined, without an ascertainable or predictable path for the rate. In particular, an exchange rate that satisfies the statistical criteria for a stabilized or a crawl-like arrangement will be classified as such unless it is clear that the stability of the exchange rate is not the result of official actions. Foreign exchange market intervention may be either direct or indirect, and serves to moderate the rate of change and prevent undue fluctuations in the exchange rate, but policies targeting a specific level of the exchange rate are incompatible with floating. The Philippines is under this regime.  Free floating: A floating exchange rate can be classified as free floating if intervention occurs only exceptionally and aims to address disorderly market conditions and if the authorities have provided information or data confirming that intervention has been limited to at most three instances in the previous six months, each lasting no more than three business days. Examples are Australia, Canada, Mexico, Japan, the U.K., the United States, and the euro zone. European Monetary System The EMS, was formally launched in March 1979. Among its chief objectives are: 1. To establish a “zone of monetary stability” in Europe. 2. To coordinate exchange rate policies vis-à-vis the non-EMS currencies. 3. To pave the way for the eventual European monetary union. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION The two main instruments of the EMS were the European Currency Unit and the Exchange Rate Mechanism. The European Currency Unit (ECU) is a “basket” currency constructed as a weighted average of the currencies of member countries of the European Union (EU). The weights are based on each currency’s relative GNP and share in intra-EU trade. The ECU serves as the accounting unit of the EMS and plays an important role in the workings of the exchange rate mechanism. The Exchange Rate Mechanism (ERM) refers to the procedure by which EMS member countries collectively manage their exchange rates. The ERM is based on a “parity grid” system, which is a system of par values among ERM currencies. The par values in the parity grid are computed by first defining the par values of EMS currencies in terms of the ECU. Despite the recurrent turbulence in the EMS, European Union members met at Maastricht (Netherlands) in December 1991 and signed the Maastricht Treaty. According to the treaty, the EMS would irrevocably fix exchange rates among the member currencies by January 1, 1999, and subsequently introduce a common European currency, replacing individual national currencies. The European Central Bank, to be located in Frankfurt, Germany, would be solely responsible for the issuance of common currency and conducting monetary policy in the euro zone. National central banks of individual countries then would function pretty much like regional member banks of the U.S. Federal Reserve System. The Asian Currency Crisis On July 2, 1997, the Thai baht, which had been largely fixed to the U.S. dollar, was suddenly devalued. What at first appeared to be a local financial crisis in Thailand quickly escalated into a global financial crisis, first spreading to other Asian countries—Indonesia, Korea, Malaysia, and the Philippines—then far afield to Russia and Latin America, especially Brazil. The 1997 Asian crisis was the third major currency crisis of the 1990s, preceded by the crises of the European Monetary System (EMS) of 1992 and the Mexican peso in 1994–1995. The Asian crisis, however, turned out to be far more serious than its two predecessors in terms of the extent of contagion and the severity of resultant economic and social costs. Following the massive depreciations of local currencies, financial institutions and corporations with foreign-currency debts in the afflicted countries were driven to extreme financial distress and many were forced to default. What’s worse, the currency crisis led to an unprecedentedly deep, widespread, and long-lasting recession in East Asia, a region that, for the last few decades, has enjoyed the most rapidly growing economy in the world. At the same time, many lenders and investors from the developed countries also suffered large capital losses from their investments in emerging-market securities. Origins of the Asian Currency Crisis Several factors are responsible for the onset of the Asian currency crisis: a weak domestic financial system, free international capital flows, the contagion effects of changing market sentiment, and inconsistent economic policies. As capital markets were liberalized, both firms and financial institutions in the Asian developing countries eagerly borrowed foreign currencies from U.S., Japanese, and European investors, who were attracted to these fast-growing emerging markets for extra returns for their portfolios. Meanwhile, the booming economy with a fixed or stable nominal exchange rate inevitably brought about an appreciation of the real exchange rate. This, in turn, resulted in a marked slowdown in export growth in such Asian countries as Thailand and Korea. In addition, a long-lasting recession in Japan and the yen’s depreciation against the dollar hurt Japan’s neighbors, further worsening the trade balances of the Asian developing countries. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION In Thailand, as the run on the baht started, the Thai central bank initially injected liquidity to the domestic financial system and tried to defend the exchange rate by drawing on its foreign exchange reserves. With its foreign reserves declining rapidly, the central bank eventually decided to devalue the baht. The sudden collapse of the baht touched off a panicky flight of capital from other Asian countries with a high degree of financial vulnerability. Contagion of the currency crisis was caused at least in part by the panicky, indiscriminate flight of capital from the Asian countries for fear of a spreading crisis. As lenders withdrew their capital and refused to renew short-term loans, the former credit boom turned into a credit crunch, hurting creditworthy as well as marginal borrowers. As the crisis unfolded, the International Monetary Fund (IMF) came to rescue the three hardest-hit Asian countries—Indonesia, Korea, and Thailand—with bailout plans. As a condition for the bailing out, however, the IMF imposed a set of austerity measures, such as raising domestic interest rates and curtailing government expenditures, that were designed to support the exchange rate. Because these austerity measures, contractionary in nature, were implemented when the economies had already been contracting because of a severe credit crunch, the Asian economies consequently suffered a deep, long-lasting recession. According to a World Bank report (1999), one-year declines in industrial production of 20 percent or more in Thailand and Indonesia are comparable to those in the United States and Germany during the Great Depression. Lessons from the Asian Currency Crisis Generally speaking, liberalization of financial markets when combined with a weak, underdeveloped domestic financial system tends to create an environment vulnerable to currency and financial crises. Among other things, the government should strengthen its system of financial-sector regulation and supervision. In addition, banks should be encouraged to base their lending decisions solely on economic merits rather than political considerations. Furthermore, firms, financial institutions, and the government should be required to provide the public with reliable financial data in a timely fashion. A higher level of disclosure of financial information and the resultant transparency about the state of the economy will make it easier for all the concerned parties to monitor the situation better and mitigate the destabilizing cycles of investor euphoria and panic accentuated by the lack of reliable information. Even if a country decides to liberalize its financial markets by allowing cross-border capital flows, it should encourage foreign direct investments and equity and long-term bond