Unit-3_International_Finance(Compiled).pptx

This is the compilation of International finance unit 3.

1. International Unit – 3 Finance BMS – 3B

2. Forex Exposure, Alternative Currency Translation Methods, Standard No.8 & 52 Deepak Jaiswal (21052) Harshil Rana (21080) BMS – 3B

3. Part of syllabus covered Foreign Exchange Exposures Alternative Currency Translation Methods, Standards No.8, Standards No.-52 Contents

4. Foreign Exchange Exposure & Global Companies Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure "Exposure" refers to the state of being subjected to or affected by something . It implies being in a position where one is vulnerable to certain risks, influences, or experiences. As business becomes international, firms are exposed to the risk of fluctuating exchange rates. This is known as "Foreign Exchange Exposure" Essentially, it is the risk that a foreign currency may move in a direction which is financially detrimental to the global firm. Thus, firms must assess and manage their foreign exchange exposures. Cash Flow of the Firm How changes in Forex Rates impacts a Global firm Settlement of Contracts Global Competitive Position Consolidated Statements

5. Foreign currency exposure is classified into three types : 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. Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. Any anticipated changes in exchange rates would have been already discounted and reflected in the firm’s value. Translation exposure refers to the potential that the firm’s consolidated financial statements can be affected by changes in exchange rates as consolidation involves translation of subsidiaries’ financial statements from local currencies to the home currency. Transaction exposure Economic exposure Translation exposure Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure Types of Foreign Exchange Exposure

6. Introduction to Transaction Exposure: Understanding need, Issues and methods Sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Transaction exposure arises from fixed-price contracting in a world of constantly changing exchange rates. Examples of Transaction exposure: •An Account Receivable denominate in a foreign currency. •A maturing financial asset (e.g., a bond) denominated in a foreign currency. •An Account Payable denominate in a foreign currency. •A maturing financial liability (e.g., a loan) denominated in a foreign currency. Transaction Exposure Reason for Transaction Exposure Management of Transaction Exposure Forward Market Hedge Money Market Hedge Options Market Hedge Swap Market Hedge Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure

7. Introduction to Translation Exposure: Understanding need, Issues and methods Potential that the firm’s consolidated financial statements can be affected by changes in exchange rates Because home country investors would be interested in home currency values , the foreign currency balance sheet accounts and income statements must be assigned home currency values  The financial statements of an MNC's overseas subsidiaries must be translated from local currency to home currency prior to consolidation with the parent's financial statements. If currency values change, foreign exchange translation gains or losses may result. Assets and liabilities that are translated at the current (post change) exchange rate are considered to be exposed Translation exposure is simply the difference between exposed assets and exposed liabilities Translation Exposure (Accounting Exposure) Need for Translation Exposure to changes in exchange rate Methods of translation Current/ Non-Current Method Monetary/ Non-Monetary  Temporal Method Current Rate Method Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure

8. Alternative Currency Translation Methods Current/ Non-Current Method Average of exchange rate BALANCE SHEET as on… Income Statement for the period… ASSETS LIABILITIES Current Assets Non-Current Assets Non-Current Liabilities Current Liabilities Current Rate Historical Rate R evenue and expense items that are associated with noncurrent assets or liabilities are translated at the historical rate Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure

9. Monetary/ Non-Monetary Method of Translation Average of exchange rate BALANCE SHEET as on… Income Statement for the period… ASSETS LIABILITIES Monetary Assets Non-Monetary Assets Non-Monetary Liabilities Monetary Liabilities Current Rate Historical Rate R evenue and expense items that are associated with non monetary assets or liabilities are translated at the historical rate Alternative Currency Translation Methods Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure

10. Temporal Method Modified Version of Monetary/ Non-Monetary Method Monetary Items: Current Rate Other Items: If carried at historical cost: Historical Rate If at current value in books: Current Rate Current Rate Method All Balance sheet items translated in current rate* Income statement items are to be translated at the exchange rate at the dates the items are recognized Alternative Currency Translation Methods Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure *Except for the common stock which is translated in historical rate

11. Alternative currency Translation method BALANCE SHEET Current/Non-Current Method Monetary/Non-Monetary Method Temporal Method                  Current Rate Method Cash Current Rate Current Rate Current Rate Current Rate Inventory Current Rate Historical Rate Current Rate Net Fixed Assets Historical Rate Historical Rate Historical Rate Current Rate Total Assets Current Liabilities Current Rate Current Rate Current Rate Current Rate Long Term Debt Historical Rate Current Rate Current Rate Current Rate Common Stock Historical Rate Historical Rate Historical Rate Historical Rate Retained Earning {Balancing Figure} Total Liabilities and equity INCOME STATEMENT Sales Average Average Average Average COGS Average Historical Rate Average Average Depreciation Historical Rate Historical Rate Historical Rate Historical Rate Net Operating Income Income Tax PAT Foreign exchange gains and loss Net Income Dividend Additional Retained Earnings Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure

12. Past Year question on alternative currency Translation method 2022 Q4(1) BALANCE SHEET Local Currency Cash $ 225.00 Inventory $ 325.00 Net Fixed Assets $ 3,450.00 Total Assets $ 4,000.00 Current Liabilities $ 425.00 Long Term Debt $ 1,085.00 Common Stock $ 2,000.00 Retained Earning $ 490.00 Total Liabilities and equity $ 4,000.00     INCOME STATEMENT   Sales $ 3,400.00 COGS $ 2,050.00 Depreciation $ 650.00 Net Operating Income $ 700.00 Income Tax $ 210.00 PAT $ 490.00 Foreign exchange gains and loss $ - Net Income $ 490.00 Dividend $ - Additional Retained Earnings $ 490.00 Note: Current Value of Inventory is $350 Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure

13. Past Year question on alternative methods of translation 2022 Q4(1) Introduction Translation Methods FAS 8 FAS 52 Types Of Exposure

14. Financial Accounting Standard FAS-8: Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements Need: wide variation in the results reported under different methods of translation Introduce: FASB 8 became effective on January 1, 1976. measure in dollars an enterprise’s assets, liabilities, revenues, or expenses that are denominated in a foreign currency according to generally accepted accounting principles Objective: Scope: Standard for reporting foreign currency transactions Standard for translating foreign currency Financial statements Features: Its principal virtue was its consistency with generally accepted accounting practice that requires balance sheet items to be valued (translated) according to their underlying measurement basis (that is, current or historical). Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

15. Financial Accounting Standard-8 FAS-8: Accounting for the Translation of Foreign Currency Transactions and Foreign Currency Financial Statements Based on: FASB 8 is essentially the temporal method of translation There are some subtleties e.g. According to the temporal method, revenues and expenses are to be measured at the average exchange rate for the period. In practice, MNCs prepare monthly statements. What is done is to cumulate the monthly figures to obtain the total for the year. Foreign Currency Transactions Foreign Currency Financial Statements At transaction date: Record at dollar amount using rate effective on that date At Balance Sheet date: Balances representing cash and amounts owed by or to Current Rate Assets at market price Current Rate Assets at book value Historical Rate Prepare according to USA GAAP Accounts carried at past prices: Accounts carried at current prices: Historical Rate Current Rate Revenue and expenses not related to balance sheet Average Rate Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

16. Financial Accounting Standard-8 This Statement requires that all amounts measured in a foreign currency be translated at the exchange rate in effect at the date at which the foreign currency transaction was measured. All exchange gains and losses were required to be included in income in the period in which they arose, i.e., when the rates changed Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

17. Issues in FAS-8 and introduction to FAS-52 Acceptance Problems faced by FAS-8 Reported earnings could, and did, fluctuate substantially from year to year, which was irritating to corporate executives MNCs did not like translating inventory at historical rates, which was required if the firm carried the inventory at historical values, as most did, and do. BALANCE SHEET as on… Income Statement for the period… ASSETS LIABILITIES Revenue Non Current Liabilities Current Liabilities Equity Non Current Assets Current Assets 1000 200 800 1500 500 1000 Expense 600 Profit 400 Exposure Gain/Loss Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

18. Issues in FAS-8 and introduction to FAS-52 Acceptance Problems faced by FAS-8 Issuing FAS-52 to supersede FAS-8 Reported earnings could, and did, fluctuate substantially from year to year, which was irritating to corporate executives MNCs did not like translating inventory at historical rates, which was required if the firm carried the inventory at historical values, as most did, and do. In February 1979, a task force was established with representatives of the board, the International Accounting Standards Committee FASB-52 was issued in December 1981, and all U.S. MNCs were required to adopt the statement for fiscal years beginning on or after December 15, 1982. Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

19. Issues in FAS-8 and introduction to FAS-52 Acceptance Problems faced by FAS-8 Issuing FAS-52 to supersede FAS-8 Objectives of FAS-52 Reported earnings could, and did, fluctuate substantially from year to year, which was irritating to corporate executives MNCs did not like translating inventory at historical rates, which was required if the firm carried the inventory at historical values, as most did, and do. In February 1979, a task force was established with representatives of the board, the International Accounting Standards Committee FASB-52 was issued in December 1981, and all U.S. MNCs were required to adopt the statement for fiscal years beginning on or after December 15, 1982. Provide information that is generally compatible with the expected economic effects of a rate change on an enterprise’s cash flows and equity Reflect in consolidated statements the financial results and relationships of the individual consolidated entities as measured in their functional currencies in conformity with U.S. generally accepted accounting principles Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

