International Financial Management Paper
INTERNATIONAL FINANCIAL MANAGEMENT Undertaken at “TECNIA INSTITUTE OF ADVANCED STUDIES” Submitted in the partial fulfillment for the award of the degree of MASTER OF BUSINESS ADMINISTRATION Under the Supervision Submitted by and Guidance ofRAMAN KUMAR Ms. Sakshi Goel 05117003910 (Lecturer IFM)MBA- 3rd Sem SESSION: 2010 – 2012 TECNIA INSTITUTE OF ADVANCED STUDIES (Approved by AICTE, Ministry of HRD, Govt. of India) Affiliated To Guru Gobind Singh Indraprastha University, Delhi INSTITUTIONAL AREA, MADHUBAN CHOWK, ROHINI, DELHI- 110085 E-Mail:[email protected] rg, Website: www. tecniaindia. org Fax No: 27555120, Tel: 27555121-24 Ques 1) Bring out the similarities and dissimilarities in the financing facilities at IMF and World Bank. Discuss how the two institutions help in the development of developing countries? World Bank and IMF * The World Bank and the IMF are twin pillars supporting the world’s economic and financial structure. The World Bank is an investment bank owned by its member nations. The IMF functions more like a credit union whose members can draw from a common pool of funds to assist in emergencies. As of Aug. 1, 2010, its biggest borrowers were Romania, Ukraine and Hungary. 1944–1969 * From July 1 to 22, 1944, the IMF and World Bank Articles of Agreement were formulated at the International Monetary and Financial Conference in Bretton Woods, New Hampshire. On May 8, 1947, France became the first nation to borrow from the IMF. On Sept. 29, 1967, the IMF board approved a plan to establish special drawing rights (SDRs), which are international reserve assets used by member countries to supplement their foreign exchange reserves. 1970–1985 * On Aug. 15, 1971, the U. S. topped using the gold standard to settle international transactions. In 1974, the IMF adopted a new method of SDR valuation based on a basket of 16 currencies. This basket was simplified on Sept. 17, 1980, to hold five currencies, and today it holds four: the U. S. dollar, euro, Japanese yen and pound sterling. On Dec. 2, 1985, the two agencies expressed support for a U. S. initiative for comprehensive adjustment measures by debtors, increased and more effective structural lending by multilateral development banks, and expanded lending by commercial banks. 1986-Onward * On Dec. 9, 1987, the IMF established the Enhanced Structural Adjustment Facility (ESAF) to provide resources to developing nations undergoing fundamental debt restructuring and economic reform. Countries of the former Soviet Union joined the two agencies in 1992. The IMF, in conjunction with the G7, helped stabilize the 1995 Mexican peso crisis and the 1997 Asian currency crisis. On Jan. 8, 2001, the IMF and the Bank announced debt relief for 22 countries, 18 of them in Africa. On Apr. 13, 2003, a joint IMF-World Bank project was launched to monitor the policies and actions needed to achieve the United Nations Millennium Development Goals by 2015.
On Sept. 25, 2005, agreement was reached on a G7/G8 proposal to provide 100 percent debt relief to the world’s heavily indebted poor countries (HIPCs). During their April 2006 meetings, the IMF and the Bank focused on ways to finance clean energy in developing countries, and the role of governance in meeting worldwide social, health and economic goals. Similarities & Differences The overall structure of the United Nations System and World Bank Group has been described in previous posts. Both of those groups have expanded exponentially since their creation.
Given that both the UN and World Bank were born from the same parents almost simultaneously, the extent of differences among organizations both within and between those two broad institutional systems is surprising: 1. Although membership in all entities within the UN System and World Bank Group is limited to sovereign- states, all members of the United Nations General Assembly are not necessarily members of IBRD (or other World Bank subsidiary bodies or specific UN specialized agencies); 2.