investments; it should not encourage short-term investments that can be reversed overnight, causing financial turmoil. Fixed versus Flexible Exchange Rate Regimes The key arguments for flexible exchange rates rest on (i) easier external adjustments and (ii) national policy autonomy. Suppose a country is experiencing a balance of payments deficit at the moment. This means that there is an excess supply of the country’s currency at the prevailing exchange rate in the foreign exchange market. Under a flexible exchange rate regime, the external value of the country’s currency will simply depreciate to the level at which there is no excess supply of the country’s currency. At the new exchange rate level, the balance of payments disequilibrium will disappear. As long as the exchange rate is allowed to be determined according to market forces, external balance will be achieved automatically. Consequently, the government does not have to take policy actions to correct the balance of payments disequilibrium. With flexible exchange rates, therefore, the government can use its monetary and fiscal policies to pursue whatever economic goals it chooses. Under a fixed rate regime, however, the government may have to take contractionary (expansionary) monetary and fiscal policies to correct the balance of payments deficit (surplus) at the existing exchange rate. Since policy tools need to be committed to maintaining the exchange AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION rate, the government cannot use the same policy tools to pursue other economic objectives. As a result, the government loses its policy autonomy under a fixed exchange rate regime. A possible drawback of the flexible exchange rate regime is that exchange rate uncertainty may hamper international trade and investment. Proponents of the fixed exchange rate regime argue that when future exchange rates are uncertain, businesses tend to avoid foreign trade. Since countries cannot fully benefit from international trade under exchange rate uncertainty, resources will be allocated suboptimally on a global basis. The choice between the alternative exchange rate regimes is likely to involve a trade-off between national policy independence and international economic integration. If countries would like to pursue their respective domestic economic goals, they are likely to pursue divergent macroeconomic policies, rendering fixed exchange rates infeasible. On the other hand, if countries are committed to promoting international economic integration, the benefits of fixed exchange rates are likely to outweigh the associated costs. An ideal international monetary system (IMS) should provide:  liquidity,  adjustment, and  confidence. In other words, a good IMS should be able to provide the world economy with sufficient monetary reserves to support the growth of international trade and investment. It should also provide an effective mechanism that restores the balance of payments equilibrium whenever it is disturbed. Lastly, it should offer a safeguard to prevent crises of confidence in the system that result in panicked flights from one reserve asset to another. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION TOPIC 3: CORPORATE GOVERNANCE AROUND THE WORLD Learning Outcomes Once you are done with this lesson you should be able to:  Explain key issues in corporate governance.  Identify possible remedies to agency problem.  Understand how laws and regulations connect to having sound corporate governance. We argue that the key goal of financial management should be shareholder wealth maximization. However, when “self-interested” managers take control of the company, they sometimes engage in actions that are profoundly detrimental to the interests of shareholders and other stakeholders. When managerial self-dealings are excessive and left unchecked, they can have serious negative effects on corporate values and the proper functions of capital markets. In fact, there is a growing consensus around the world that it is vitally important to strengthen corporate governance to protect shareholder rights, curb managerial excesses, and restore confidence in capital markets. Corporate governance can be defined as the economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers, and other stakeholders of the company. Governance of the Public Corporation: Key Issues The public corporation, which is jointly owned by a multitude of shareholders protected by limited liability, is a major organizational innovation with powerful economic consequences. The majority of global corporations that drive economic growth and innovations worldwide, such as Amazon, Apple, Google, General Electric (GE), IBM, Toyota, Samsung Electronics, British Petroleum (BP), and BMW, are chartered as public corporations rather than as private companies. The genius of public corporations stems from their capacity to allow efficient sharing or spreading of risk among many investors, who can buy and sell their ownership shares on liquid stock exchanges and let professional managers run the company on behalf of shareholders. This efficient risk-sharing mechanism enables public corporations to raise large amounts of capital at relatively low costs and undertake many investment projects that individual entrepreneurs or private investors might avoid because of the costs and/or risks. A public corporation has a key weakness—namely, the conflicts of interest between managers and shareholders. The separation of the company’s ownership and control, which is especially prevalent in such countries as the United States and the United Kingdom, where corporate ownership is highly diffused, gives rise to possible conflicts between shareholders and managers. In many countries with concentrated corporate ownership, conflicts of interest are greater between large controlling shareholders and small outside shareholders than between managers and shareholders. The central problem in corporate governance remains the same everywhere: how to best protect outside investors from expropriation by the controlling insiders so that the investors can receive fair returns on their investments. How to deal with this problem has enormous practical implications for shareholder welfare, corporate allocation of resources, corporate financing and valuation, development of capital markets, and economic growth. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Remedies for the Agency Problem It is a matter of vital importance for shareholders to control the agency problem; otherwise, they may not be able to get their money back. It is also important for society as a whole to solve the agency problem, since the agency problem leads to waste of scarce resources, hampers capital market functions, and hinders economic growth. Several governance mechanisms exist to lessen or remedy the agency problem: 1. Independent board of directors 2. Incentive contracts 3. Concentrated ownership 4. Accounting transparency 5. Debt 6. Shareholder activism 7. Overseas stock listings 8. Market for corporate control Board of Directors If the board of directors remains independent of management, it can serve as an effective mechanism for controlling the agency problem. But due to the diffused ownership structure of the public company, management often gets to choose board members who are likely to be friendly to management. An insider-dominated board becomes a poor governance mechanism. Incentive Contracts Managers capture residual control rights and thus have enormous discretion over how to run the company. Although managers run the company at their own discretion, they may not significantly benefit from the profit generated from their efforts and expertise. This situation implies that managers may not be very interested in the maximization of shareholder wealth. When professional managers have small equity positions of their own in a company with diffused ownership, they have both power and a motive to engage in self-dealings. Aware of this situation, many companies provide managers with incentive contracts, such as stocks