20. Mechanism of FASB-52 Identifying the functional currency of the entity's economic environment Measuring all elements of the financial statements in the functional currency Using the current exchange rate for translation from the functional currency to the reporting currency, if they are different Distinguishing the economic impact of changes in exchange rates on a net investment from the impact of such changes on individual assets and liabilities that are receivable or payable in currencies other than the functional currency The currency of the primary economic environment in which the entity operates Functional Currency Reporting Currency currency in which the MNC prepares its consolidated financial statements. That currency is usually the currency in which the parent firm keeps its books Process Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

21. Mechanism of FASB-52 The currency of the primary economic environment in which the entity operates Functional Currency Reporting Currency currency in which the MNC prepares its consolidated financial statements. That currency is usually the currency in which the parent firm keeps its books Translation in FAS-52 is a Two Step Process and requires Identification of: Salient Features of Functional Currency Cash Flow Indicator Sales Price Indicator Sales Market Indicator Expense Indicator Financing Indicator Cash Flow Indicator Rationale behind using of Functional Currency Prevent large important balance sheet accounts, carried at historical values, from having insignificant values once translated into the reporting currency at the current rate In highly inflationary economies, FASB 52 requires that the foreign entity’s financial statements be remeasured from the local currency Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

22. Illustration: Consolidation of Financial Statements using FAS-52 Information available Exchange Rates: The parent firm is owed Ps3,000,000 by the Mexican affiliate. This sum is included in the parent’s accounts receivable as $300,000. The remainder of the parent’s (Mexican affiliate’s) accounts receivable (payable) is denominated in dollars (pesos) The Mexican affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $2,200,000. This represents the sum of the common stock (Ps16,000,000) and retained earnings (Ps6,000,000) on the Mexican affiliate’s books, translated at Ps10.00/$1.00. The Spanish affiliate is wholly owned by the parent firm. It is carried on the parent firm’s books at $1,660,000. This represents the sum of the common stock ( € 1,320,000) and the retained earnings ( € 506,000) on the Spanish affiliate’s books, translated at € 1.10/$1.00. The Spanish affiliate has outstanding notes payable of SF375,000 ( 4 SF1.3636/ € 1.00 5 € 275,000) from a Swiss bank. This loan is carried on the Spanish affiliate’s books as part of the € 1,210,000 5 € 275,000 1 € 935,000. 1 Dollar = 1.3333 Canadian Dollar = 10 Peso = 1.1 Euro = 1.5 Swiss Franc Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

23. Illustration: Consolidation of Financial Statements using FAS-52 Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

24. Illustration: Consolidation of Financial Statements using FAS-52 Translation Exposure Report for Foreign Currencies Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

25. Illustration: Consolidation of Financial Statements using FAS-52 Translation Exposure Report for Foreign Currencies 1 Dollar = 1.3333 CD= 10 Peso = 1.1 Euro = 1.5 Swiss Franc 1 Dollar = 1.3333 CD = 10 Peso = 1.1786 Euro = 1.5 Swiss Franc In other words, the net translation exposure of € 2,101,000 in dollars is $1,910,000 when translated at the exchange rate of € 1.1000/$1.00. A 7.145 percent depreciation of the euro to € 1.1786/$1.00 will result in a translation loss of $127,377 5 € 2,101,000 4 1.1786 3 .07145 Earlier Rate New Rate Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

26. Illustration: Consolidation of Financial Statements using FAS-52 Consolidated Balance Sheet after new Exchange Rate Introduction Translation Methods FAS-8 FAS 52 Types Of Exposure

27. Management of Translation & Transaction Exposure Garv Jain {21072} BMS – 3B

28. Part of syllabus covered Managing Transaction Exposure – Financial Contracts & Operational Techniques Managing Translation Exposure – Balance Sheet Hedge & Derivative Hedge Contents

29. Management of Transaction Exposure Hedging transaction exposure is possible through two ways: Financial Contracts Operational Techniques Forward Market Hedge Money Market Hedge Options Market Hedge Swap Market Hedge Choice of Invoice Currency Lead/Lag Strategy Exposure netting

30. What is Hedging ? 2. Increase in Cash Flow Predictability 4. Enhanced Focus on Primary Objectives 3. Improvement in Overall Financial Health 1. Costs of Hedging Techniques 2. Missed Profit Opportunities 3. Expertise and Complexity Hedging is a financial strategy that protects an individual’s finances from being exposed to a risky situation that may lead to loss of value Hedging Currency hedging is a strategy designed to mitigate the impact of currency or foreign exchange risk on international investments returns. Currency Hedging 1. Protection from Fx Rate Fluctuations Why Hedging? Drawbacks

31. Management of Transaction Exposure Suppose a US firm (say, Boeing Corporation) exported a Boeing 737 to British firm (say, British Airways) and billed £10 million payable in one year Forward Market Hedge Forward market hedge means entering into a contract with an authorised commercial bank to fix the domestic currency rate vis-à-vis foreign currency in which the receivable or payable is materialised Illustration Spot Exchange Rate – $1.50/£ Forward Exchange Rate – $1.46/£ Boeing decided to sell forward its pound receivable £10 million for delivery in one year, in exchange of US dollars £10 million £10 million $14.6 million Gain/Loss from Forward hedge Spot Exchange Rate on Maturity Date Unhedged Position Forward Hedge Gain/Loss $1.30 $1.46 $1.60 $13,000,000 $14,600,000 $16,000,000 $14,600,000 $1,600,000 $14,600,000 $14,600,000 ($1,400,000)

32. Management of Transaction Exposure 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 Money Market Hedge Transaction exposure can also be hedged by lending and borrowing in the domestic and foreign money markets. T he firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency Illustration UK Interest Rate – 9% per annum US Interest Rate – 6.1% per annum Borrow pounds Buy dollar at spot Invest in US Collect pound receivable Maturity value of borrowing = pound receivable Borrowed amt = Discounted value of £10 mn /1.09 = £9,174,312 Convert £ in $ at current spot rate i.e., $1.50/£ £9,174,312 x $1.50/£ = $13,761,468 Invest $13,761,468 @ 6% per annum Collect £10 mn from British Airways to repay the pound loan £9,174,312 $13,761,468 $14,600,918 £10,000,000 £10,000,000 X $1.50/£ X 1.061 X 1.09 $14,600,918 Net Amount Realised Steps 1 2 3 4

33. Management of Transaction Exposure Options Market Hedge Company ideally would like to protect itself only if currency weakens, while retaining the opportunity to benefit if it strengthens. Currency options provide such a flexible “optional” hedge against exchange exposure. In this , the firm may buy a foreign currency call (put) option to hedge its foreign currency payables (receivables) Illustration Boeing purchased a put option on 10 million British pounds Option Premium – $0.02 / £ Exercise price – $1.46 / £ This provides Boeing with the right, but not obligation , to sell up to £10 million for $l.46/£, regardless of the future spot rate Spot Exchange Rate on Maturity Date Gross $ Proceeds Option Cost Net $ Proceeds $1.30 $1.46 $1.60 $13,000,000 $14,600,000 $16,000,000 $212,200 $14,387,800 $15,787,800 $212,200 $212,200 $14,387,800

34. Management of Transaction Exposure Swap Market Hedge What is Swap ?

35. Management of Transaction Exposure Swap Market Hedge R ecurrent cashflows in a foreign currency can be hedged using currency swap contract, which is an agreement to exchange one currency for another at a predetermined exchange rate, i.e., swap rate, on series of future dates Note that a sequence of five forward contracts would not be priced at a uniform rate, $1.46/£; the forward rates will be different for different maturities 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 2024 . British Airways, in turn, is scheduled to pay £10,000,000 to Boeing on December 1 of each year for five years, starting in 2024. In this case, Boeing faces a sequence of exchange risk exposures. Illustration £10 million $14.6 million On every December 1 from 2024 to 2029, Swap Rate – $1.46/£

36. Management of Transaction Exposure Choice of Invoice Currency The firm can shift, share, or diversify exchange risk by appropriately choosing the currency of invoice Lead & Lag or or Boeing can invoice $ 15 mn rather than £ 10 mn Boeing can diversify risk by invoicing in basket currency units such as SDR Boeing can invoice half bill in US $ and half in UK £ Shift Share Diversify Exposure Netting “Lead” means to pay or collect early The firm would lead weak currency receivables and strong currency payables “Lag” means to pay or collect late The firm would lag strong currency receivables and weak currency payables Export Import £6 mn $10 mn Net Exposure : $ 10 mn – ( £6 mn * $1.5 / £) = $ 1 mn When a firm has a portfolio of foreign currency positions, it makes sense only to hedge the residual exposure rather than hedging each currency position separately.

37. Management of Translation Exposure Balance Sheet Hedge Derivative Hedge The source of translation exposure is a mismatch of net assets and net liabilities denominated in the same currency , a balance sheet hedge can eliminate it. Illustration Suppose a Canadian firm with subsidiary in Spain finds that their Exposed Assets > Exposed Liabilities Exposed Assets £7645 Exposed Liabilities £5849 Net Exposure £1826 Parent firm or the Spanish affiliate can increase its liabilities through, say, euro-denominated borrowings to affect the balance sheet hedge. However, it would simultaneously be creating transaction exposure in the euro, if this liability could not be covered from euro cash flows generated by the Spanish affiliate. Use of forward contracts with a maturity of the reporting period to attempt to manage the accounting numbers. However, using a derivatives hedge to control translation exposure really involves speculation about foreign exchange rate changes.

