FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE FINAL GROUP - III PAPER - 12 STUDY NOTES THE INSTITUTE OF COST AND WORKS ACCOUNTANTS OF INDIA 12, SUDDER STREET, KOLKATA - 700 016 First Edition : May 2008 Revised Edition : March 2009 First Reprint of Revised Edition : June 2010 Published by : Directorate of Studies The Institute of Cost and Works Accountants of India 12, Sudder Street, Kolkata - 700 016 Printed at : India Ltd., Navi Mumbai, India Copyright of these Study Notes is reserved by the Institute of Cost and Works Accountants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof PAPER - 12 FINANCIAL MANAGEMENT AND INTERNATIONAL FINANCE Contents Study Note - Overview of Financial Management Section Particulars Section Finance and Related Discipline 1–5 Section Objective & Scope of Financial Management 6–9 Section Planning Environment 10 – 15 Section Key Decisions of Financial Management 16 – 20 Section Emerging Role of Finance Managers Section Earnings Distribution Policy Section Compliance of Regulatory Requirements in Formulation of Financial Strategies Section 21 22 – 23 24 – 36 Sources of Finance - Long Term, Short Term and International Section Page No 37 – 46 Exchange rate - Risk Agencies Involved And Procedure Followed in International Financial Operations 47 – 56 Study Note - Financial Management Decisions 57 – 65 Section Capital Structure Theory Section Cost of Capital 66 – 107 Section Capital Budgeting 108 – 177 Section Replacement and Lease Decisions 178 – 202 Section Working Capital 203 – 264 Section Financial Services 265 – 284 Section Dividend Policy 285 – 319 Section Financial Management in Public Sector 320 – 332 Section Role of Treasury Function 333 – 336 Section 10 Contemporary Developments 337 – 340 Study Note - Financial Analysis and Planning Section Funds Flow Analysis 341 – 382 Section Ratio Analysis 383 – 399 Section Identification of Information Required To Access 400 – 431 Financial Performance Study Note - Leverage Section Analysis of Operating and Financial Leverages 432 – 448 Study Note - Financial Strategy Section Understanding Financial Strategy 449 – 453 Section Financial and Non-Financial Objectives of Different Organizations 454 – 465 Section Impact on Investment, Finance and Dividend Decisions 466 – 473 Section Alternative Financing Strategy in the Context of Regulatory Requirements 474 – 478 Modeling and Forecasting Cash Flows and Financial Statements 479 – 481 Sensitivity Analysis for Changes in Expected Values in the Models and Forecasts 482 – 497 Section Section Study Note - Investment Decisions Section Cost Benefits Risks Analysis for Projects 498 – 506 Section Designing Capital Structure 507 – 511 Section Capital Investment Real Options 512 – 514 Section Venture Capital 515 – 518 Section Hybrid Finance 519 – 542 Study Note - Project Management Section Project Identification and Formulation 543 – 548 Section Identification of Project Opportunities 549 – 558 Section Project Selection Considerations and Feasibility Studies 559 – 567 Section Project Appraisal and Cost Benefit Analysis 568 – 579 Section Sources of Project Finance and Foreign Collaboration 580 – 601 Study Note - International Finance Section Risk – Management of Risk 602 – 614 Section Risk – Diversification 615 – 619 Section Derivatives 620 – 649 Section Caps, Floors and Collars 650 – 652 Section Money Market Hedge 653 – 677 Study Note - Sources of International Finance Section Raising Funds in Foreign Markets and Investment in Foreign Markets 678 – 690 Section Forward (Interest) Rate Agreements – FRAS 691 – 693 Section Exposures in International Finance 694 – 696 Section Parity Theorems 697 – 703 Section Foreign Direct Investment (FDI) 704 – 706 Study Note - 10 International Monetary Fund and Financial System Section Understanding International Monetary System 707 – 717 Section Export – Import Procedures and Documentation 718 – 724 Section International Financial Management : Important Issues and Features, International Capital Market 725 – 728 Section International Financial Services and Insurance : Important Issues and Features 729 – 734 SYLLABUS Paper 12: Financial Management & International Finance (One Paper: hours: 100 marks) OBJECTIVES Understand the scope, goals and objectives of Financial Management To provide expert knowledge on concepts, methods and procedures involved in using Financial Management for managerial decision-making Learning Aims Understand and apply theories of financial management Identify the options available in financial decisions and using appropriate tools for strategic financial management Identify and evaluate key success factors in the financial management for organisation as a whole Evaluate strategic financial management options in the light of changing environments and the needs of the enterprise Determining the optimal financial strategy for various stages of the life-cycle of the enterprise Critically assess the proposed strategies Skill set required Level C: Requiring all six skill levels - knowledge, comprehension, application, analysis, synthesis, and evaluation CONTENTS Overview of Financial Management 10% Financial Management Decisions 15% Financial Analysis & Planning 10% Operating and Financial Leverages 5% Financial Strategy 15% Investment Decisions 15% Project Management 10% International Finance 10% Sources of International Finance 10 International Monetary and Financial System 5% 5% Overview of Financial Management Finance and Related Disciplines Scope of Financial Management Planning environment Key decisions of Financial Management Emerging role of finance