and stock options, in order to better align the interests of managers with those of investors. With the grant of stocks or stock options, managers can be given an incentive to run the company in such a way that enhances shareholder wealth as well as their own. Concentrated Ownership An effective way to alleviate the agency problem is to concentrate shareholdings. If one or a few large investors own significant portions of the company, they will have a strong incentive to monitor management. For example, if an investor owns 51 percent of the company, he or she can definitely control the management (he can easily hire or fire managers) and will make sure that shareholders’ rights are respected in the conduct of the company’s affairs. With concentrated ownership and high stakes, the free-rider problem afflicting small shareholders dissolves. Accounting Transparency Strengthening accounting standards can be an effective way of alleviating the agency problem. If companies are required to release more accurate accounting information in a timely fashion, managers may be less tempted to take actions that are detrimental to the interests of shareholders. Basically, a greater accounting transparency will reduce the information asymmetry between corporate insiders and the public and discourage managerial self-dealings. To achieve a greater transparency, however, it is important for (i) countries to reform the accounting rules and (ii) companies to have an active and qualified audit committee. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Debt Borrowing and the subsequent obligation to make interest payments on time can have a major disciplinary effect on managers, motivating them to restrain private perks and wasteful investments and trim bloated organizations. In fact, debt can serve as a substitute for dividends by forcing managers to disgorge free cash flow to outside investors rather than wasting it. For firms with free cash flows, debt can be a stronger mechanism than stocks for credibly bonding managers to release cash flows to investors. With debt, however, managers do not have such flexibility and the company’s survival can be threatened. Excessive debt may also induce the risk-averse managers to forgo profitable but risky investment projects, causing an underinvestment problem. For this reason, debt may not be such a desirable governance mechanism for young companies with few cash reserves or tangible assets. Shareholder Activism In recent years, “activist investors,” who invest in stocks of a company for the specific purpose of influencing the company’s management, started to play an important role in promoting shareholders’ interests. Increasingly, activist shareholders also pursue their social and political agenda by promoting changes in companies’ environmental, social, and governance practices. These activists would like to persuade the companies to make commitments to corporate social responsibilities and also increase gender and ethnic diversity on the board of directors. These activists may be individual investors, pension funds, or mutual funds. Overseas Stock Listings Companies domiciled in countries with weak investor protection can bond themselves credibly to better investor protection by listing their stocks in countries with strong investor protection, such as the United States and the United Kingdom. In other words, foreign firms with weak governance mechanisms can opt to outsource a superior corporate governance regime available in the United States via cross-listings. Studies confirm the effects of cross-border listings. Specifically, foreign firms listed in the United States are valued more than those from the same countries that are not listed in the United States. They argue that firms listed in the United States can take better advantage of growth opportunities and that controlling shareholders cannot extract as many private benefits. Market for Corporate Control Suppose a company continually performs poorly and all of its internal governance mechanisms fail to correct the problem. This situation may prompt an outsider (another company or investor) to set up a takeover bid. In a hostile takeover attempt, the bidder typically makes a tender offer to the target shareholders at a price substantially exceeding the prevailing share price. The target shareholders thus have an opportunity to sell their shares at a substantial premium. If the bid is successful, the bidder will acquire the control rights of the target and restructure the company. Following a successful takeover, the bidder often replaces the management team, divests some assets or divisions, and reduces employment in an effort to enhance efficiency. If these efforts are successful, the combined market value of the acquirer and target companies will become higher than the sum of stand-alone values of the two companies, reflecting the synergies created. The market for corporate control, if it exists, can have a disciplinary effect on managers and enhance company efficiency. Under the potential threat of takeover, managers cannot take their control of the company for granted. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Law and Corporate Governance When outside investors entrust funds to the company, they receive certain rights that are legally protected. Among these are the rights to elect the board of directors, receive dividends on a pro-rata basis, participate in shareholders’ meetings, and sue the company for expropriation. These rights empower investors to extract from management fair returns on their funds. However, the content of law protecting investors’ rights and the quality of law enforcement vary a great deal across countries. Legal scholars show that the commercial legal systems (e.g., company, security, bankruptcy, and contract laws) of most countries derive from relatively few legal origins:  English common law  French civil law  German civil law  Scandinavian civil law These distinct legal systems, especially English common law and French civil law, spread around the world through conquest, colonization, voluntary adoption, and subtle imitation. The United Kingdom and its former colonies, including Australia, Canada, India, Malaysia, Singapore, South Africa, New Zealand, and the United States, have the English common law system. On the other hand, many former overseas colonies of France, the Netherlands, Portugal, and Spain, such as Algeria, Argentina, Brazil, Chile, Indonesia, Mexico, and the Philippines, ended up with the French civil law system. Thus, in most countries, the national legal system did not indigenously develop but rather was transplanted from one of several legal origins. Although national legal systems have evolved and adapted to local conditions, it is still possible to classify them into a few distinct families. English common law countries tend to offer the strongest protection for investors, French and German civil law countries offer the weakest, and Scandinavian civil law countries fall in the middle. The quality of law enforcement, as measured by the rule of law index, is the highest in Scandinavian and German civil law countries, followed by English common law countries; it is lowest in French civil law countries. Clearly, there is a marked difference in the legal protection of investors between the two most influential legal systems, namely, English common law and French civil law. A logical question is: Why is the English common law system more protective of investors than the French civil law system? According to the prevailing view, the state historically has played a more active role in regulating economic activities and has been less protective of property rights in civil law countries than in common law countries. Corporate Governance Reform In the wake of the Asian financial crisis of 1997–1998 and the spectacular failure of several major companies like Daewoo, Enron, WorldCom, and Parmalat, scandal-weary investors around the world are demanding corporate governance reform. The failure of these companies hurts shareholders as well