38. Part of syllabus covered PYQ Numericals on Hedging Contents

39. QUESTION TIME! – 2022 ABC Corp. will receive BP 2,00,000 in 180 days. The other information is given as: Spot rate of BP as of today: $1.65 180 days forward rate of BP as of today: $1.72 Interest rates are given as: 180 days deposit rates: UK= 4.5% US= 4.5% 180 days burrowing rates: UK= 5.0%, US= 5.0% How much US $ will the firm have if it goes for money market hedge?

40. ABC will receive £ 200,000 in 180 days To offset, ABC will burrow an amount to pay back £ 200,000 in 180 days 200,000/1.05 = £ 190,476.19 burrowed ABC convert £ 190,476.19 to $314,285.714 at spot rate Invest this $ sum in US at 4.5% with rate After 180 days , ABC receives £ 200,000 Pays back loan Has an investment worth (314285.7 x 1.045) = $328,428.571 THE ANSWER!

41. QUESTION TIME! – 2019 An Indian importer has three months payable of USD 1,20,000. The USDINR spot and forward rates available today in the market are as follows: Spot: 69.4080/ 90 1mf: 10/14 2mf: 15/20 3mf: 25/30 6mf: 13/10 The prevailing interest rates are as follows: USD: 3% - 3.5% INR: 7% - 8% If you are expecting USDINR Spot after 3 months 69.6510/ 20 then suggest rational strategy to the importers among the following: No hedging and Forward hedging Money market hedging (5+5= 10 marks)

42. Summary $120,000 payable THE ANSWER! BID ASK SPOT 69.4080 69.4090 3 months 69.4105 69.4120 Expected 69.6510 69.6520 No hedging: $120,000 x 69.6520 = Rs. 83,58,240 Forward hedging: $120,000 x 69.4120 = Rs. 83,29,440 Money Market hedging: Since $120,000 is payable after 3 months, Lend/ Interest in US the adjusted value. = $120,000 / (1.0025)^3 {3/12 =0.25%} = $119,104.572 We will burrow this amount from India at spot, $119,104.572 x 69.4090 = Rs. 82,66,929.2 Amount payable after 3 months, Rs. 82,66,929.2 x [1+(8/12)]^3 = Rs. 84,33,372.5

43. QUESTION TIME! – 2022 ZYLO Corp. has receivable of BP 2,00,000 in 180 days from now. Assume that there is a Put Option available with an exercise of $1.75, and option premium of $0.05 per unit. ZYLO Corp. forecasts the future spot rate in 180 days as follow with probabilities. Exchange rate $1.62 $1.75 $1.85 Probability 35% 25% 40% How much US dollars will the firm receive if it goes for option hedging? (5 marks)

44. THE ANSWER! Purchasing option GBP200,000 x $0.05 = $10,000 After 180 days, cost of option = $10,000 x CVF This gives Zylo the option, but not any objection to sell up to GBP 200,000 for $1.75/ GBP Case Exercising Option Not exercising Case I 35% $1.75/ GBP =$350,000 – Option cost $1.62/ GBP =$324,000 – Option cost Case II 25% $1.75/ GBP =$350,000 – OC $1.75/ GBP =$350,000 – OC Case III 40% $1.75/ GBP =$350, 000 – OC $1.85/ GBP =$370,000 – OC Taking OC as $10,000; (3,40,000 x 0.35) + (3,40,000 x 0.25) + (3,60,000 x 0.4) Firm will receive $3,48,000

45. INTERNATIONAL FINANCE ECONOMIC EXPOSURE MEASURING & MANAGING HARSHITA GUPTA

46. Part of syllabus covered Foreign Exchange Risk Economic Exposure How to Measure Economic Exposure How to Manage Economic Exposure Contents

47. FOREIGN EXCHANGE RISK AND EXPOSURE Foreign exchange risk, also known as exchange rate risk, is the risk of financial impact due to exchange rate fluctuations. In simpler terms, foreign exchange risk is the risk that a business’ financial performance or financial position will be impacted by changes in the exchange rates between currencies. The general concept of exposure refers to the degree to which a company is affected by exchange rate changes. This impact can be measured in several ways. As so often happens, economists tend to favor one approach to measuring foreign exchange exposure, whereas accountants favor an alternative approach.

48. FOREIGN EXCHANGE RISK AND EXPOSURE TRANSACTION EXPOSURE OPERATING EXPOSURE TRANSLATION EXPOSURE Translation exposure, also known as accounting exposure or balance-sheet exposure, arises from the need, for purposes of reporting and consolidation, to convert the financial statements of foreign operations from the local currencies (LC) involved to the home currency (HC) Transaction exposure arises from contractually binding future foreign currency cash flows. Fluctuating exchange rates between transaction initiation and settlement affect the value of these cash flows, resulting in currency gains or losses. Operating exposure gauges how currency fluctuations can impact a company's future operating cash flows, including revenues and costs. Any company affected by currency changes, regardless of being domestic, faces operating exposure, impacting its financial performance.

49. ECONOMIC EXPOSURE Economic exposure refers to an effect caused on a company’s cash flows due to unexpected currency rate fluctuations. It comprises both transaction exposure and operating exposure. These are long-term in nature and have a substantial impact on a company’s market value. It can prove to be difficult to hedge as it deals with unexpected fluctuations in foreign exchange rates.

50. CHANNELS OF ECONOMIC EXPOSURE ASSET EXPOSURE OPERATING EXPOSURE EXCHANGE RATE FLUCTUATIONS FIRM VALUE HOME CURRENCY VALUE OF ASSETS AND LIABILITIES FUTURE OPERATING CASH FLOWS

51. Transaction exposure arises from foreign currency settlements in trade, borrowing, lending, and subsidiary activities. It includes on-balance sheet items like loans and receivables, as well as off-balance sheet items such as future sales and purchases, lease payments, and forward contracts. However, transaction exposure reports may overlook adjustments in local currency costs and revenues following exchange rate changes, leading to misleading evaluations. Measuring exposure without considering inflation, which affects nominal exchange rates through purchasing power parity, is also flawed. Thus, accurately assessing economic exposure requires accounting for potential adjustments in consumer and firm behaviour and the impact of inflation on currency changes. TRANSACTION EXPOSURE

52. Operating exposure refers to the impact of currency fluctuations on a company's future revenues and costs, affecting its operating cash flows. It arises when a company invests in markets subject to foreign competition or sources goods internationally. Unlike transaction exposure, which arises from foreign currency settlements, operating exposure is a longer-term concern, reflecting the firm's competitiveness in the face of exchange rate changes. While the exposure of assets and liabilities is listed in accounting statements, operating exposure depends on the effect of random exchange rate changes on the firm's competitive position, making it challenging to measure. Properly managing operating exposure is crucial as it often accounts for a significant portion of the firm's total exposure. Formally, operating exposure is defined as the extent to which a firm's operating cash flows would be affected by random changes in exchange rates. OPERATING EXPOSURE

53. HOW TO MEASURE ECONOMIC EXPOSURE FACTORS THAT HELP DETERMINE ECONOMIC EXPOSURE Economic exposure is higher for firms having both, product prices and input costs sensitive to currency fluctuations. It is lower when costs and prices are not sensitive to currency fluctuations. Economic exposure is higher for firms which do not adjust its markets, product mix, and source of inputs in accordance with currency fluctuations. Flexibility in adapting to currency rate fluctuations indicates lesser economic exposure.

54. HOW TO MEASURE ECONOMIC EXPOSURE Economic exposure is the sensitivity of the future home currency value of the firm’s assets and liabilities and the firm’s operating cash flow to random changes in exchange rates. There exist statistical measurements of sensitivity. Sensitivity of the future home currency values of the firm’s assets and liabilities to random changes in exchange rates. Sensitivity of the firm’s operating cash flows to random changes in exchange rates

55. HOW TO MEASURE ECONOMIC EXPOSURE If a U.S. MNC were to run a regression on the dollar value (P) of its British assets on the dollar pound exchange rate, S($/£), the regression would be of the form: P = a + b×S + e Where a is the regression constant e is the random error term with mean zero The regression coefficient b measures the sensitivity of the dollar value of the assets (P) to the exchange rate, S.

56. HOW TO MEASURE ECONOMIC EXPOSURE 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. b= Cov(P,S) Var(S)

57. MANAGING ECONOMIC EXPOSURE Marketing Management of Exchange Risk Production Management of Exchange Risk Planning for Exchange Rate Changes Financial Management of Exchange Risk

58. MARKETING MANAGEMENT OF EXCHANGE RISK Market Selection Pricing Strategy Product Strategy Firms must identify markets where currency changes offer competitive opportunities. For example, during periods of a strong dollar, foreign companies capitalized on market share gains against U.S. rivals. Conversely, when the dollar weakened, U.S. firms regained competitiveness. Firms must decide whether to prioritize market share or profit margin when facing currency volatility. For instance, after currency depreciation, exporters can either raise prices to boost margins or keep prices constant to expand market share, depending on factors like price elasticity and economies of scale. Companies often adjust their product strategies in response to exchange rate fluctuations. This may involve timing new product introductions to capitalize on competitive advantages following currency depreciation or expanding product lines to cover a wider consumer spectrum after home currency devaluation.

59. EXAMPLES As a result of the strong dollar during the early 1980s, for example, some discouraged U.S. firms pulled out of markets that foreign competition made unprofitable. From the perspective of foreign companies, however, the strong U.S. dollar was a golden opportunity to gain market share at the expense of their U.S. rivals. Following dollar depreciation, for example, U.S. exports will gain a competitive price advantage on the world market. A U.S. exporter now has the option of raising its dollar price and boosting its profit margins or keeping its dollar price constant and expanding its market share. The decision is influenced by factors such as whether this change is likely to persist, economies of scale, the cost structure of expanding output, consumer price sensitivity, and the likelihood of attracting competition if high unit profitability is obvious. For example, Japanese exporters responded to the rising yen by shifting production from commodity-type goods to more sophisticated, high-value products. Demand for such goods, which embody advanced technology, high-quality standards, and other nonprice features, is less sensitive to price increases caused by yen appreciation.

