FINANCIAL TECHNIQUE FOR MANAGING TRANSACTION EXPOSURE

A thorough knowledge of international risk exposure techniques can serve as an effective way to supplement legal strategies for clients involved in international business transactions. While creative and thorough legal drafting can go a long way to reduce some international transactions risks, many business risks can be obviated in whole or in part by the financial markets. One such area of particular risk is known as transaction risk and is associated with foreign exchange rate. Mostly this type of risk correlated with imports or exports. If a company imports or exports goods on credit the amount it will pay out or receive in home currency terms is subject to uncertainty. For example, suppose that Mitsubishi of Japan enters into a loan contract with the Swiss bank UBS that calls for payment of SF100 million for principal and interest in one year. To the extent that the yen/Swiss franc exchange rate is uncertain, Mitsubishi does not know how much yen will be required to buy SF100 million spot in one year’s time. If the yen appreciates (depreciates) against the Swiss franc, a smaller (larger) yen amount will be needed to retire the SF-denominated loan.

This example suggests that whenever a firm has foreign-currency-denominated receivables or payables, it is prone to transaction exposure, and the firm’s cash flow position is subject to be potentially affected by eventual settlements. Because of modern firms are often involved in commercial and financial contracts denominated in foreign currencies, management of transaction exposure has become an important function of international financial management. There are some alternative methods of hedging transaction exposure using various financial techniques, and the techniques are:

1.      Forward Contracts

When there is an agreement for a firm to pay (receive) a fixed amount of foreign currency at  some date in the future, in most currencies it can retrieve a contract today that specifies a price at which it can buy (sell) the foreign currency at the specified date in the future. This substantially converts the uncertain future home currency value of this liability (asset) into a certain home currency value to be earned on the specified date, independent of the change in the exchange rate over the remaining life of the contract. 

2.      Futures Contracts

These are identical to forward contracts in function, although they vary in several important features. Futures contracts are exchange traded and therefore have standardized and limited contract sizes, maturity dates, initial collateral, and several other features. Given that futures contracts are available in only certain sizes, maturities and currencies, it is generally not possible to get an exactly offsetting position to totally eliminate the exposure. The futures contracts, unlike forward contracts, are traded on an exchange and have a liquid secondary market that make them easier to loosen or close out in case the contract timing does not match the exposure timing. In addition, the exchange requires position taker to post s bond (margins) based upon the value of their positions. This virtually eliminates the credit risk involved in trading in futures.

3.      Money Market Hedge

This method employs the fact from covered interest parity, that the forward price must be exactly equal to the current spot exchange rate times the ratio of the two currencies' riskless returns. It can also be thought of as a form of financing for the foreign currency transaction. A firm that has an agreement to pay foreign currency at a specified date in the future can determine the present value of the foreign currency obligation at the foreign currency lending rate and convert the appropriate amount of home currency given the current spot exchange rate. This converts the obligation into a home currency payable and eliminates all exchange risk.

4.      Options

Foreign currency options are contracts that have an upfront fee, and give the owner the right, but not the obligation to trade domestic currency for foreign currency (or vice versa) in a specified quantity at a specified price over a specified time period. The key difference between an option and the three hedging techniques above is that an option has a nonlinear payoff profile. They allow the removal of downside risk without cutting off the benefit form upside risk.

HOW TO RAISE EQUITY CAPITAL

Huge corporations would not have been able to grow to their present size without being able to find innovative ways to raise capital to finance expansion. Corporations have some methods for obtaining that money. There are several types of funding options that can be exposed by the corporations.

1. Debt Financing

Debt financing involves borrowing money from banks or organizations and raising equity capital in which you sell a portion of the business ownership to others. Debt financing has become an attractive option for most people due to acquiring loan for a business allows you to retain full ownership; you are not responsible to investors or shareholders who have a stake in your business. You have the ‘reigns’ in your hands and apart from paying back the loan, interest and fee there is not a lot that needs to come out of your pocket. It’s undoubtedly a more affordable alternative to raising capital. However there is a drawback to it as well, in some circumstances lenders may have significant influence. For example, lenders may urge that the company does not exceed certain liquidity or solvency ratio levels, or they may take a charge over a particular building as security for loan, moreover it will be restricting the director’s freedom of action over the use and disposal of that building.