as other stakeholders, including workers, customers, and suppliers. Many employees who invested heavily in company stock for their retirement were dealt severe financial blows. It is not just the companies’ internal governance mechanisms that failed; auditors, regulators, banks, and institutional investors also failed in their respective roles. Failure to reform corporate governance will damage investor confidence, stunt the development of capital markets, raise the cost of capital, distort capital allocation, and even shake confidence in capitalism itself. There is a growing consensus that corporate governance reform should be a matter of global concern. Although some countries face more serious problems than others, existing governance AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION mechanisms have failed to effectively protect outside investors in many countries. What should be the objective of reform? A simple answer is: Strengthen the protection of outside investors from expropriation by managers and controlling insiders. Among other things, reform requires:  Strengthening the independence of boards of directors with more outsiders,  enhancing the transparency and disclosure standard of financial statements, and  energizing the regulatory and monitoring functions of the SEC (in the United States) and stock exchanges. In many developing and transition countries, it may be necessary to first modernize the legal framework. However, as we have seen from the experiences of many countries, governance reform is easier said than done. First of all, the existing governance system is a product of the historical evolution of the country’s economic, legal, and political infrastructure. It is not easy to change historical legacies. Second, many parties have vested interests in the current system, and they will resist any attempt to change the status quo. To be successful, reformers should understand the political dynamics surrounding governance issues and seek help from the media, public opinion, and nongovernmental organizations (NGOs). The Sarbanes-Oxley Act Facing public uproar following the U.S. corporate scandals, politicians took actions to remedy the problem. The U.S. Congress passed the Sarbanes-Oxley Act in July 2002. The key objective of the Act is to protect investors by improving the accuracy and reliability of corporate disclosure, thereby restoring the public’s confidence in the integrity of corporate financial reporting. The major components of the Sarbanes-Oxley Act are:  Accounting regulation—The creation of a public accounting oversight board charged with overseeing the auditing of public companies, and restricting the consulting services that auditors can provide to clients.  Audit committee—Companies should appoint independent “financial experts” to the audit committees.  Internal control assessment—Public companies and their auditors should assess the effectiveness of internal control of financial record keeping and fraud prevention.  Executive responsibility—Chief executive and finance officers (CEO and CFO) must sign off on the company’s quarterly and annual financial statements. If fraud causes an overstatement of earnings, these officers must return any bonuses. The Sarbanes-Oxley Act represents one of the most important securities legislations since the original securities laws of the 1930s. As mandated by the Act, the NYSE and the NASDAQ also strengthened the listing standards by adopting various measures to protect investors. These measures call for, among other things: (i) listed companies to have boards of directors with a majority of independents; (ii) the compensation, nominating, and audit committees to be entirely composed of independent directors; and (iii) the publication of corporate governance guidelines and reporting of annual evaluation of the board and CEO. These measures, if properly implemented, should improve the corporate governance regime in the United States. The Dodd-Frank Act Following the subprime mortgage crisis and the bailout of large financial institutions with taxpayers’ money, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. Among other things, the act aims at strengthening government regulation of banking firms and their internal governance mechanisms, thereby preventing similar financial crises in the future. The act represents the most comprehensive overhaul of the rules of finance since the Great AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Depression and is likely to have a major impact on the way decisions are made within financial firms. The key features of the Dodd-Frank Act include:  Volker rule—Deposit-taking banks will be banned from proprietary trading and from owning more than a small fraction of hedge funds and private equity firms. The rule is named after Paul Volker, former Federal Reserve chairman, who argued that banks should not be allowed to engage in casino-like activities that endanger the safety of depositors’ money.  Resolution authority—The government can seize and dismantle a large bank in an orderly manner if the bank faces impending failure and poses a systemic risk to the broader financial system. This authority aims, in part, to reduce the cost and risk associated with the bailing out of banks that are “too big to fail.” Banks that are deemed too big to fail can have skewed incentives for excessive risk-taking. Shareholders at big firms get nonbinding votes on executive pay and golden parachutes, to control skewed executive incentives.  Derivative securities—Derivatives trading in over-the-counter markets will be transferred to electronic exchanges, with contracts settled through central clearing houses, to increase transparency and reduce counterparty risk.  Systemic risk regulation—A Financial Stability Oversight Council of government regulators chaired by the Treasury secretary will identify systemically important financial firms and monitor their activities and financial conditions. These firms must draw up a “living will” to describe how they would be liquidated if they fail.  Consumer protection—A new, independent Consumer Financial Protection Bureau will monitor predatory mortgage loans and other loan products. In May 2018, however, the U.S. Congress passed a new law, the Economic Growth, Regulatory Relief, and Consumer Protection Act, that significantly weakened the Dodd-Frank Act. Most importantly, the 2018 act raises the asset threshold for application of Dodd-Frank’s enhanced prudential standards from $50 billion to $250 billion, exempting most small and mid-sized banks and bank holding companies from stress testing and heightened risk management requirements. From these discussion, it is noted that corporate governance reforms would not only strengthen shareholders’ cash flow rights but also enhance corporate performance. Studies show that enhancement of corporate governance would improve firm performance, boost firm value, and raise stock returns. Specifically, corporate valuation is directly related to the quality of corporate governance, as well as the economic growth options and the degree of financial openness. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION TOPIC 4: MANAGEMENT OF FOREIGN EXCHANGE TRANSACTION EXPOSURE Learning Outcomes Once you are done with this lesson you should be able to:  Define what transaction exposure is.  Explain why or how a firm should use hedging in managing foreign exchange exposure.  