60. Input Mix PRODUCTION MANAGEMENT OF EXCHANGE RISK Plant Location Firms respond to exchange rate volatility by shifting production overseas or adjusting the input mix. For example, Caterpillar increased global sourcing following a strong dollar, while Airbus shifted sourcing to the United States to offset dollar weakness. Plant locations may also be diversified to hedge against currency risk, as seen in the auto industry's global production distribution. Firms may establish new plants abroad to maintain competitiveness in markets with devalued currencies. Japanese firms built plants in the U.S. during yen appreciation, while German automakers like BMW and Mercedes-Benz established U.S. plants to mitigate currency fluctuations.

61. Shifting Production Among Plants PRODUCTION MANAGEMENT OF EXCHANGE RISK Raising Productivity Multinational firms reallocate production among global plants based on changing currency costs, allowing flexibility in response to exchange rate fluctuations. This strategy reduces exchange risk by diversifying production locations. Companies improve productivity through plant closures, automation, and negotiations with unions to lower costs. Japanese firms streamline product offerings to reduce complexity and cut costs, focusing on models and variations that drive the majority of sales and profits.

62. EXAMPLE For example, Caterpillar responded to the soaring U.S. dollar and a tenacious competitor, Japan’s Komatsu, by ‘‘shopping the world’’ for components. More than 50% of the pistons that Caterpillar uses in the United States now come from abroad, mainly from a Brazilian company. Some work previously done by Caterpillar’s Milwaukee plant was moved in 1984 to a subsidiary in Mexico. Caterpillar also stopped most U.S. production of lift trucks and began importing a new line—complete with Cat’s yellow paint and logo—from South Korea’s Daewoo. German automakers such as BMW and Mercedes-Benz have built plants in the United States to shield themselves from currency fluctuations. In 2007, Volkswagen announced it was considering building a new plant in the United States to hedge against a strong euro by offsetting its dollar revenues with dollar costs.

63. Even if currency changes are unpredictable, however, contingency plans can be made. This planning involves developing several plausible currency scenarios, analyzing the effects of each scenario on the firm’s competitive position and its profitability, and deciding on strategies to deal with these possibilities. Part of the competitive analysis involves assessing the effects of a given currency scenario on foreign competitors. For example, in 2008, while the yen rose against the dollar by 23%, the won fell by 26%, putting Japanese manufacturers such as Toyota and Panasonic at a particular disadvantage against Korean companies such as Hyundai and Samsung with whom they directly compete. PLANNING FOR EXCHANGE RATE CHANGES

64. One approach involves financing assets used for export profits in a manner that offsets operating cash flow shortfalls resulting from exchange rate changes, thereby reducing debt-servicing expenses. For example, Volkswagen could have mitigated its operating exposure by matching dollar financing with the net dollar cash flow from its U.S. sales. This strategy, which competitors like DaimlerChrysler and Porsche have adopted, helps cushion the impact of currency fluctuations on profitability. FINANCIAL MANAGEMENT OF EXCHANGE RISK

65. FINANCIAL MANAGEMENT OF EXCHANGE RISK However, implementing a hedging policy can be challenging due to the inherent unpredictability of cash-flow effects associated with currency changes. Trained personnel are required to implement and monitor such programs effectively. To illustrate, consider a scenario where a subsidiary's operating profit increases due to a local currency devaluation, despite a reduction in dollar production costs. In such cases, the parent company can structure financing to balance the subsidiary's operating losses with reduced debt-servicing expenses. This strategy involves setting up the liability structure of the multinational corporation in a way that any change in asset earnings resulting from currency fluctuations is matched by corresponding changes in liabilities used to fund those assets.

66. Economic Exposure Transaction Exposure Translation Exposure Meaning ⁠Change in the value of future cash flows from operations arising from a change in the exchange rate Change in the value of a transaction arising from a change in the exchange rate Change in the accounting values such as net income and owner's equity arising from a change in the exchange rate Source It is cumulative of both future contracts (Operating exposure) and already signed contracts (Transaction exposure) It is a financial risk that is associated with the already signed contracts This exposure can be found out when the process of consolidation of global accounts of all the operating units is done Impact Represents the potential impact of exchange rate fluctuations on a company's overall value It affects businesses that import or export goods and services and those with foreign currency receivables or payables It primarily affects multinational companies that consolidate their financial statements across multiple countries

67. Presented by: Arohi Jain (21034) Multinational Financial System INTERNATIONAL FINANCE

68. Part of syllabus covered Value of the MFS – Tax Arbitrage Financial Markets Arbitrage Regulatory Systems Arbitrage Contents

69. Value of the MFS Tax Arbitrage Financial Markets Arbitrage Regulatory Systems Arbitrage Intercompany Fund Flow Mechanisms Inter-company Loans Transfer Pricing Reinvoicing Centers Royalties Leading and Lagging Dividends INTRODUCTION OVERVIEW What is the Multinational Financial System? From a financial management standpoint, one of the distinguishing characteristics of the multinational corporation, in contrast to a collection of independent national firms dealing at arm’s length with one another, is its ability to move money and profits among its affiliated companies through internal financial transfer mechanisms. Collectively, these mechanisms make up the multinational financial system. These mechanisms include transfer prices,intercompany loans, dividend payments, leading (speeding up) and lagging (slowing down) intercompany payments, and fee and royalty charges.

70. Value of the Multinational Financial Management FINANCIAL MARKETS ARBITRAGE REGULATORY SYSTEM ARBITRAGE The ability to transfer funds and to reallocate profits internally presents multinationals with three different types of arbitrage opportunities. The value of the MNC’s network of financial linkages stems from the wide variations in national tax systems and significant costs and barriers associated with international financial transfers. The various factors that enhance the value of internal, relative to external, financial transactions include formal barriers to international transactions, informal barriers, and barriers or imperfections in the domestic capital market. These restrictions are usually imposed to allow nations to maintain artificial values (usually inflated) for their currencies. In addition, capital control are necessary when governments set the cost of local funds at a lower-than-market rate when currency risks are accounted for—that is, when government regulations do not allow the international Fisher effect or interest rate parity to hold. TAX ARBITRAGE

71. Market Imperfections That Enhance the Value of Internal Financial Transactions Quantitative restrictions (exchange controls) and direct taxes on international movements of funds Differential taxation of income streams according to nationality and global tax situation of the owners Restrictions by nationality of investor and/or investment on access to domestic capital markets Costs of obtaining information Difficulty of enforcing contracts across national boundaries Transaction costs Traditional investment patterns Imperfections in Domestic Capital Markets Formal Barriers to International Transactions Informal Barriers to International Transactions Ceilings on interest rates Mandatory credit allocations Limited legal and institutional protection for minority shareholders High transaction costs because of small market size and/or monopolistic practices of key financial institutions Difficulty of obtaining information needed to evaluate securities

72. Tax arbitrage: MNCs can reduce their global tax burden by shifting profits from units located in high-tax nations to those in lower-tax nations. Or they may shift profits from units in a taxpaying position to those with tax losses. Tax arbitrage is possible because wide variations exist in global tax systems. Firms want to reduce the taxes paid, especially the “triple-taxed” MNC who move funds to low-tax jurisdiction. Financial market arbitrage: By transferring funds among units, MNCs may be able to circumvent exchange controls, earn higher risk-adjusted yields on excess funds, reduce their risk-adjusted cost of borrowed funds, and tap previously unavailable capital sources. Financial Market Arbitrage is possible if we assume imperfect markets exist and the parity conditions may not be in effect everywhere. Regulatory system arbitrage: When subsidiary profits are a function of government regulations (e.g., when a government agency sets allowable prices on the firm’s goods), rather than the marketplace, the ability to disguise true profitability by reallocating profits among units may give the multinational firm a negotiating advantage. A fourth possible arbitrage opportunity is the ability to permit an affiliate to negate the effect of credit restraint or controls in its country of operation. Examples include, union wage pressures, regulations on environmental pollution etc. ARBITRAGE SYSTEMS 1. 2. 3.

73. Inter-Company Fund-flow Mechanisms: cost and benefits, Designing a global remittence policy By: Aastha Singh (21001) BMS 3B International Finance

74. Part of syllabus covered Fund Flow Methods – Unbundling, Transfer Pricing, Reinvoicing Centres, Royalties, Leading & Lagging, Dividends Costs vs Benefits of Fund-flow mechanisms Designing Global Remittance Policy Contents

75. INTER-COMPANY FUND-FLOW MECHANISM

76. Objectives: To optimize the allocation of resources within the corporate group Ensure liquidity where needed Support the financial health and growth of individual entities within the group-internal financing Cash Management: efficient cash allocation Maintaining compliance with relevant regulations and accounting standards Inter-Company Fund-Flow Mechanism The Inter-Company Fund Flow Mechanism refers to the process by which funds are transferred or managed between different entities within the same corporate group or organization. This mechanism is essential for ensuring efficient financial management and coordination among the various subsidiaries, divisions, or departments within the organization. Methods: 1. Unbundling 2. Transfer Pricing 3. Reinvoicing Centres 4. Royalties 5. Leading and Lagging 6. Dividends

77. Unbundling is a process by which a company with several different lines of businesses retains core businesses while selling off, spinning off, or carving out assets, product lines, divisions, or subsidiaries. To improve its operations, a company may “unbundle” by selling off assets, product lines, subsidiaries, or divisions. Unbundling may also refer to offering products or services separately that had previously been packaged together. If a company’s share price is performing poorly, the board of directors may call for unbundling to raise capital or distribute cash to its shareholders if they believe the process will help improve its performance. Method 1: Unbundling Example: unbundling of the conglomerate ITT Corporation in the 1990s ITT Corporation was a large conglomerate with diverse business interests spanning multiple industries, including manufacturing, defense contracting, hospitality, and financial services. However, by the late 1980s, ITT faced pressure from shareholders and investors to streamline its operations and focus on core businesses to enhance shareholder value. It spun off its Hospitality Business and Financial Services; and set up its Defence Contracting business as the core business. The unbundling strategy was generally well-received by investors, as it allowed ITT to focus on its core businesses and allocate resources more effectively.