managers in India Earnings distributions policy Compliance of regulatory requirements in formulation of financial strategies Sources of finance – long term, short term and international Exchange rate – risk agencies involved and procedures followed in international financial operations Financial Management Decisions Capital structure theories and planning Cost of capital Designing Capital Structure Capital budgeting Lease financing Working capital management Financial services Dividend and retention policies Criteria for selecting sources of finance, including finance for international investments Effect of financing decisions on Balance Sheet and Ratios Financial management in public sector Role of Treasury function in terms of setting corporate objectives, funds management – national and international Contemporary developments – WTO, GATT, Corporate Governance, TRIPS, TRIMS, SEBI regulations as amended from time to time Financial analysis & planning Funds flow and cash flow analysis Financial ratio analysis -Ratios in the areas of performance, profitability, financial adaptability, liquidity, activity, shareholder investment and financing, and their interpretation Limitations of ratio analysis Identification of information required to assess financial performance Effect of short-term debt on the measurement of gearing Operating and financial leverages Analysis of operating and financial leverages Concept and nature of leverages operating risk and financial risk and combined leverage Operating leverage and Cost volume Profit analysis – Earning Before Interest and Tax (EBIT) and Earning Per Share (EPS), indifference point Financial Strategy Financial and Non-Financial objective of different organizations Impact on Investment, finance and dividend decisions Sources and benefits of international financing Alternative Financing strategy in the context of regulatory requirements Modeling and forecasting cash flows and financial statements based on expected values for variables – economic and business Sensitivity analysis for changes in expected values in the models and forecasts Emerging trends in financial reporting Investment Decisions Costs, Benefits and Risks analysis for projects Linking investment with customer’s requirements Designing Capital Structure The impact of taxation, potential changes in economic factors and potential restrictions on remittance on these calculations Capital investment real options Venture Capital financing Hybrid financing / Instruments Project Management Project Identification and Formulation Identification of Project opportunities Project Selection Consideration and Feasibility Studies Project appraisal & Cost Benefit analysis Source of Project Finance & Foreign Collaboration International Finance Minimization of risk Diversification of risk Forward and futures Forward rate agreements Interest rate swaps Caps, floors and collars Parity theorems FDI Money market hedge Options Sources of International Finance Rising funds in foreign markets and investments in foreign projects Forward rate agreements and interest rate guarantees Transaction, translation and economic risk, Interest rate parity, purchasing power parity and the Fisher effects Foreign Direct Investment 10 International Monetary and Financial System Understanding the International Monetary System Export and Import Practices International Financial Management: Important issues and features, International Capital Market International Financial Services and Insurance: Important issues and features COST-VOLUME-PROFIT ANALYSIS International Monetary Fund and Financial System Buyers’ Credit If credit is granted to the buyer by a financial institution in the seller country or a financial institution in the buyer country, then it is called buyer’s credit The buyer enters into an agreement with the financial institutions to pay the supplier on cash basis or document basis and credit granted to the buyers for the purpose The financial agreement between the buyers and the financial institution lays down the conditions to be fulfilled by the supplier before payment is made to him such as the form, values and maturity of promissory notes, the form in which the supplier must present the claims and bills to the financing bank, interest rate applicable, credit repayment terms, taxes, commission and other charges to be paid by the borrower, and the procedure to be followed in the case of defaults Such credits are generally granted by the supplier country’s financial institution like EXIM Bank for periods ranging from to 10 years The supplier in such cases gets the government and the central bank’s clearance and for arranging this type of credit Lines of Credit A line of credit is granted by a foreign government or an international institution in the buyer country so that a larger number of buyers could benefit from it This generally is available for a programme such as Railways, Roads, Electricity, Water Supply etc., and the responsibility for assessing the creditworthiness of the buyers or of the project is passed on to the buyer country’s financial institution Such credit lines are granted to ICICI in India by the German banks and UK banks for purchase of capital goods and machinery in respect of plastics, drugs etc and by the IDBI to Bangladesh, Malaysia, Mauritius etc LETTERS OF CREDIT – DOCUMENTARY AND NON-DOCUMENTARY Letter of credit is the most important mode of payment for trade throughout the world As the buyers and sellers are often not known to each other and the bankers are well known for their credit standing, the banks creditworthiness is