Although sovereign-state members are represented by their respective governments within UN System and World Bank Group entities, different agencies within those governments represent them in those different international bodies (for example, [i] ministries of foreign affairs generally represent their governments in the General Assembly and Security Council, [II] bi-lateral development agencies, ministries of external affairs, or sector-specific line ministries normally represent them inspecialized agencies, and [iii] ministries of finance or central banksnormally represent them in the World Bank and International Monetary Fund [IMF]); 3.
Although informal agreements existed that the Administrator of the United Nations Development Programme (UNDP) and thePresident of the World Bank should both be Americans,6 a wide range of other nationalities have always served in the highest leadership position of other UN specialized agencies; 4. Although senior leaders within both systems stressed the importance of “country-knowledge” among staff, the UN system began posting Resident Representatives to client countries very early-on while the World Bank continues to rely primarily on staff and consultants dispatched from its Washington headquarters; and 5.
Although the UN system fairly rapidly expanded its interests in international development assistance and capacity to provide it, the attention of its overall leadership and Secretariat staff remains focused on, in the words of Craig Murphy, “matters of international high politics. ” IMF and World Bank help in the development of developing countries The IMF and World Bank collaborate regularly and at many levels to assist member countries and work together on several initiatives. In 1989, the terms for their cooperation were set out in a concordat to ensure effective collaboration in areas of shared responsibility.
High-level coordination: During the Annual Meetings of the Boards of Governors of the IMF and the World Bank, Governors consult and present their countries’ views on current issues in international economics and finance. The Boards of Governors decide how to address international economic and financial issues and set priorities for the organizations. A group of IMF and World Bank Governors also meet as part of the Development Committee, whose meetings coincide with the Spring and Annual Meetings of the IMF and the World Bank.
This committee was established in 1974 to advise the two institutions on critical development issues and on the financial resources required to promote economic development in low-income countries. Management consultation. The Managing Director of the IMF and the President of the World Bank meet regularly to consult on major issues. They also issue joint statements and occasionally write joint articles, and have visited several regions and countries together. Staff collaboration. The staffs of the IMF and the Bank collaborate closely on country assistance and policy issues that are relevant for both institutions.
The two institutions also often conduct country missions in parallel and staff participate in each other’s missions. IMF assessments of a country’s general economic situation and policies provide input to the Bank’s assessments of potential development projects or reforms. Similarly, Bank advice on structural and sectoral reforms is taken into account by the IMF in its policy advice. The staffs of the two institutions also cooperate on the conditionality involved in their respective lending programs.
The 2007 external review of Bank-Fund collaboration led to a Joint Management Action Plan on World Bank-IMF Collaboration (JMAP) to further enhance the way the two institutions work together. Under the plan, Fund and Bank country teams discuss their country-level work programs, which identify macro-critical sectoral issues, the division of labor, and the work needed from each institution in the coming year. A recent review of JMAP implementation underscored the importance of these joint country team consultations in enhancing collaboration.
Reducing debt burdens. The IMF and World Bank also work together to reduce the external debt burdens of the most heavily indebted poor countries under theHeavily Indebted Poor Countries (HIPC) Initiative and the Multilateral Debt Relief Initiative (MDRI). The objective is to help low-income countries achieve their development goals without creating future debt problems. IMF and Bank staff jointly prepare country debt sustainability analyses under the Debt Sustainability Framework (DSF) developed by the two institutions. Reducing poverty.
In 1999, the IMF and the World Bank initiated the Poverty Reduction Strategy Paper (PRSP) approach—a country-led plan for linking national policies, donor support, and the development outcomes needed to reduce poverty in low-income countries. PRSPs underpin the HIPC Initiative and most concessional lending by the IMF (in particular, the Extended Credit Facility (ECF)) and World Bank. Monitoring progress on the MDGs. Since 2004, the Fund and Bank have worked together on the Global Monitoring Report (GMR), which assesses progress needed to achieve the UN Millennium Development Goals (MDGs).