78. Transfer pricing is an accounting practice that represents the price that one division in a company charges another division for goods and services provided. A transfer price is based on market prices in charging another division, subsidiary, or holding company for services rendered. Uses of Transfer Pricing Tax Reduction : By setting transfer prices artificially high or low, companies can manipulate their taxable income in different jurisdictions to reduce overall taxes paid. Tariff Reduction : Transfer pricing can also be used to reduce tariffs on imported goods by understating their value. Avoidance of Exchange Controls: Companies may use transfer pricing to bypass exchange controls in certain countries by manipulating the value of goods or services in internal transactions. Method 2: Transfer Pricing Eg: Technology companies like Google, Apple, and Microsoft have faced scrutiny from tax authorities in various countries for their transfer pricing practices. For instance, in 2015, the European Commission ordered Apple to repay Ireland €13 billion in unpaid taxes, alleging that the company had received illegal state aid through its transfer pricing arrangements. Apple's transfer pricing strategy involved transferring intellectual property rights to its Irish subsidiaries, which then charged royalties to other Apple entities based on profits from European sales. This reduced taxable income in higher-tax jurisdictions and shifted it to Ireland, benefiting from its lower corporate tax rate.

79. By using high mark-up policy  Overall taxes (A+B) is lower  Basic rule : Between Affiliates A and B If tax rate (A) > tax rate (B)  Set transfer price and mark-up policy as Low as possible If tax rate (A) < tax rate (B)  Set transfer price and mark-up policy as High as possible Effect : Profits shifted from higher to lower tax jurisdiction Method 2: Transfer Pricing Companies use transfer pricing to reduce the overall tax burden of the parent company. Eg: Suppose affiliate A produces 100 circuit boards for $10 apiece and sells them to affiliate B Affiliate B sells the boards for $22 apiece to unrelated customer Pre-tax profit for consolidated company is $1 million – regardless of price at which goods are transferred from A to B

80. FUNCTIONS Centralized Transaction Processing Efficiency and Control Transfer Pricing Management Tax Optimization Currency Management Documentation & Compliance Method 3: Reinvoincing Centres Reinvoicing centers are subsidiaries or separate divisions of a multinational corporation that handle intra-firm transactions in different currencies. A reinvoicing center is a division in a multinational corporation that reconciles intra-firm transactions involving different currencies. The purpose is to streamline and centralize multi-currency transactions and reduce exchange rate risk for the company as a whole. Reinvoiving centers can also allot liquidity to different global divisions inside the firm, but having a dedicated foreign exchange division increases a corporation's overhead and complicate taxes. Example: Global Business Services (GBS) division of IBM IBM's GBS division acts as a central hub for managing intra-firm transactions involving different currencies across its global operations. GBS is responsible for reconciling transactions, setting transfer prices, managing currency exposure, and ensuring compliance with tax regulations and transfer pricing rules.GBS reconciles the transactions, sets transfer prices based on the arm's length principle, and manages currency risks to optimize the company's financial performance. It plays a crucial role in allocating liquidity to different business units within IBM, ensuring that each division has access to the necessary funds to support its operations.

81. Intercompany royalties are the remuneration charged when intangible property is transferred or licensed between related company entities. For example, if an MNE transfers the rights to its patented technology designs to one of its subsidiary companies, which is a related legal entity of the MNE, then the MNE must apply an accurate transfer price for the transaction. In order to meet tax regulations, the royalty rate needs to meet the arm’s length principle. This means the fee should be the same as if the intangibles had been licensed to an unrelated entity. Essentially, the royalty rate needs to reflect the going market rate for similar intellectual property. Method 4: Royalties Example: Disney Disney's subsidiary in the United States licenses the rights to a popular character to its European subsidiary for merchandise sales in Europe. The European subsidiary pays royalties to the U.S. subsidiary for using the character's intellectual property. These royalties, typically a percentage of merchandise sales revenue, ensure fair compensation for the use of the character. Both subsidiaries must adhere to transfer pricing regulations to determine fair royalty rates. These royalty arrangements allow Disney to monetize its intellectual property globally while optimizing its tax and financial strategies.

82. A highly favored means of shifting liquidity among affiliates is an acceleration (leading) or delay (lagging) in the payment of inter-affiliate accounts by modifying the credit terms extended by one unit to another. For example, suppose affiliate A sells goods worth $1 million monthly to affiliate B on 90-day credit terms. Then, on average, affiliate A has $3 million of accounts receivable from affiliate B and is, in effect, financing $3 million of working capital for affiliate B. If the terms are changed to 180 days, there will be a one-time shift of an additional $3 million to affiliate B. Conversely, reducing credit terms to 30 days will create a flow of $2 million from affiliate B to affiliate A. Method 5: Leading & Lagging

83. The value of leading and lagging depends on the opportunity cost of funds to both the paying unit and the recipient. When an affiliate already in surplus position receives payment, it can invest the additional funds at the prevailing local lending rate. If it requires working capital, the payment received can be used to reduce its borrowings at the borrowing rate. If a paying unit has excess funds, it loses cash that it would have invested at the lending rate. If it’s in a deficit position, it has to borrow at the borrowing rate. Assessment of the benefits of shifting liquidity among affiliates require that these borrowing and lending rates be calculated on an after-tax dollar basis. Method 5: Leading & Lagging Example: Toyota In the automotive industry, Toyota employs leading tactics by extending payment terms to suppliers, allowing them to delay payments and invest in operations. Conversely, lagging tactics involve shortening payment terms to accelerate cash inflow for Toyota's strategic initiatives, with suppliers expediting deliveries to meet earlier payment obligations. These approaches optimize cash flow, manage working capital, and strengthen supplier relationships.

84. Dividends are the primary method for transferring funds from foreign affiliates to the parent company. When deciding on dividend payments, multinational corporations consider factors like taxes, financial statement impacts, exchange risk, currency controls, financing needs, availability and cost of funds, and the parent company's dividend payout ratio . The parent's payout ratio often influences dividends from abroad, with some firms aiming for uniformity across subsidiaries, while others set targets based on overall foreign-source earnings. This approach ensures subsidiaries contribute their fair share of dividends to stockholders, aiding in persuading foreign governments of the necessity of these payments. Method 6: Dividends Example: Apple Inc Apple Inc. regularly repatriates profits from its global subsidiaries to its U.S. headquarters through dividend payments. These dividends serve as a key method for transferring funds from foreign affiliates to the parent company, contributing significantly to Apple's overall cash flow. When determining dividend payments, Apple considers factors such as tax implications, financial statement effects, exchange rate risks, and the parent company's dividend payout ratio. This approach ensures compliance with regulatory requirements and optimizes cash flow while balancing various financial considerations.

85. A parallel loan is a method of effectively repatriating blocked funds, circumventing exchange control restrictions, financing foreign affiliates without incurring additional exchange risk, or obtaining foreign currency financing at attractive rates. it consists of two related but separate, parallel borrowings and usually involves four parties in at least two different countries. For eg, a U.S. parent firm wishing to invest in Spain lends dollars to the U.S. affiliate of a Spanish firm that wants to invest in the United States. In return, the Spanish parent lends euros in Spain to the U.S. firm’s Spanish subsidiary. Drawdowns, payments of interest, and repayments of principal are made simultaneously. The differential between the rates of interest on the two loans is determined, in theory, by the cost of money in each country and anticipated changes in currency values. Method 7 – INTERCOMPANY LOANS A principal means of financing foreign operations and moving funds internationally is to engage in intercompany lending activities. The making and repaying of intercompany loans is often the only legitimate transfer mechanism available to the MNC. only legitimate transfer mechanism available to the MNC. Intercompany loans are more valuable to the firm than arm’s-length transactions only if at least one of the following market distortions exists: (1) credit rationing (because of a ceiling on local interest rates), (2) currency controls, or (3) differential tax rates among countries. Back-to-back loans , also called fronting loans or link financing, are often employed to finance affiliates located in nations with high interest rates or restricted capital markets, especially when there is a danger of currency controls or when different rates of withholding tax are applied to loans from a financial institution. In the typical arrangement, the parent company deposits funds with a bank in country A that in turn lends the money to a subsidiary in country B. From the bank’s point of view, the loan is risk free because the parent’s deposit fully collateralizes it. The bank simply acts as an intermediary or a front; compensation is provided by the margin between the interest received from the borrowing unit and the rate paid on the parent’s deposit. 2 1 COMMON TYPES OF LOANS (this slide is from Arohi’s Presentation)

86. INTER-COMPANY TRANSACTIONS INCREASE REVENUE AND PROFITS REDUCE COSTS AND EXPENSES Cost and Benefits: Inter-Company Fund-Flow Mechanism Intercompany transactions can enhance financial performance by strategically setting transfer prices. For instance, selling products or services to subsidiaries at inflated prices can increase revenue and profit in low-tax jurisdictions, while reducing them in high-tax areas. This tactic optimizes tax liabilities, benefiting the overall financial position of the corporate group. Buying products or services from subsidiaries at discounted prices can lower expenses in high-tax jurisdictions, while increasing them in low-tax areas. This tactic optimizes tax liabilities and improves the overall financial position of the corporate group. IMPROVE CASH FLOW & LIQUIDITY When lending or borrowing funds from subsidiaries, companies can set interest rates above or below market rates. This practice impacts interest income, expenses, and cash flows, benefiting firms in managing cash flow and liquidity across diverse entities, currencies, or regions.