substituted for the creditworthiness of the buyer under this method The documentary L/C is an undertaking given by the bank to pay or accept the bill provided the beneficiary (exporter) fulfils the terms and conditions of sale as set out in the application made to the bank by the importer (buyer) Generally, banks follow in India uniform customs and practice code in the issue of the documentary credits which will be binding as between banks and between banks and customers The documentary credit protects the seller from the risk of loss of funds due to the uncertain credit position of the buyer and promotes foreign trade and foreign investment The bank charges from the buyer-importer at the interest rate admissible for the credit so granted and may or may not ask for a margin deposit of funds for the purpose The banks also charge for the handling of documents in the process of negotiation or collection In the case of non-documentary credits, no documents need accompany the Bill of Exchange in which case the exporter bank only arranges to collect the amounts involved and no handling charges may be levied TYPES OF CREDIT : Documentation in respect of credit will depend upon the type of credit available from banks a) Revocable or Irrevocable: While revocable credit can be cancelled at any time without the concurrence of the beneficiary, the irrevocable credit cannot be so revoked 720 Financial Management & International Finance The revocable letter of credit, according to the International Chamber of Commerce, is “not a legally binding undertaking between the bank or banks concerned and the beneficiary” Irrevocable letter of credit is a definite undertaking on the part of the issuing banks and constitutes an obligation to the beneficiary to honour bills or drafts under the credit, provided the terms and conditions of the credit are complied with Even the revocable credit is good until it is cancelled and the cancellation is notified to the beneficiary and/or his bank and proves the bonafides and the intention of importing by the buyers b) Confirmed and unconfirmed Credits: A documentary L/C which is irrevocable can be confirmed or unconfirmed The confirmation of the importer bank is communicated through its correspondent or agent or branch in the exporter’s country If it is an irrevocable credit, the latter bank – correspondent, agent or branch – confirms the credit to the beneficiary The confirmation adds further strength to the exporter in his own country by his own banker If the local bank advises the credit without confirming, it is called “unconfirmed credit” While the confirming bank has an obligation to negotiate bills under this credit drawn by the beneficiary, the advising or notifying bank has no such obligation c) Transferable Credit: It is one which contains an express provision that the benefits under it to be enjoyed by the beneficiary can be transferred from the latter to a third party who supplies him raw materials for this manufacture or supplies manufactured outputs if he is a merchant trader d) Back-to-back Credits: There are the secondary credits opened by a bank on behalf of the beneficiary of an original credit in favour of the domestic supplier This is a formal opening of another credit line on the basis of credit to the beneficiary Suppose a London importer of tea opens a confirmed irrevocable Letter of Credit through the Barclays Bank in London to the Bank of India in Calcutta As the tea merchant has to buy tea from a tea producer, the former may arrange with the Bank of India to issue a confirmed letter in favour of the tea producer for his use in the manufacturing process This is known as “back-to-back credit” e) Red Clause or Green Clause: This is incorporated only in irrevocable credits and authorizes the negotiating bank to make advances to the beneficiary to enable him to manufacture or purchase the goods from the local suppliers When relations between the exporter and importer are close or they are connected as collaboration or suppliers of long standing, then the red clause is incorporated in the L/C at the request of the importer buyer for the benefit of the exporter Such clauses are used in packing credit arrangements in wool exports, tea exports, etc f) Revolving Credit: These credits are granted on a revolving basis to suit the requirements of suppliers who are doing this business on a continuing basis This credit obviates the need for opening fresh letters for each shipment As soon as the negotiated drafts under the credit are reimbursed by the importer to the bank opening the credit, fresh credit is available to the foreign negotiation bank Financial Management & International Finance 721 COST-VOLUME-PROFIT ANALYSIS International Monetary Fund and Financial System It will thus be seen from the above discussion that the parties to the L/C, besides the buyer, beneficiary and the issuing bank are the notifying bank which advises the credit to the exporter in his country, confirming bank which confirms the credit to the exporter in his country, the negotiating bank which negotiates the drafts, bills of exchange etc., and the paying bank which finally pays to the exporter If the notifying bank also confirms the credit and negotiates the bills, then all the three parties are merged into one bank The paying bank may be the original issuing bank in the buyer’s country in which case, the bill is drawn in the foreign currency (from the point of view of exporter) or by the notifying or confirming bank in which case the bill is drawn and paid in the local currency of the exporter DOCUMENTATION OF FOREIGN