The report also considers how well developing countries, developed countries, and the international financial institutions are contributing to the development partnership and strategy to meet the MDGs. Assessing financial stability. The IMF and World Bank are also working together to make financial sectors in member countries resilient and well regulated. The Financial Sector Assessment Program (FSAP) was introduced in 1999 to identify the strengths and vulnerabilities of a country’s financial system and recommend appropriate policy responses. Ques 2) What to do understand by swap?
What are the various types of swaps? An Introduction To Swaps Derivatives contracts can be divided into two general families: 1. Contingent claims, i. e. , options 2. Forward claims, which include exchange-traded futures, forward contracts and swaps 3. A swap is an agreement between two parties to exchange sequences of cash flows for a set period of time. Usually, at the time the contract is initiated, at least one of these series of cash flows is determined by a random or uncertain variable, such as an interest rate, foreign exchange rate, equity price or commodity price.
Conceptually, one may view a swap as either a portfolio of forward contracts, or as a long position in one bond coupled with a short position in another bond. This article will discuss the two most common and most basic types of swaps: the plain vanilla interest rate and currency swaps. The Swaps Market Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few (if any) individuals ever participating.
Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. (For background reading, see Futures Fundamentals and Options Basics. ) The first interest rate swap occurred between IBM and the World Bank in 1981. However, despite their relative youth, swaps have exploded in popularity. In 1987, the International Swaps and Derivatives Association reported that the swaps market had a total notional value of $865. 6 billion. By mid-2006, this figure exceeded $250 trillion, according to the Bank for International Settlements.
That’s more than 15 times the size of the U. S. public equities market. Plain Vanilla Interest Rate Swap The most common and simplest swap is a “plain vanilla” interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency.
The specified payment dates are called settlement dates, and the time between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. (For related reading, see How do companies benefit from interest rate and currency swaps? ) For example, on December 31, 2006, Company A and Company B enter into a five-year swap with the following terms: * Company A pays Company B an amount equal to 6% per annum on a notional principal of $20 million. Company B pays Company A an amount equal to one-year LIBOR + 1% per annum on a notional principal of $20 million. LIBOR, or London Interbank Offer Rate, is the interest rate offered by London banks on deposits made by other banks in the eurodollar markets. The market for interest rate swaps frequently (but not always) uses LIBOR as the base for the floating rate. For simplicity, let’s assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. At the end of 2007, Company A will pay Company B $20,000,000 * 6% = $1,200,000.
On December 31, 2006, one-year LIBOR was 5. 33%; therefore, Company B will pay Company A $20,000,000 * (5. 33% + 1%) = $1,266,000. In a plain vanilla interest rate swap, the floating rate is usually determined at the beginning of the settlement period. Normally, swap contracts allow for payments to be netted against each other to avoid unnecessary payments. Here, Company B pays $66,000, and Company A pays nothing. At no point does the principal change hands, which is why it is referred to as a “notional” amount.
Figure 1 shows the cash flows between the parties, which occur annually (in this example). (To learn more, read Corporate Use Of Derivatives For Hedging. ) | Figure 1: Cash flows for a plain vanilla interest rate swap| Plain Vanilla Foreign Currency Swap The plain vanilla currency swap involves exchanging principal and fixed interest payments on a loan in one currency for principal and fixed interest payments on a similar loan in another currency. Unlike an interest rate swap, the parties to a currency swap will exchange principal amounts at the beginning and end of the swap.