87. INTER-COMPANY TRANSACTIONS RISKS & CHALLENGES Maintaining compliance with the Arm’s Length Principle: Arm’s Length Principle : The arm's length principle in transfer pricing dictates that intercompany transactions should be priced as if the entities involved were independent, ensuring fairness and compliance with tax regulations. Comply with the tax laws and regulations of each country otherwise, failure to do so can result in tax audits, penalties, or adjustments, undermining financial stability. Accurately eliminating intercompany transactions from consolidated financial statements is critical to prevent double-counting or performance distortion. This necessitates meticulous recording, reconciliation, and reporting processes to ensure transparency and regulatory adherence. Cost and Benefits: Inter-Company Fund-Flow Mechanism EFFECTIVE MANAGEMENT Establish a defined transfer pricing policy outlining methods, rules, and documentation. Implement a reliable intercompany accounting system to track, validate, and reconcile transactions and balances. Foster transparent communication and collaboration among entities involved, including external auditors and tax authorities.

88. BENEFITS COSTS Cost and Benefits: Inter-Company Fund-Flow Mechanism Efficient capital allocation within the corporate group Simplified cash management and liquidity optimization Potential tax advantages through centralized financing structures Enhanced control and visibility over intra-group transactions Facilitates strategic investments and funding of subsidiaries Streamlines financial reporting and reduces redundant processes. Administrative overhead for establishing and maintaining intercompany arrangements Compliance costs associated with regulatory requirements and transfer pricing rules Potential risks such as currency fluctuations or interest rate volatility Increased complexity in financial reporting and auditing Dependency on effective communication and coordination among group entities Possible challenges in allocating costs fairly among subsidiaries

89. GLOBAL REMITTANCE POLICY Designing a

90. Designing a Global Remittance Policy A global remittance policy is a set of guidelines and procedures established by a multinational corporation to govern the movement of funds between its various entities or subsidiaries across different countries or jurisdictions. This policy typically outlines the rules, processes, and criteria for transferring funds, including intercompany transactions such as dividends, loans, or capital injections. The task for international financial executives involves coordinating financial linkages to maximize firm value through decisions on remittance amount, timing, destination, and transfer methods. Multinationals often make remittance decisions independently, neglecting overall optimization due to the complexity of interaffiliate connections. However, compromise shouldn't mean ignoring profit potential. Despite regulatory constraints and complexities, firms can still seek high-yield uses of their internal financial systems. Simplified decision rules, such as maximizing local borrowing in credit rationing situations, can guide resource allocation. Many firms focus on optimizing flows among a limited number of affiliates rather than achieving global optimization, aiming for profit improvement over system optimization. To take advantage of its internal financial system, the firm must conduct a comprehensive analysis of the available remittance options and their associated costs and benefits. It must also compare the value of deploying funds in affiliates other than just remitting subsidiary and the parent.

91. Pre-requisites of Global Remittance Policy 1. Number of financial links: More links provide greater flexibility for achieving specific goals. 2. Volume of interaffiliate transactions: Higher volume allows for more efficient deployment of funds. 3. Foreign-affiliate ownership pattern: 100% ownership removes impediments to fund allocation. 4. Degree of product and service standardization: More standardized products limit flexibility in transfer pricing. 5. Government regulations: Tax, credit allocation, and exchange control policies both incentivize and impede international fund maneuvers. Centralized decision-making implementation requires information on below given factors to assess the costs and benefits of operating an integrated financial system, including available funds, transfer options, opportunity costs of money for different affiliates, and associated tax effects. To fully utilize its global financial system, a multinational firm needs detailed information on: Information Required for Global Remittance Policy Affiliate financing requirements Sources and costs of external credit Local investment yields Available financial channels Volume of interaffiliate transactions Relevant tax factors Government restrictions and regulations on fund flow Information Required for Global Remittance Policy

92. Transfer Pricing & Tax Evasion Presented by Aryan Agarwal (21040)

93. Part of syllabus covered Transfer Pricing Arm’s Length Principle Methods of Transfer Pricing Tax Evasion – Rules & Regulations Apple Case study Current Scenario Contents

94. What is Transfer Pricing? Transfer pricing is all about setting the prices for goods and services traded between companies under the same control. This could be between subsidiaries of a large corporation, different departments within a company, or any entities with a common ownership structure.

95. Example

96. Department A Department B Tax Rate- 30% Tax Rate- 10% Profit Made $20 $20 Taxes Paid $6 $2 Profit Made $10 $30 Taxes Paid $3 $3 If Department A charges B $60 per widget The company saves $2 in this transaction

97. Arm’s Length Principle The basis of transfer pricing is the Arm’s Length Principle, as it is known internationally. This principle states that the price agreed in a transaction between two related parties must be the same as the price agreed in a comparable transaction between two unrelated parties. The Arm’s Length Principle was agreed upon by all OECD member countries and adopted as an objective guideline for use by multinational companies and tax administrations in international taxation. Its objective is to avoid the erosion of the tax base or the transfer of profits to low tax jurisdictions. When unrelated companies carry out transactions with each other, market forces normally determine the terms of the commercial and financial relationships (e.g. the price of goods transferred or services rendered). However, when transactions take place between related companies, external market forces may not directly affect prices, either because of corporate synergies, economies of scale or tax planning.

98. Factors in analysing transactions by related companies 01. 02. 03. The agreed price of the goods and/or services The margins obtained in the purchase and sale of goods and/or services Assets used and risks assumed 04. The agreed terms and conditions of the transactions.

99. Tax Minimization A significant driver for transfer pricing is tax optimization. Companies can: 1.Shift profits to low-tax countries: By selling goods or services to subsidiaries in low-tax countries at inflated prices, the profits are taxed less in the high-tax country. 2.Reduce customs duties: Transfer pricing can be used to lower the declared value of goods shipped to countries with high import duties. Supply Chain Management Transfer prices can influence decisions related to production locations and sourcing strategies. Companies can incentivize efficient production in certain locations by setting transfer prices that reflect cost advantages. Management Performance Evaluation Transfer prices can be a tool to assess the performance of different departments within a company. Setting clear pricing structures allows for a more accurate evaluation of each department's profitability and efficiency. Uses of Transfer Pricing

100. Methods of Transfer Pricing

101. Under the CUP method, a price that is charged in an uncontrolled transaction between the comparable firms is recognized and evaluated with a verified entity price for determining the Arm’s Length Price. Example: A Ltd. purchases 10,000 MT metal from B Ltd. its subsidiary @INR 30,000 /MT. Also purchase from C Ltd. 2,500 MT @ INR 40,000/MT. A Ltd. received a discount of INR 500 /MT as a quantity discount from B Ltd. B Ltd. allows credit of one month at 1.25% pm. The transaction with B Ltd. is at FOB (Free on board) whereas with C Ltd. is at CIF (Cost, Insurance, and Freight). The cost of freight and Insurance is INR 1,000. Here, the terms of transactions are not the same and hence, it has affected the cost of the crude metal. Hence, adjustments are needed. Adjustments required for differences in; Quantity discount: In case a similar discount is offered by C Ltd., the price that was charged by C Ltd. would have been lower by INR 500/MT. Freight & Insurance (FOB Vs CIF): In case the purchase from C Ltd. was also on FOB, then the price charged by C Ltd. would have been lesser. Hence, the cost of freight & insurance must be reduced from the purchase price. Credit period: In case similar credit was offered by C Ltd., then the price charged by them would have been more after factoring in such cost. Hence, 1.25% pm must be added to the purchase price. Comparable Uncontrolled Price (CUP) Method

102. This method is most reliable and is considered as a direct way of applying the arms-length principle and for determining the prices for related party transactions. However, while considering whether the controlled and uncontrolled transactions are comparable, high care has to be taken. Hence, this way of arriving at transfer price isn’t applied unless products or services meet the stringent requirements of the high comparability.

103. Resale Price Method or Resale Minus Method In this method, it takes the prices at which the associated enterprise sells its product to the third party. This price is referred to as the resale price. The gross which is determined by comparing the gross s in a comparable uncontrolled transaction is then reduced from this resale price. After this, costs which are associated with the purchase of such product such as the customs duty are deducted. What remains is considered as arm’s length price for a controlled transaction between the associated enterprises. Example: An Ltd is a deal in IT products. An Ltd had purchased desktops from a related party, B Ltd and also from a non-related party B Ltd.