Understand how financial contracts, as well as operational techniques, can be used to hedge transaction exposure. Transaction exposure can be defined as the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Therefore, it is about how the amount of money the firm owes in foreign currency (or expects to receive in foreign currency) in the future changes due to exchange rate movements. This is a significant risk that MNCs, especially exporters and importers, face. Since settlements of these contractual cash flows affect the firm’s domestic currency cash flows, transaction exposure is sometimes regarded as a short-term economic exposure. To illustrate, suppose that a U.S. firm sold its product to a German client on three-month credit terms with the amount of €1 million. When the U.S. firm receives €1 million in three months, assuming that the firm does not enter into a hedge, it will have to convert the euros into dollars at the spot exchange rate prevailing on the maturity date, which cannot be known in advance. As a result, the dollar receipt from this foreign sale becomes uncertain; should the euro appreciate (depreciate) against the dollar, the dollar receipt will be higher (lower). This situation implies that if the firm does nothing about the exposure, it is effectively speculating on the future course of the exchange rate. In view of the fact that firms, especially MNCs, are now more frequently entering into commercial and financial contracts denominated in foreign currencies, cautious management of transaction exposure has become an important function of international financial management. Note that the magnitude of transaction exposure is the same as the amount of foreign currency that is receivable or payable. Should the Firm Hedge? Various market imperfections can be looked at, for a firm to consider hedging as a means to manage corporate exposure risk. 1. Information asymmetry: Management knows about the firm’s exposure position much better than stockholders. Thus, the management of the firm, not its stockholders, should manage exchange exposure. 2. Differential transaction costs: The firm is in a position to acquire low-cost hedges; transaction costs for individual stockholders can be substantial. 3. Default costs: If default costs are significant, corporate hedging would be justifiable because it will reduce the probability of default. Perception of a reduced default risk, in turn, can lead to a better credit rating and lower financing costs. 4. Progressive corporate taxes: Under progressive corporate tax rates, stable before-tax earnings lead to lower corporate taxes than volatile earnings with the same average value. This happens because under progressive tax rates, the firm pays more taxes in high-earning periods than it saves in low-earning periods While not every firm is hedging exchange exposure, many firms are engaged in hedging activities, suggesting that corporate risk management is relevant to maximizing the firm’s value. To the extent AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION that for various reasons, stockholders themselves cannot properly manage exchange risk, the firm’s managers can do it for them, contributing to the firm’s value. Hedging Foreign Currency Receivables To help better understand how to manage transaction exposure, we will use as an example a particular business situation. Suppose that Boeing Corporation (a U.S. company) exported a landing gear of a Boeing 737 aircraft to British Airways and billed £10 million payable in one year. Note that £ is the sign for British pound sterling or GBP. The money market interest rates and foreign exchange rates are given as follows:  The U.S. interest rate: 6.10% per annum  The U.K. interest rate: 9.00% per annum  The spot exchange rate: $1.50/£  The forward exchange rate: $1.46/£ (1-year maturity) When Boeing receives £10 million in one year, it will convert the pounds into dollars at the spot exchange rate prevailing at the time. Since the future spot rate is unknown today, the dollar proceeds from this foreign sale is uncertain unless Boeing hedges. Various techniques for managing this transaction exposure can be used. Forward Market Hedge Considered the most direct and popular way of hedging transaction exposure is by currency forward contracts. Here the firm may sell (buy) its foreign currency receivables (payables) forward to eliminate its exchange risk exposure. In the presented data in the above example, in order to hedge foreign exchange exposure, Boeing may simply sell forward its pounds receivable, £10 million for delivery in one year, in exchange for a given amount of U.S. dollars. On the maturity date of the contract, Boeing will have to deliver £10 million to the bank, which is the counterparty of the contract, and, in return, take delivery of $14.6 million ($1.46/£ × £10 million), regardless of the spot exchange rate that may prevail on the maturity date. Boeing will, of course, use the £10 million that it is going to receive from British Airways to fulfill the forward contract. Since Boeing’s pound receivable is exactly offset by the pound payable (created by the forward contract), the company’s net pound exposure becomes zero. Since Boeing is assured of receiving a given dollar amount, $14.6 million, from the counterparty of the forward contract, the dollar proceeds from this British sale will not be affected at all by future changes in the exchange rate. Once Boeing enters into the forward contract, exchange rate uncertainty becomes irrelevant for Boeing. One question now is how the dollar proceeds from the British sale will be affected by the future spot exchange rate when exchange exposure is not hedged. If the future spot exchange rate turns out to be less that the forward rate, the dollar proceeds under the forward hedge will be higher than those under the unhedged position. The opposite will hold if the future spot rate becomes higher than the forward rate; in this case, Boeing forgoes an opportunity to benefit from a strong pound. No one can know for sure what the future spot rate will be beforehand. To help the firm decide, it is useful to consider the following three alternative scenarios:  Spot rate on maturity date = Forward exchange rate  Spot rate on maturity date < Forward exchange rate  Spot rate on maturity date > Forward exchange rate AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Under the first scenario, the “expected” gains or losses are approximately zero. But forward hedging eliminates exchange exposure. Under this scenario the firm would be inclined to hedge as long as it is averse to risk. Under the second scenario, the firm expects a positive gain from forward hedging. Lastly, under the third scenario, the firm can eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds from the foreign sale. Thus, the firm would be less inclined to hedge under this scenario, other things being equal. Despite lower expected dollar proceeds, however, the firm may still end up hedging. Whether the firm actually hedges or not depends on the degree of risk aversion; the more risk averse the firm is, the more likely it is to hedge. From the perspective of a hedging firm, the reduction in the expected dollar proceeds can be viewed implicitly as an “insurance premium” paid for avoiding the hazard of exchange risk. Money Market Hedge Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign money markets. Generally speaking, the firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency. Using the same example presented above, Boeing can eliminate the exchange exposure arising from the British sale by first borrowing in pounds, then converting the loan proceeds into dollars, which then can be invested at the dollar interest rate. On the maturity date of the loan, Boeing is going to use the pound receivable to pay off the pound loan. If Boeing borrows a particular pound amount so that the maturity value of this loan becomes exactly equal to the pound receivable from the British sale, Boeing’s net pound exposure is reduced to zero, and Boeing will receive the future maturity value of the dollar investment. The first important step in money market hedging is to determine the amount of pounds to borrow. This means that the maturity value of borrowing should be the same as the pound receivable. The step-by-step procedure of money market hedging can be illustrated as follows: Step 1: Borrow £9,174,312. This is the computed present value of the pound receivable after 1 year, that is, £10 million ∕ 1.09. From our example, remember that the U.K. interest rate: 9.00% per annum. Step 2: Convert £9,174,312 into $13,761,468 at the current spot exchange rate of $1.50/£. Step 3: Invest $13,761,468 