There is also contradiction between debt finance and equity finance in term of requiring regular cash outlays in the form of interest and the repayment of capital sum. The firm have to maintain the repayment schedule every year eventhough they are experienced a bad year or there is possibility of action being taken by the lender to recover their money by forcing the firm to sell assets or liquidate.

2. Selling Common Stock

Company will able to raise capital by issuing common stock if they were on good financial health. Usually, investment banks help companies issue stock, agreeing to buy any new shares issued at a set price if the public refuses to buy the stock at a certain minimum price. Although common shareholders have the exclusive right to elect a corporation's board of directors, they rank behind holders of bonds and preferred stock when it comes to sharing profits.

Investors are attracted to stocks in two ways. Some companies pay large dividends, offering investors a steady income. But others pay little or no dividends, hoping instead to attract shareholders by improving corporate profitability and hence, the value of the shares themselves. In general, the value of shares increases as investors come to expect corporate earnings to rise. Companies whose stock prices rise substantially often "split" the shares, paying each holder, say, an additional share for each share held. This does not raise any capital for the corporation, but it makes it easier for stockholders to sell shares on the open market. In a two-for-one split, for instance, the stock's price is initially cut in half, attracting investors.

However there are some drawbacks of this type of funding, first of all it is quite often that the cost of selling common stock is higher than the cost of raising the same amount of money by obtaining additional loans. For instance there is the direct cost issue such as the costs of advice from investment bank or broker. And the other downside is dividends cannot be used to reduce taxable profit because the dividends are paid out after-tax earnings, whereas interest payments on loans are tax deductible.  When a company pays interest the tax authorities regard this as a cost of doing business and therefore it can be used to reduce the profit subject to tax.

3. Using Profits

Companies also can finance their operations by retaining their earnings. Strategies concerning retained earnings vary. Some corporations, especially electric, gas, and other utilities, pay out most of their profits as dividends to their stockholders. Others distribute, say, 50 percent of earnings to shareholders in dividends, keeping the rest to pay for operations and expansion. Still other corporations, often the smaller ones, prefer to reinvest most or all of their net income in research and expansion, hoping to reward investors by rapidly increasing the value of their shares.

The Role of International Capital Markets in Economic Growth

National boundaries are no longer an obstruction to lenders and borrowers meeting in a market to buy and sell securities. It is possible for borrowers in one country to issue securities denominated in the currency of another, and these to be sold to investors in a third country. Often, such transactions will be organized by financial institutions located in yet another country, usually one of the three primary centers of these international capital markets which are New York, London, and Tokyo.

There was some significant beneficiary that could be impact by international capital markets for the growth of economy. And These are two of their benefits :

1. Capital Markets Improve the Allocation of Capital

The development of the capital markets has generated two major sets of economic benefits. First, it has improved the allocation of capital. Because the prices of corporate debt and equity respond immediately to shifts in demand and supply, changes in the outlook for an industry (and/or company) are quickly embodied in current asset prices. The signal created by such a price change encourages (i.e., by higher prices) or discourages (i.e., by lower prices) capital inflows into the industry (and/or company). Businesses with high returns attract additional capital quickly and easily. When returns drop due to added capacity or a decline in demand, prices drop, and this signal causes investors to cut the flow of new capital to that industry.

The ability of companies in their early stages of development to raise funds in the capital markets is also beneficial because it allows these companies to grow very quickly. This growth in turn speeds the dissemination of new technologies throughout the economy. Furthermore, by raising the returns available from pursuing new ideas, technologies, or ways of doing business, the capital markets facilitate entrepreneurial and other risk taking activities.

International capital market also provides equity capital and infrastructure development that has strong socio-economic benefits in developing countries like roads, water and sewer systems, housing, energy, telecommunications, public transport, ideal for financing through capital markets via long dated bonds and asset backed securities. Capital markets are very important because they play a significant role in the economy by channeling investment where it is needed and put into the best use.

2. Capital Markets Help Facilitate Superior Economic Performance

The improved allocation of capital and risk sharing facilitated by capital markets has led to superior economic performance. As the capital markets have become more developed in the UK and the US, the economic performance of these countries has improved. Superior economic performance is measured by three different aspects :

2.1 Higher productivity growth

The capital markets have played an important role in this process. First, the capital markets helped improve the allocation of capital, thereby raising the average return on capital. Second, the capital markets facilitated the allocation of risk and helped provide a mechanism by which start-up companies could raise capital.