The two specified principal amounts are set so as to be approximately equal to one another, given the exchange rate at the time the swap is initiated. For example, Company C, a U. S. firm, and Company D, a European firm, enter into a five-year currency swap for $50 million. Let’s assume the exchange rate at the time is $1. 25 per euro (i. e. , the dollar is worth $0. 80 euro). First, the firms will exchange principals. So, Company C pays $50 million, and Company D pays ¬40 million. This satisfies each company’s need for funds denominated in another currency (which is the reason for the swap). |
Figure 2: Cash flows for a plain vanilla currency swap, Step 1. | Then, at intervals specified in the swap agreement, the parties will exchange interest payments on their respective principal amounts. To keep things simple, let’s say they make these payments annually, beginning one year from the exchange of principal. Because Company C has borrowed euros, it must pay interest in euros based on a euro interest rate. Likewise, Company D, which borrowed dollars, will pay interest in dollars, based on a dollar interest rate. For this example, let’s say the agreed-upon dollar-denominated interest rate is 8. 5%, and the euro-denominated interest rate is 3. 5%. Thus, each year, Company C pays ¬40,000,000 * 3. 50% = ¬1,400,000 to Company D. Company D will pay Company C $50,000,000 * 8. 25% = $4,125,000. As with interest rate swaps, the parties will actually net the payments against each other at the then-prevailing exchange rate. If, at the one-year mark, the exchange rate is $1. 40 per euro, then Company C’s payment equals $1,960,000, and Company D’s payment would be $4,125,000. In practice, Company D would pay the net difference of $2,165,000 ($4,125,000 – $1,960,000) to Company C. |
Figure 3: Cash flows for a plain vanilla currency swap, Step 2| Finally, at the end of the swap (usually also the date of the final interest payment), the parties re-exchange the original principal amounts. These principal payments are unaffected by exchange rates at the time. | Figure 4: Cash flows for a plain vanilla currency swap, Step 3| Who would use a swap? The motivations for using swap contracts fall into two basic categories: commercial needs and comparative advantage. The normal business operations of some firms lead to certain types of interest rate or currency exposures that swaps can alleviate.
For example, consider a bank, which pays a floating rate of interest on deposits (i. e. , liabilities) and earns a fixed rate of interest on loans (i. e. , assets). This mismatch between assets and liabilities can cause tremendous difficulties. The bank could use a fixed-pay swap (pay a fixed rate and receive a floating rate) to convert its fixed-rate assets into floating-rate assets, which would match up well with its floating-rate liabilities. Some companies have a comparative advantage in acquiring certain types of financing.
However, this comparative advantage may not be for the type of financing desired. In this case, the company may acquire the financing for which it has a comparative advantage, then use a swap to convert it to the desired type of financing. For example, consider a well-known U. S. firm that wants to expand its operations into Europe, where it is less well known. It will likely receive more favorable financing terms in the US. By then using a currency swap, the firm ends with the euros it needs to fund its expansion. Exiting a Swap Agreement
Sometimes one of the swap parties needs to exit the swap prior to the agreed-upon termination date. This is similar to an investor selling an exchange-traded futures or option contract before expiration. There are four basic ways to do this. 1. Buy Out the Counterparty Just like an option or futures contract, a swap has a calculable market value, so one party may terminate the contract by paying the other this market value. However, this is not an automatic feature, so either it must be specified in the swaps contract in advance, or the party who wants out must secure the counterparty’s consent. . Enter an Offsetting Swap For example, Company A from the interest rate swap example above could enter into a second swap, this time receiving a fixed rate and paying a floating rate. 3. Sell the Swap to Someone Else Because swaps have calculable value, one party may sell the contract to a third party. As with Strategy 1, this requires the permission of the counterparty. 4. Use a Swaption A swaption is an option on a swap. Purchasing a swaption would allow a party to set up, but not enter into, a potentially offsetting swap at the time they execute the original swap.
This would reduce some of the market risks associated with Strategy 2.. Conclusion Swaps can be a very confusing topic at first, but this financial tool, if used properly, can provide many firms with a method of receiving a type of financing that would otherwise be unavailable. This introduction to the concept of plain vanilla swaps and currency swaps should be regarded as the groundwork needed for further study. You now know the basics of this growing area and how swaps are one available avenue that can give many firms the comparative advantage they are looking for.