TRADE : The documents used in foreign trade are broadly of two categories, namely substantive documents and auxiliary documents In the first category are included: (1) Bill of Lading (2) Marine Insurance and (3) Bill of Exchange The auxiliary instruments are commercial invoices, consular invoice, custom invoice, certificate of origin, inspection certificate, packing list, etc Bill of Lading The Bill of Lading is an important document issued by a common carrier, namely, the shipping company or Airways, stating that the goods mentioned therein have been received for shipment or airlift and that it has undertaken to deliver the goods at a named destination on payment of freight or for which freight has already been paid (c.i.f or c.f.) The Bill of Lading is a document of title to goods, transferable by endorsement and is a receipt from the shipping company regarding the number of packages with a particular weight and markings and a contract for the transportation of the same to a part of destination mentioned therein The shipping company is governed by the carriage of goods by the Sea Act which provides protection to shippers and obligations on the shipping companies A Bill of Lading stating “Received for Shipment” is not adequate if the sales terms are “on board” The bill should specify that goods have been “on board” or “shipped” to satisfy the terms of c.i., or c.i.f Bills of Lading are the following types (a) Freight paid or freight payable In the case of c.i.f or c.f., the freight should be paid by the shipper and in case of f.o.b., it may be payable by the consignee or importer or his agent The bill of lading “Freight collect” is, therefore, not proper tender for c.i.f terms of sale; (b) Clean or claused bill In the case of any adverse remarks such as “damaged bags” or “bill torn” or “Drums dirty or old”, such bill are called “claused” or dirty bills as against clean bills which not mention anything adverse on the condition of packages, (c) Stale bill of lading If the bills are kept for too long with the shipper and by that time goods might have reached the destination port, the importer has to pay demurrages for non-acceptance of the goods which is due to delay in the receipt of shipping documents Such delayed bills of lading are called “Stale Bills” Mates’s Receipt When goods are delivered to the agent of a shipping company for shipment by a specified vessel and he agrees to so, then a Mate’s Receipt is given to the shipper This is exchanged for a regular Bill of Lading from the Master of the ship or the shipping company Mate’s Receipt is, however, not an acceptable document to the Bank from the point of its negotiation For such terms as “on board” or shipped or c.i.f or c.f., this is not adequate delivery 722 Financial Management & International Finance Through or Transhipment Bills If the transportation involves more than one mode, namely ship, rail, road etc., then a “Through Bill” is issued Such bills are not accepted by some bankers as they are not certain about the state in which goods will reach the consignee after all the transshipments If the sale terms are specific about “on board” or “shipped” only such terms are to be used and transshipment bills are avoided There has been more recently cases of exports using more than one means of transport, in India which gave rise to combined transport documents In the case of inland container depots in Bangalore, Delhi, Guntur and Coimbatore, for example, export cargo may be loaded direct at these dry ports involving transport by land/air/sea leading to the use of combined transport documents India was making efforts to get these documents officially recognized by the International Chamber of Commerce and U.N bodies Charter Party Bill When goods are in bulk, a shipper or a group of shippers charter a complete vessel for transport of those goods Such bills arising out of Charger Vessels are called “Charter Party Bills” If a charter agreement is not known to a third party who has booked on this vessel, the Bills of Lading arising out of this are not so attractive to bankers as they not know their route and destination and the time periods involved Negotiability of Bill of Lading All Bills of Lading are negotiable if the terms used are “consignee or is order” or the “party or his order” The Bills are issued in triplicate – all in original and signed by the Master of the ship When any one is used for taking delivery of goods, the others become invalid Airway Bills Airway Bills is specifically designed for quick transport; it is a document of title to goods but not negotiable They are generally made out in the name of the consignee who takes delivery and makes payment Three parts of the Airways Bill are issued – the first part marked for “Carrier”, second for the “consignee” and the third for the ”consignor” While the first is signed by the “consignor” and the second is signed by both the consignor and the carrier, the third is signed by the carrier or his agent Marine Insurance Policy As the banks are lending against goods in transport, they wish to avoid risks of loss and invariably insist on insurance Marine insurance is done through a policy of insurance taken at a stated premium and is a quasi-negotiable instrument This policy indemnifies the partyshipper against the normal marine losses or perils of the sea, such as damages to the vessel, or cargo by accidents or casualties, fire, jettison, natural calamities, etc Marine insurance policy generally has a legal standing and not a certificate of insurance The bank has to scrutinize whether there are any added clauses on