104. With the Cost Plus Method, you emphasize on costs of the supplier of goods or services in the controlled transaction. Once you’re aware of the costs, you need to add a markup. This markup must reflect the profit for the associated enterprise on basis of risks and functions performed. The result is the arm’s length price. Generally, the markup in the cost plus method would be calculated after the direct and indirect cost related to production or supply is considered. But, the operating expenses of an enterprise (like overhead expenses) aren’t part of this markup. Example: Associated Enterprise-A, a computer manufacturer in Thailand, manufactures under a contract for Associated Enterprise B.  Associated Enterprise B would instruct Associated Enterprise-A about the quantity and quality of computers to be manufactured. The Associated Enterprise-A would be guaranteed of its sales to Associated Enterprise B and would have little or no risk. Let’s assume that the Cost of goods sold is INR 50,000. Also, assume that the arm’s length markup which Associated Enterprise-A should earn is 40%. The resulting arm’s length price between Associated Enterprise-A and Associated Enterprise B is INR 70,000 (i.e. INR 50,000 x (1 + 0.40)). Cost Plus Method

105. Rules & Regulations

106. Transfer pricing law in India applies to both domestic and international transactions which fall above a threshold in terms of deal value. Transfer Pricing was introduced through inserting Section(s) 92A-F and relevant Rule(s) 10A-E of the Income Tax Rules 1962. It ensures that the transaction between ‘related’ parties is at a price that would be comparable if the transaction was occurring between unrelated parties. The following sections of the Income Tax Act, 1961 apply to international transactions in terms of transfer pricing. Section 92 of the Income Tax Act, 1961 Computation of income from international transactions having regard to arm’s length price. This section states that any international or specified domestic transaction between associated enterprises which has been mutually agreed and undertaken for the purpose of allocation or apportionment of any cost or expense incurred or to be incurred for a benefit, service or facility undertaken or to be undertaken by one or more of the enterprises, then the cost or expense allocated, must be contributed having regard to the arm’s length price of such benefit, service or facility.

107. Section 92B of the Income Tax Act, 1961 –Meaning of international transaction This section defines international transaction(s) for the purpose of this Section and the Section(s) 92, 92C, 92D and 92E as a transaction between two or more associated enterprises, wherein either one or both the enterprises are non-residents. The nature of transactions between the enterprises shall be recorded through a mutual agreement or arrangement. It can be a purchase, sale or lease of tangible or intangible assets, provision of services, borrowing or lending of money or any other transaction which has some effect on the profit or income or loss or assets of the enterprises and the enterprises have mutually agreed to apportion cost or expense incurred in the process of such transactions.

108. Apple's tax practices in Ireland were investigated by the European Commission, which concluded that Ireland offered Apple illegal state aid by allowing them to pay significantly lower taxes than other companies. The case hinged on transfer pricing arrangements between Apple's Irish subsidiary and other group companies. Tax Evasion Example- Apple’s Tax Dispute in Ireland

109. Apple in Ireland- A timeline 1980s The Business Setup: •Apple established subsidiaries in Ireland in the 1980s to manage its European operations. •These subsidiaries, Apple Sales International (ASI) and Apple Operations Europe (AOE), became hubs for intellectual property (IP) rights for Apple products globally. The Transfer Pricing Strategy: Apple allegedly used transfer pricing to attribute most of its European profits to ASI and AOE. The crux of the issue lies in how much these Irish subsidiaries paid to the parent company for the use of the valuable intellectual property. Critics argued that the transfer prices were set artificially low, shifting a significant portion of profits to Ireland, which has a lower corporate tax rate compared to other European countries. The European Commission Investigation: The European Commission launched an investigation in 2014, suspecting Ireland of granting illegal state aid to Apple through favorable tax rulings. The investigation focused on the transfer pricing methodology employed by Apple and whether it reflected "arm's length" principles, meaning the prices would be similar to those charged between unrelated parties. The Court Case and Outcome: In 2016, the European Commission ruled that Ireland's tax agreements with Apple constituted illegal state aid and ordered Apple to pay €13 billion ($14.5 billion) in back taxes to Ireland. Ireland and Apple both appealed the decision. In 2020, the General Court of the European Union surprisingly overturned the Commission's decision. The court ruled that it wasn't proven that Ireland gave Apple a selective advantage through the tax rulings, and therefore, it wasn't illegal state aid. 1990s- 2000s 2014 2016

110. Current Situation The legal battle between the European Commission, Ireland, and Apple is ongoing. The final judgment from the European Court of Justice will determine whether Apple owes the back taxes and set a precedent for future transfer pricing cases in the EU. This case has highlighted the global debate on corporate tax avoidance and the role of transfer pricing strategies. It has also raised questions about the tax policies of countries like Ireland, which attract multinational corporations with lower tax rates.

111. Issue of ADR, GDR, Eurobonds & Foreign Bonds Shreya Jain (21214) BMS-3D

112. Part of syllabus covered DRs – Steps, Adv- Disadv , Types ADRs GDRs – Concept, Types, ADRs vs GDRs International Bonds Market – Eurobonds & Foreignbonds Contents

113. What is a Depositary Receipt?

114. Depository Receipt (DR) A depositary receipt is a negotiable instrument issued by a bank to represent shares in a foreign public company, which allows investors to trade in the global markets. Depositary receipts allow investors to invest in companies in foreign countries while trading in a local stock exchange in the investors’ home country. Earlier, if investors wanted to buy shares in a foreign company, they would need to exchange their money into a foreign currency and open a foreign brokerage account. Then, they would be able to purchase shares through the brokerage account on a foreign stock exchange. The creation of depositary receipts eliminates the entire process and makes it simpler and more convenient for investors to invest in international companies.

115. How are Depositary Receipts Issued?

116. Steps in the issue of DRs When a company listed in a particular country, say H, wants to issue its shares in a foreign country, say F, it first transfers its shares to a local bank, known as the domestic custodian. The domestic custodian bank must be a branch of the bank in the country F (called the overseas depository bank) which is eventually going to issue the depository receipts. The custodian bank holds the shares on behalf of the company and informs its counterpart in the country F about the same. This overseas depository bank can now issue DRs to the investors in country F as an acknowledgement of holding the company’s shares. The DRs can now be traded on the stock exchange of country F. When the cash flows from the investors to the depository bank and ultimately to the company in exchange of the DRs, the overseas fund raising process is said to be complete.

117. Suppose Australian investors may want to invest in the stock of Singtel , a Singaporean company , but Singtel’s stock is not listed on the Australian Stock Exchange. Buying Singtel’s stock on the Singapore Stock Exchange is expensive and inconvenient for Australian investors. To make this process easier, a financial institution in Australia, such as a bank, can buy Singtel’s stock on the Singapore Stock Exchange and make it available to Australian investors. Rather than making the shares directly available for trading on the Australian Stock Exchange, the bank holds the shares in custody and issues DRs against the shares held. The Singtel DRs issued by the custodian bank are listed on the Australian Stock Exchange for trading. In essence, the Singtel DRs trade like the stock of a domestic company on the Australian Stock Exchange in the local currency (Australian Dollar). Example

118. Important Points about DRs 1 share of the issuing company need not always be equal to 1 DR of that company. It is generally decided by the bank and the company after assessing the foreign country’s market. DRs derives their value from the price movement of the shares of the issuing company and hence, will fluctuate as and when the domestic price of the shares fluctuates. Companies try to bring their DRs in the countries where they have a good established business. They aim to strengthen their presence in that country by getting themselves listed on that country’s stock exchange.

119. Diversification of Portfolio Additional Sources of Funds International Attention Convinient Method of Investment Advantages of DRs Investors can diversify their investment portfolio by investing in foreign companies, in addition to stocks offered by domestic companies. DRs provide internatinal companies with a way to raise more capital by entering global markets and attracting internatonal investors. Investing through DRs is more convinient and less expensive than purchasing stocks in foreign markets as transactions costs are reduced. Companies are able to attract positive international attention and expand their shareholder base through issue of DRs.

120. An expensive method to raise capital Foreign Currency Risk Limited Access Less Liquidity Disadvantages of DRs Due to higher processing and administrative fees to compensate for custodial services, and foreign country taxes, it is an expensive method. As DRs involve dealing in diferent currencies there is higher risk due to volatility in foreign currency exchange rates. Often there are not many buyers and sellers of DRs which makes them relatively less liquid. Sometimes DRs are not listed on stock exchanges, and only institutional investors can invest in them leaving lesser choices for other investors.

121. What are the types of Depositary Receipts?

122. American Depositary Receipts (ADRs) Types of Depositary Receipts Global Depositary Receipts (GDRs)

123. American Depositary Receipts (ADRs)

124. Concept ADRs were devised in the late 1920s to help Americans invest in overseas seurities and to assist non-US companies willing to have their stock traded in the American market. An ADR is a negotiable certificate issued by a U.S. bank acknowledging the ownership of American Depositary Shares (ADSs). An ADS is a U.S. dollar-denominated security representing shares of stock in a foreign company that are held on behalf of the ADS owner by a custodian bank in the issuing company’s home country. They are traded in the same way as shares in U.S. companies, on the New York Stock Exchange, the Nasdaq, and the American Stock Exchange. The ADS owner is entitled to the corporate and economic rights of the foreign shares, subject to the terms specified on the ADR certificate. The first ADR was created in 1927 by J.P. Morgan. This was to allow Americans to invest in shares of Selfridges, a British department store. Today, there are more than 2,000 ADRs available, representing shares of companies located in more than 70 countries. JPMorgan Chase, The Bank of New York, and Citigroup are among the leading depositary banks, which create and issue ADRs.