in the United States. Step 4: After one year, collect £10 million from British Airways and use it to repay the pound loan. Step 5: Receive the maturity value of the dollar investment, that is, $14,600,918 = $13,761,468×1.061, noting from our example that the U.S. interest rate: 6.10% per annum. $14,600,918 is the guaranteed dollar proceeds from the British sale. Analyzing the cash flow of money market hedging, the net cash flow is zero at the present time, implying that, apart from possible transaction costs, the money market hedge is fully self-financing. At maturity date, the £10 million receivable is exactly offset by the £10 million payable (created by borrowing), leaving a net cash flow of $14,600,918 on the maturity date. Options Market Hedge One possible shortcoming of both forward and money market hedges is that in these methods the firm has to forgo the opportunity to benefit from favorable exchange rate changes. In our example, with its pound receivable, Boeing ideally would like to protect itself only if the pound weakens, while retaining the opportunity to benefit if the pound strengthens. Currency options provide such a flexible “optional” hedge against exchange exposure. Generally speaking, the firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables). AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION A currency call option gives the holder the right, but not the obligation, to buy a certain amount of a foreign currency at a specific exchange rate up to or at the maturity date. On the other hand, a currency put option gives the holder the right, but not the obligation, to sell a certain amount of a foreign currency at a specific exchange rate again up to or at the maturity date. Price of call or put options that option buyers have to pay is called premium. To show how the options hedge works, suppose that in the over-the-counter market Boeing purchased a put option on £10 million with an exercise price of $1.46/£ and a one-year expiration. Assume that the option premium (price) was $0.02 per pound. Boeing thus paid $200,000, computed $0.02 × 10 million for the option. This transaction provides Boeing with the right, but not the obligation, to sell up to £10 million for $l.46/£, regardless of the future spot rate. Now assume that the spot exchange rate turns out to be $1.30 on the expiration date. Since Boeing has the right to sell each pound for $1.46, it will certainly exercise its put option on the pound and convert £10 million into $14.6 million. The main advantage of options hedging is that the firm can decide whether to exercise the option based on the realized spot exchange rate on the expiration date. Recall that Boeing paid $200,000 upfront for the option. Considering the time value of money to compute for the net dollar proceeds, this upfront cost is equivalent to $212,200, calculated $200,000 × 1.061, as of the expiration date. This means that under the options hedge, the net dollar proceeds from the British sale become $14,387,800, that is $14,600,000 − $212,200. Since Boeing is going to exercise its put option on the pound whenever the future spot exchange rate falls below the exercise rate of $1.46, it is assured of a “minimum” dollar receipt of $14,387,800 from the British sale. Now, consider an alternative scenario where the pound appreciates against the dollar. Assume that the spot rate turns out to be $1.60 per pound on the expiration date. In this event, Boeing would have no incentive to exercise the option. It will rather let the option expire and convert £10 million into $16 million at the spot rate in the market on option maturity date. Subtracting $212,200 for the option cost, the net dollar proceeds will become $15,787,800 under the option hedge. As suggested by these scenarios, the options hedge allows the firm to limit the downside risk while preserving the upside potential. The firm, however, has to pay for this flexibility in terms of the option premium. To summarize the hedging strategies for a foreign currency receivable, using the Boeing example, please see the table below: AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Hedging Foreign Currency Payables Suppose Boeing imported a Rolls-Royce jet engine for £5 million payable in one year. The market condition is summarized as follows:  The U.S. interest rate: 6.00% per annum  The U.K. interest rate: 6.50% per annum  The spot exchange rate: $1.80/£  The forward exchange rate: $1.75/£ (1-year maturity) Given exchange rate fluctuations, Boeing is concerned about the future dollar cost of this purchase. Facing an account payable, Boeing will have to try to minimize the dollar cost of paying off the payable. Forward Market Hedge If Boeing decides to hedge this payable exposure using a forward contract, it only needs to buy £5 million forward in exchange for the following dollar amount: £5,000,000 × $1.75/£ = $8,750,000 On the maturity date of the forward contract, Boeing will receive £5,000,000 from the counterparty of the forward contract in exchange for $8,750,000. Boeing then can use £5,000,000 to make payment to Rolls-Royce. Since Boeing will have £5,000,000 for sure in exchange for a given dollar amount, that is, $8,750,000, regardless of the spot exchange rate that may prevail in one year, Boeing’s foreign currency payable is fully hedged. Money Market Hedge In the case where the firm has an account payable denominated in pounds, this calls for borrowing in dollars, buying pounds spot, and investing at the pound interest rate. First, Boeing needs to compute for the present value of its foreign currency payable, that is, £5,000,000 ∕ 1.065 = £4,694,836. This is the pound amount Boeing will invest at the U.K. interest rate of 6.5 percent per annum, so that they can be assured of receiving £5 million after one year. Since Boeing has no pounds, and they can only borrow in USD, they need to know the conversion of pound to dollar, that is, £4,694,836 × $1.80/£ = $8,450,705. This is the dollar amount Boeing needs to borrow today in order for them to convert to pound, which they need to invest. The future value of this dollar cost of buying the necessary pound amount is computed using the U.S. interest rate, that is, $8,450,705 × 1.06 = $8,957,747. This is the guaranteed dollar cost of the foreign purchase with the money market hedge, regardless of future spot rate. Note that there is no currency position at present, since the dollar Boeing borrowed was converted to pound; and the pound received from the conversion was invested. Options Market Hedge If Boeing decides to use a currency options contract to hedge its pound payable, it needs to buy “call” options on £5,000,000 because Boeing needs to acquire pounds in order to deliver them to Rolls-Royce after 1 year. Assuming that Boeing chooses the exercise price at $1.80/£ with the premium of $0.018 per pound. The total cost of options as of the maturity date (considering the time value of money) then can be computed as: £5,000,000 × $0.018/£ × 1.06 = $95,400. If the British pound appreciates against the dollar beyond $1.80/£, the strike price of the options contract, Boeing will choose to exercise its options and purchase £5,000,000 for $9,000,000 = £5,000,000 × $1.80/£. If the spot rate on the maturity date turns out to be below the strike price, on the other hand, Boeing will let the option expire and purchase the pound amount in the spot market. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION To summarize the hedging strategies for a foreign currency payable, using the Boeing example, please see the table below: Cross-Hedging Minor Currency Exposure If a firm has receivables or payables in major currencies such as the British pound, euro, and Japanese yen, it can easily use forward, money market, or options contracts to manage its exchange risk exposure. In contrast, if the firm has positions in less liquid currencies it may be either very costly or impossible to use financial contracts in these currencies. This is because financial markets of developing countries are relatively underdeveloped and often highly regulated. Facing this situation, the firm may consider using cross-hedging techniques to manage its minor currency exposure. Cross-hedging involves hedging a position in one asset by taking a position in another asset. Suppose a U.S. firm has an account receivable in Korean won and would like to hedge its won position. If there were a well-functioning forward market in won, the firm would simply sell the won receivable forward. But the firm finds it costly to do so. However, since the won/dollar exchange rate is highly correlated with the yen/dollar exchange rate, the U.S. firm may sell a yen amount, which is equivalent to the won receivable, forward against the dollar thereby cross-hedging its won exposure. Obviously, the effectiveness of this cross-hedging technique would depend on the stability and strength of the won/yen correlation. Hedging Contingent Exposure In addition to providing a flexible hedge against exchange exposure, options contracts can also provide an effective hedge against what might be called contingent exposure. Contingent exposure refers to a situation in which the firm may or may not be subject to exchange exposure. Suppose General Electric (GE) is bidding on a hydroelectric project in Quebec Province, Canada. If the bid is accepted, which will be known in three months, GE is going to receive C$100 million to initiate the project. Since GE may or may not face exchange exposure depending on whether its bid will be accepted, it faces a typical contingent exposure situation. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION It is difficult to deal with contingent exposure using traditional hedging tools like forward contracts. An alternative approach is to buy a three-month put option on C$100 million. In this case, there are four possible outcomes: 1. The bid is accepted and the spot exchange rate turns out to be less than the exercise rate: In this case, the firm will simply exercise the put option and convert C$100 million at the exercise rate. 2. The bid is accepted and the spot exchange rate turns out to be greater than the exercise rate: In this case, the firm will let the put option expire and convert C$100 million at the spot rate. 3. The bid is rejected and the spot exchange rate turns out to be less than the exercise rate: In this case, although the firm does not have Canadian dollars, it will exercise the put option and make a profit. 4. The bid is rejected and the spot rate turns out to be greater than the exercise rate: In this case, the firm will simply let the put option expire. The above scenarios indicate that when the put option is purchased, each outcome is adequately covered; the firm will not be left with an unhedged foreign currency position. Again, it is stressed that the firm has to pay the option premium upfront. Hedging Recurrent Exposure with Swap Contracts Firms often have to deal with a “sequence” of accounts payable or receivable in terms of a foreign currency. Such recurrent cash flows in a foreign currency can best be hedged using a currency swap contract, which is an agreement to exchange one currency for another at a predetermined exchange rate, that is, the swap rate, on a sequence of future dates. Suppose that Boeing is scheduled to deliver an aircraft to British Airways at the beginning of each year for the next five years, starting in 2020. British Airways, in turn, is scheduled to pay £100,000,000 to Boeing on December 1 of each year for five years, starting in 2020. In this case, Boeing faces a sequence of exchange risk exposures. Boeing can hedge this type of exposure using a swap agreement by which Boeing delivers £100,000,000 to the counterparty of the contract on December 1 of each year for five years and receives a predetermined dollar amount each year. If the agreed swap exchange rate is $1.50/£, then Boeing will receive $150 million each year, regardless of the future spot and forward rates. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION TOPIC 5: MANAGEMENT OF FOREIGN EXCHANGE ECONOMIC EXPOSURE Learning Outcomes Once you are done with this lesson you should be able to:  Understand economic exposure, and how it can be measured.  Explain what operating exposure is.  Discuss how to properly manage operating exposure. As the business environment becomes increasingly global, more and more firms find it necessary to pay careful attention to foreign exchange exposure and to design and implement appropriate hedging strategies. For example, suppose the U.S. dollar substantially depreciates against the Japanese yen. This change in the exchange rate can have significant economic consequences for both U.S. and Japanese firms. It can adversely affect the competitive position of Japanese car makers in the highly competitive U.S. market by forcing them to raise dollar prices of their cars by more than their U.S. competitors do. In other words, depreciation of the U.S. dollar against the yen would strengthen the competitive position of U.S. car makers at the expense of Japanese car makers. On the other hand, if the yen depreciates against the dollar, it would help the sales and profits of Japanese car makers. The same change in the exchange rate, however, will tend to weaken the competitive position of import-competing U.S. car makers. Changes in exchange rates can affect not only firms that are directly engaged in international trade but also purely domestic firms. Though a domestic company does not have any foreign-currency receivables or payables, but competes with a company (offering the same product) importing from abroad, then the local company may be hurt when the currency related to the importing competitor depreciates against the local currency. This means that the competitor can buy the imported product at a cheaper price, and then offer lower-priced to local customers. Changes in exchange rates may affect not only the operating cash flows of a firm by altering its competitive position but also the home currency values of the firm’s assets and liabilities. How to Measure Economic Exposure Currency risk or uncertainty, which represents random changes in exchange rates, is not the same as the currency exposure, which measures “what is at risk.” Under certain conditions, a firm may not face any exposure at all—that is, nothing is at risk, even if the exchange rates change randomly. Exposure to currency risk thus can be properly measured by the sensitivities of (i) the future home currency values of the firm’s assets (and liabilities) and (ii) the firm’s operating cash flows to random changes in exchange rates. Let us first look at asset exposure. Suppose a U.S. firm owns an asset in Britain. From the perspective of the U.S. firm, the exposure can be measured by the coefficient (b) in regressing the dollar value (P) of the British asset on the dollar/pound exchange rate (S). Presented with the equation, P = a + b × S + e where a is the regression constant and e is the random error term with mean zero, that is, E(e) = 0; P = SP*, where P* is the local currency (pound) price of the asset. From the above equation, the regression coefficient b measures the sensitivity of the dollar value of the asset (P) to the exchange rate (S). If the regression coefficient is zero, that is, b = 0, the dollar AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION value of the asset is independent of exchange rate movements, implying no exposure. On the basis of the above analysis, one can say that exposure is the regression coefficient. Statistically, the exposure coefficient, b, is defined as follows: where Cov(P,S) is the covariance between the dollar value of the asset and the exchange rate, and Var(S) is the variance of the exchange rate. Suppose that a U.S. firm has an asset in Britain whose local currency price is random. For simplicity, let us assume that there are three possible states of the world, with each state equally likely to occur. The future local currency price of this British asset as well as the future exchange rate will be determined, depending on the realized state of the