the policy, the amount covered, voyages and goods covered and the risks covered and the extent of the coverage The ‘Institute Clauses’ are the standard policy clauses which are included and attached and amplified in the policy to avoid misunderstanding Such clauses are accepted by the Institute of London Underwriters Types of Losses a Total loss b General average loss borne proportionately by all interests at risk Financial Management & International Finance 723 COST-VOLUME-PROFIT ANALYSIS International Monetary Fund and Financial System c d e f Partial loss on particular average loss but not of a general type if the ship is sunk, burnt or stranded Losses attributed to fire, explosion, collision etc Discharge at a port of distress Special charges for landing, warehousing, forwarding etc (FPA) Free of Particular Average Policy This policy covers losses or damages falling under a particular average clause This is a minimum liability insurance and gives only partial cover for losses Particular Average (WPA) Clauses This widens the range of partial losses covered above at a slightly higher premium WPA clauses generally cover all marine losses plus General Average loses plus particular average losses if the loss is above a specified value of shipped goods and up to a percentage value of goods This gives fuller protection than the FPA clauses All Risks Clause This gives 100 per cent protection in respect of risks covered but not cover risks due to war, strikes, riots, inherent vice or damage in the goods, etc Sometimes, arrangements are made for more than 100 per cent coverage of risks at a extra premium As none of the above policies covers war risks, strikes, riots, if any, the party desiring to have them, has to have additional cover for them Warehouse to Warehouse Cover This is a comprehensive cover called transit clause covering protection from the commencement of transit to the final destination Action for Claiming Indemnity The concerned bank holding the policy should give prompt notice to insurers, carriers and all parties concerned in the event of damage or loss A survey of the loss should be got done to assess the extent and the degree of damage and send a claim to insurers accordingly in time The documents required to be submitted for claim either for partial loss or full loss coverage are the insurance policy, packing list, weight list, bills of lading, invoice, Master’s Protest certifying any unusual happening on the voyage, survey report on the nature and extent of damage etc Types of Insurance Documents There are various types of insurance policies such as floating policy, open cover policy, specific policy, etc Of these, specific policy is most acceptable, from the point of view of the banker (a) Floating Policy A floating policy is a contract of insurance to cover a number of shipments the maximum value of which is given but the details of which such as the name of the vessel, destination, weight and specification of cargo, etc., are not declared These details are expected to be filled in or endorsed on it later This is not, however, valid from the point of view of the banker unless the sale terms include the tender of such an insurance certificate 724 Financial Management & International Finance 10.3 International Financial Management: Important Issues and Features, International Capital Market This Section includes : FOREIGN EXCHANGE MARKET Eurocurrency market Euro Credit market International commodity market Asian Currency Market International Banking Financing Foreign Trade INTRODUCTION : International financial markets are a major source of funds for international transactions Most countries have recently internationalized their financial markets to attract foreign business Internationalization involves both a harmonization of rules and a reduction of barriers that will allow for the free flow of capital and permit all firms to compete in all markets THE FOREIGN EXCHANGE MARKET : The foreign exchange market is the market in which currencies of various countries are bought and sold against each other The foreign exchange market is an over-the-counter market Geographically, the foreign exchange markets span all time zones from New Zealand to the West Coast of the United States of America The retail market for foreign exchange deals with transactions involving travelers and tourists exchanging one currency for another in the form of currency notes or travelers cheques The wholesale market often referred to as the interbank market is entirely different and the participants in this market are commercial banks, corporations and central banks Participants: • Commercial Banks are commonly known as the “market makers” in this market In other words, on demand, they will quote buying and selling rates for one currency against another and express willingness to take either side of the transaction They also buy and sell on their own account and carry inventories of currencies • Foreign exchange brokers are essentially middlemen providing information to market making banks about prices and a counter party to transactions Brokers not buy or sell on their own account, instead that they have helped strike between two market making banks Financial Management & International Finance 725 COST-VOLUME-PROFIT ANALYSIS International Monetary Fund and Financial System • Central banks also intervene in the markets from time to time in order to move the market in a particular direction • Corporations use the foreign exchange markets for many purposes On the operational front, they use the foreign exchange markets for payments towards