125. List of Indian ADRs

126. Mechanism of ADRs Objective : Overseas Funds Raising Domestic Custodian Overseas Depository Bank (US) Investors in US ADRs Cash Flow Deposits its shares Acknowledgement of the share deposits American Depository Shares (ADS) 1 ADR = 3 Shares

127. Example of ADR Issue Suppose RIL in India wants to raise $1,00,000 through issue of ADRs. Exchange Rate of $1 = Rs. 80 1 share of RIL is currently priced at Rs. 1,600 Equivalent value of 1 share of RIL in US$ would be: Rs. 1600/Rs. 80 = $20 If 5 shares of RIL underlie each ADR , worth of each ADR of RIL = $20*5 shares = $100 For raising $1,00,000, number of ADRs to be issued : $1,00,000/$100 = 1,000 ADRs

128. Global Depositary Receipts (GDRs)

129. Concept Any depositary receipt that does not originate from the investor’s home country is called a Global Depository Receipt. GDRs are commonly listed on European stock exchanges such as the London Stock Exchange, the Luxembourg Stock Exchange and the Frankfurt Stock Exchange. A GDR works similarly to an ADR. If for example, an Indian company which has issued ADRs in the American market wishes to further extend it to other developed and advanced countries such as in Europe, then they can sell the DRs to the public of Europe and the same would be named as GDR. DR can be issued in more than one country and can be denominated in any freely convertible currency.

130. Concept GDRs and their dividends are priced in the local currency of the exchanges where the GDRs are traded. The currency used for a GDR may impact its price and the risks associated with the investment, such as currency risk, as the price of its shares overseas are denominated in local currency. Several international banks issue GDRs, such as JPMorgan Chase, Citigroup, Deutsche Bank, The Bank of New York Mellon.

131. Types of GDRs Global Depository Receipts (GDRs) can be classified into following common types: Listed GDRs: Unlisted GDRs: Sponsored GDRs Unsponsored GDRs These are GDRs that are listed and traded on recognized stock exchanges such as the London Stock Exchange (LSE), Luxembourg Stock Exchange ( LuxSE ), or Nasdaq. Listed GDRs offer liquidity and visibility to investors and are subject to the regulations of the exchange where they are listed. Unlisted GDRs are not traded on any stock exchange and are typically issued through private placements to institutional investors. These GDRs may offer more flexibility in terms of issuance and reporting requirements but may lack liquidity compared to listed GDRs. They are issued with the cooperation and endorsement of the issuing company. The company actively participates in the GDR program, providing support for marketing, investor relations, and corporate actions. Sponsored GDRs are often preferred by investors due to the company's involvement and support. They are issued without the involvement or endorsement of the issuing company. These GDRs are typically created by financial institutions without the company's cooperation and may not have the same level of support or access to company information as sponsored GDRs.

132. List of Indian GDRs

133. A negotiable instrument issued by a US bank, representing non-US company’s shares trading in the US stock exchange A negotiable instrument issued by an international depositary bank, representing foreign company’s stock trading globally Foreign companies can trade in US stock market Foreign companies can trade in any country’s stock market United States domestic capital market European Capital Market American Stock Exchange such as NYSE or NASDAQ Non-US Stock Exchange such as London Stock Exchange or Luxembourg Stock Exchange In America only All over the world ADRs vs GDRs Meaning Relevance Issued in Listed in Negotiation

134. International Bond Market

135. Eurobonds The international bond market encompasses two basic market segments: Foreign Bonds

136. Eurobonds A Eurobond is a fixed-income debt instrument that is denominated in a currency other than the home currency of the country or market in which it is issued. It is issued by governments or corporates and is usually a long-term debt instrument. They allow corporations to raise funds by issuing bonds in a foreign currency. Eurobonds are frequently grouped together by the currency in which they are denominated. For example, a US dollar-denominated bond sold outside of the United States – in Europe or elsewhere – is a Eurodollar bond. Similarly, a sterling denominated bond sold outside of the United Kingdom is a Eurosterling bond. It does not mean the bond was issued in Europe or denominated in the euro currency. It originated from the fact that the Eurobond market initially emerged in the 1960s in Europe. The size of a single bond issuance can be well over a billion dollars, and these bonds are generally issued with 5-30 years of maturity. The fisrt Eurobond emerged in 1963 from Autostrade, the company overseeing Italy's national railways. This $15 million eurodollar bond, designed by London-based bankers, was launched at Amsterdam Airport Schiphol and redeemed in Luxembourg to minimize tax obligations. It presented European investors with a safe avenue for dollar-denominated investments.

137. How are Eurobonds Issued? Deciding the terms and conditions of the Eurobond, i.e., amount to be raised, currency, maturity date, and interest rate. 1. Preparation The issuer appoints investment banks as underwriters who assist in structuring and selling the bonds to investors. 4. Offering Memorandum The underwriters conduct due diligence (evaluating financial statements, market conditions, and the issuer’s reputation) to assess the issuer’s creditworthiness. 2. Appointment of Underwriters The underwriters market the Eurobond to potential investors globally. The bond price is determined based on market demand and prevailing interest rates. 3. Due Diligence An offering memorandum is prepared, providing detailed information about the Eurobond, such as the terms, risk factors, and financial background of the issuer. 5. Marketing and Pricing

138. How are Eurobonds Issued? Interested investors submit their subscription orders to the underwriters, indicating the quantity of Eurobonds they wish to purchase. 6. Subscription The underwriters allocate the Eurobonds to investors based on their subscription orders, ensuring a fair distribution 8. Settlement After the allocation, the investors transfer the purchase amount to the underwriters, and in return, they receive the Eurobonds. 7. Allocation If the issuer chooses to list the Eurobond on a stock exchange, they work with the exchange to fulfill listing requirements and facilitate trading. 9. Listing

139. Access to International Capital Diversified Sources of Funds Currency Flexibility Lower Borrowing Costs Benefits of Eurobonds Eurobonds provide issuers access to a large base of international investors, allowing them to raise capital outside their domestic markets. Eurobonds help diversify their funding sources and reduce dependence on domestic investors or banks. With lower borrowing costs than domestic bonds, particularly for issuers with good credit ratings, Eurobonds result in significant savings on interest payments. Eurobonds enable issuers to raise funds in currencies other than their home currency, which can benefit multinational corporations with global operations. To issuers:

140. Diversificaton of Portfolio Higher Yield Liquidity Benefits of Eurobonds Eurobonds allow investors to diversify their investment portfolios internationally, reducing exposure to a single market or currency. Eurobonds, especially those issued by entities with lower credit ratings, often offer higher yields than government or highly rated corporate bonds. As Eurobonds can be bought or sold in the secondary market easily, they are highly liquid. This gives investors flexibility and the ability to adjust their positions as market conditions change. To investors:

141. Foreign Bonds A foreign bond is a bond issued in a domestic market by a foreign company in the domestic market's currency as a means of raising capital. For example, a Canadian firm might sell a bond in New York denominated in US dollars. Similarly, a Brazilian company might sell a euro-denominated bond in Germany. Because investing in foreign bonds involves multiple risks, foreign bonds typically have higher yields than domestic bonds. Foreign bonds must meet the security regulations of the country in which they are issued. Foreign bonds have varied names that designate the country in which they are issued. For example, Yankee bonds are dollar–denominated foreign bonds originally sold to U.S. investors, Samurai bonds are yen-denominated foreign bonds sold in Japan, and Bulldogs are pound sterling– denominated foreign bonds sold in the U.K.

142. Foreign Bonds Some Examples of Foreign Bonds: Yankee Bonds - These foreign bonds are U.S. dollar-denominated bonds that are issued by foreign borrowers within the American bond markets . The issuers of these bonds are foreign governments or entities, and corporate borrowers with high ratings. Issuers of Yankee bonds are required to adopt American accounting practices and are required to be rated by American credit rating agencies as opposed to foreign ones. Samurai Bonds - These foreign bonds are issued in domestic Japanese markets by borrowers who aren’t Japanese. The time frame for the maturity of these bonds ranges between 3 to 20 years. While supranational and their entities are given priority, sovereigns along with quality private corporations may also be permitted to issue Samurai bonds.

143. Foreign Bonds Some Examples of Foreign Bonds: Bulldog Bonds - These foreign bonds are available in the UK domestic securities market and are British pound sterling denominated. The time frame needed for maturity ranges from 5 years to 25 years or greater. Matilda Bonds - They are foreign bond s issued in the Australian market by non-Australian firms and are denominated in Australian Dollars. The bonds are subject to the securities regulations of Australia. A Matilda bond is also known as a "Kangaroo Bond."

144. Interest Rate Risk Foreign bonds bring with them an interest rate risk. This means that when interest rates rise, the resale value or market price of these bonds declines. Inflation Risk When a bond is purchased at a predetermined interest rate, the real value of the bond is determined by the amount of inflation taken away from the yield. Risk Considerations Currency Risk It is implicit in all foreign bonds. The currency exchange risk can account for a significant portion of a bond’s risk and return. Political Risk Checking whether the government issuing the bond is stable, what laws surround the bond’s issuance, etc. before investing. Foreign bonds face repayment risk. Investors may lose some or all of their principal and interest.

145. Eurobonds are not subject to the law of a single country’s financial authorities Foreign bonds are subject to the rules of the country where they are issued Eurobonds can be issued anywhere globally Foreign bonds are issued in a specific foreign country Eurobonds attract a broader international investor base Foreign bonds tend to be more targeted towards investors in the country where they are issued Eurobonds offer issuers the flexibility to choose the currency to denominate the bond Foreign bonds are denominated in the country’s currency where they are issued Eurobonds vs Foreign Bonds Regulation Location of Issue Investor Base Currency Choice