2.2 Greater macroeconomic stability

Capital markets have helped to reduce economic volatility in two ways. First, because the capital markets use mark-to-market accounting, it is more difficult for problems to be deferred. As a result, pain is borne in real time, which means that the ultimate shock to the economy tends to be smaller. Second, by providing immediate feedback to policy makers, the capital markets have increased the benefits of following good policies and increased the cost of following bad ones.

2.3 Greater home ownership

The revolution in mortgage finance has increased the ability of households to purchase their own home. The closing costs associated with obtaining a residential mortgage have fallen, and the terms (for example, the loan-to-value ratio) have become less stringent. At times, homeowners can obtain 100 percent financing to purchase a home.

HOW FIRSTGROUP’S NEWLY APPOINTED CHAIRMAN COULD MAXIMIZE SHAREHOLDERS VALUE

Aviva’s chairman John McFarlane was chosen to be the new firstgroup’s chairman. He replaced Martin Gilbert who has previously led the company for almost 20 years. The appointment of Aviva chairman John McFarlane ended a six-month search for a replacement for Martin Gilbert. And McFarlane became the group’s chairman since 1 January 2014

 

John Mc Farlane

McFarlane arrived at the company in a state of turmoil where in 2013 firstgroup’s experienced a significant downfall on profit and their share prices plummeted which caused the company to plead its shareholders for £615m in an effort to reduce its debts and avoid a credit rating downgrade.

Shareholders began to lose trust on the company as dividend payments were suspended and dismissed the plan from shareholders to sell greyhound in order to be able to pay the debt. This is now an essential job for McFarlane to restore shareholder’s trust and to deliver sustainable long-term value for shareholders.

There are some significant actions that must be taken by McFarlane to maximizing shareholders’ value :

1.      Carry only assets that maximize value.

First, value-oriented companies regularly monitor whether there are buyers willing to pay a meaningful premium over the estimated cash flow value to the company for its business units, brands, and other detachable assets. Such an analysis is clearly a political minefield for businesses that are performing relatively well against projections or competitors but are clearly more valuable in the hands of others. Yet failure to exploit such opportunities can seriously compromise shareholder value.

On this occasion Mcfarlane could sell firstgroup’s assets in United States, Greyhound Bus company. Even though greyhound’s profit has steadily climbed, with this action firstgroup would be able to recoup part or even all of their debt and in addition could focus on profitability by reducing capital spending and inventory levels.

2.      Return cash to shareholders when there are no credible value-creating opportunities

Value-conscious companies with large amounts of excess cash and only limited value-creating investment opportunities return the money to shareholders through dividends and share buybacks. Not only does this give shareholders a chance to earn better returns elsewhere, but it also reduces the risk that management will use the excess cash to make value-destroying investments—in particular, ill-advised, overpriced acquisitions.to invest in the business.

Firstgroup are noticeably holding the dividends because of the need for cash to pay for their debts, which definitely does not send the correct signals for the sustainability of the company. Actions that needs to be done by McFarlane in the future could be to sell one of their assets and deliver the dividends that were suspend to the shareholders. This is crucial since holding the dividends would only spark more turmoil and controversy within the company and also there are no credible value-creating opportunities at the moment since company are now are focusing on paying their debt load. So it is mandatory for McFarlane to return the cash to shareholder.

3.      Provide investors with value-relevant information.

Better disclosure not only offers an antidote to short-term earnings obsession but also serves to lessen investor uncertainty and so potentially reduce the cost of capital and increase the share price. McFarlane has to provide corporate performance statements to shareholder separating out cash flows and accruals, providing a historical baseline for estimating a company’s cash flow prospects and enabling analysts to evaluate how reasonable accrual estimates are and then classify accruals with long cash-conversion cycles into medium and high levels of uncertainty. This also provides a range and the most likely estimate for each accrual rather than traditional single-point estimates that ignore the wide variability of possible outcome and finally details assumptions and risks for each line item while presenting key performance indicators that drive the company’s value. In reality executives in well-managed companies already use the type of information contained in a corporate performance statement.