world. First, consider Case 1, described in the table below. Case 1 indicates that the local currency price of the asset (P*) and the dollar price of the pound (S) are positively correlated, so that depreciation (appreciation) of the pound against the dollar is associated with a declining (rising) local currency price of the asset. The dollar price of the asset on the future (liquidation) date can be $1,372, or $1,500 or $1,712, depending on the realized state of the world. When we compute the parameter values for Case 1, we obtain Cov(P,S) = 34/3, Var(S) = 0.02/3, and thus b = £1,700. This pound amount, £1,700, represents the sensitivity of the future dollar value of the British asset to random changes in exchange rate. This finding implies that the U.S. firm faces a substantial exposure to currency risk. Note that the magnitude of the exposure is expressed in British pounds. For illustration, the computations of the parameter values for Case 1 are shown below: AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Next, consider Case 2. This case indicates that the local currency value of the asset is clearly negatively correlated with the dollar price of the British pound. In fact, the effect of exchange rate changes is exactly offset by movements of the local currency price of the asset, rendering the dollar price of the asset totally insensitive to exchange rate changes. The future dollar price of the asset will be uniformly $1,400 across the three states of the world. Although this case may be unrealistic, it shows that uncertain exchange rates or exchange risk does not necessarily constitute exchange exposure. Despite the fact that the future exchange rate is uncertain, the U.S. firm has nothing at risk in this case. Since the firm faces no exposure, no hedging will be necessary. For Case 3, the local currency price of the asset is fixed at £1,000. In this case, the U.S. firm faces a “contractual” cash flow that is denominated in pounds. This case, in fact, represents an example of the special case of economic exposure, transaction exposure. Intuitively, what is at risk is £1,000, that is, the exposure coefficient, b, is £1,000. Measurement of transaction exposure is thus very simple. The exposure coefficient, b, is the same as the magnitude of the contractual cash flow fixed in terms of foreign currency. Operating Exposure As the economy becomes increasingly globalized, more firms are subject to international competition. Fluctuating exchange rates can seriously alter the relative competitive positions of such firms in domestic and foreign markets, affecting their operating cash flows. Unlike the exposure of assets and liabilities (such as accounts payable and receivable, loans denominated in foreign currencies, and so forth) that are listed in accounting statements, the exposure of operating cash flows depends on the effect of random exchange rate changes on the firm’s competitive position, which is not readily measurable. This difficulty notwithstanding, it is important for the firm to properly manage operating exposure as well as asset exposure. In many cases, operating exposure may account for a larger portion of the firm’s total exposure than contractual exposure. Formally, operating exposure can be defined as the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates. Suppose that a U.S. computer company has a wholly owned British subsidiary, Albion Computers PLC, that manufactures and sells personal computers in the U.K. market. Albion Computers imports microprocessors from Intel. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION Consider the possible effect of a depreciation of the pound on the projected dollar operating cash flow of Albion Computers. Assume that the pound may depreciate from $1.60 to $1.40 per pound. The dollar operating cash flow may change following a pound depreciation due to: 1. The competitive effect: A pound depreciation may affect operating cash flow in pounds by altering the firm’s competitive position in the marketplace. 2. The conversion effect: A given operating cash flow in pounds will be converted into a lower dollar amount after the pound depreciation. Determinants of Operating Exposure Unlike contractual (i.e., transaction) exposure, which can readily be determined from the firm’s accounting statements, operating exposure cannot be determined in the same manner. A firm’s operating exposure is determined by (i) the structure of the markets in which the firm sources its inputs, such as labor and materials, and sells its products, and (ii) the firm’s ability to mitigate the effect of exchange rate changes by adjusting its markets, product mix, and sourcing. Generally speaking, a firm is subject to high degrees of operating exposure when either its cost or its price is sensitive to exchange rate changes. On the other hand, when both the cost and the price are sensitive or insensitive to exchange rate changes, the firm has no major operating exposure. Given the market structure, however, the extent to which a firm is subject to operating exposure depends on the firm’s ability to stabilize cash flows in the face of exchange rate changes. In other words, the firm’s flexibility regarding production locations, sourcing, and financial hedging strategy is an important determinant of its operating exposure to exchange risk. It would also be useful to examine the relationship between exchange rate changes and the price adjustments of goods. Facing exchange rate changes, a firm may choose one of the following three pricing strategies: (i) pass the cost shock fully to its selling prices (complete pass-through), (ii) fully absorb the shock to keep its selling prices unaltered (no pass-through), or (iii) do some combination of the two strategies described above (partial pass-through). Managing Operating Exposure As the economy becomes increasingly globalized, many firms are engaged in international activities such as exports, cross-border sourcing, joint ventures with foreign partners, and establishing production and sales affiliates abroad. The cash flows of such firms can be quite sensitive to exchange rate changes. The objective of managing operating exposure is to stabilize cash flows in the face of fluctuating exchange rates. Since a firm is exposed to exchange risk mainly through the effect of exchange rate changes on its competitive position, it is important to consider exchange exposure management in the context of the firm’s long-term strategic planning. Managing operating exposure is thus not a short-term tactical issue. The firm can use the following strategies for managing operating exposure: 1. Selecting low-cost production sites. When the domestic currency is strong or expected to become strong, eroding the competitive position of the firm, it can choose to locate production facilities in a foreign country where costs are low due to either the undervalued currency or underpriced factors of production. Also, the firm can choose to establish and maintain production facilities in multiple countries to deal with the effect of exchange rate changes. Maintaining multiple manufacturing sites, however, may prevent the firm from taking advantage of economies of scale, raising its cost of production. The resultant higher cost can partially offset the advantages of maintaining multiple production sites. AD USUM PRIVATUM STUDENTIUM DR. YANGA’S COLLEGES, INC. COLLEGE OF BUSINESS ADMINISTRATION 2. Flexible sourcing policy. Even if the firm has manufacturing facilities only in the domestic country, it can substantially lessen the effect of exchange rate changes by sourcing from where input costs are low. A flexible sourcing policy need not be confined just to materials and parts. Firms can also hire low-cost guest workers from foreign countries instead of high-cost domestic workers in order to be competitive. 3. Diversification of the market. As long as exchange rates do not always move in the same direction, the firm can stabilize its operating cash flows by diversifying its expor

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