imports, conversion of export receipts, hedging receivables and payables position and payment of interest on foreign currency loans which they have taken Companies that are cash rich tend to also park surplus funds and take active positions in the foreign exchange market to earn profits from exchange rate movements There are others who, as a matter of company policy, restrict their participation to producing and selling of goods and services and only hedge their exposures Identification of Foreign Exchange Exposures Foreign exchange exposures arise from many different activities A traveler going to visit another country has the risk that if that country’s currency appreciates against their own the trip will be more expensive An importer who buys goods priced in foreign currency has the risk that the foreign currency will appreciate thereby making the local currency cost greater than expected An exporter who sells his product in foreign currency has the risk that if the value of that foreign currency falls then the revenues in the exporter’s home currency will be lower Fund Managers and companies who own foreign assets are exposed to fall in the currencies of the countries where they own the assets This is because if they were to sell those assets there and repatriate the money, the exchange rate would have a negative effect on the home currency value Further, physical movement of assets from a country is more complex Markets that allow exchange of currencies and flow of capital across countries facilitate international business These markets are known as international financial markets, which may take any of the following form: • FOREIGN EXCHANGE MARKET • Eurocurrency market • Euro Credit market • International commodity market • Asian Currency Market • International Banking • Financing Foreign Trade THE FOREIGN EXCHANGE MARKET : A market where currencies are exchanged in order to buy products or invest in securities denominated in a foreign currency The Euro Currency Market is composed of several large 726 Financial Management & International Finance banks (sometimes referred to as Euro Banks) that accept deposits and provide loans in various currencies Eurocurrency Markets : Eurocurrency market consists of banks that accept deposits and make loans in foreign currencies outside the country of issue These deposits are commonly known as Eurocurrencies Thus, US dollars deposited in London are called Eurodollars; British pounds deposited in New York are called Eurosterling, etc Eurocurrency markets are very large, well organized and efficient They serve a number of valuable purposes for multinational business operations Eurocurrencies are a convenient money market device for MNCs to hold their excess liquidity They are a major source of short term loans to finance corporate working capital needs and foreign trade Euro Credit Market: Euro credit or Euro Loans are the loans extended for one year or longer The market that deals in such loans is called Euro Credit Market Euro Bond Market: This market caters to the long term financial needs of the international players International Commodity Market: It is a market where major primary commodities are traded including price forecasts, regional price indices, transportation costs etc Asian Currency Market In 1968, an Asian version of the Eurodollar came into existence with the acceptance of dollar denominated deposits by commercial banks in Singapore, which was an ideal location for the birth of the Asian currency market due to its excellent communication network, important banks and a stable government Asian currency market developed when the Singapore branch of the bank of America proposed that the monetary authority of Singapore relax taxes and restrictions International Banking International banking has grown with the unprecedented expansion of economic activity since the world war International banks perform many vital tasks to help the international transactions of multinational companies They finance foreign trade and foreign investment, underwrite international bonds, borrow and lend in the Eurodollar market, organize syndicated loans, participate in international cash management, solicit local currency deposits and loans and give information and advice to clients Financial Management & International Finance 727 COST-VOLUME-PROFIT ANALYSIS International Monetary Fund and Financial System Interbank Clearing House Systems: There are three key clearing house systems of interbank fund transfers which transfer funds between banks through wire and facilitate international trade a The clearinghouse interbank payments system(CHIPS) This is used to move dollars among New York offices of about 150 financial institutions that handle 95 percent of all foreign exchange trades and almost all Eurodollar transactions b The clearing house payments assistance system(CHPAS) This began its operations in 1983 and provides services similar to those of CHIPS It is used to move funds among London offices of most financial institutions c The Society for Worldwide Interbank Financial Telecommunications (SWIFT): It is an interbank communication network which carries messages for financial transactions It represents a common denominator in the international payment system and uses the latest communication technology It has reduced multiplicity of formats used by banks in different parts of the world International payments can be made very cheaply and efficiently Financing Foreign Trade There are three major documents involved in foreign trade, namely, a draft, a bill of lading and a letter of credit Documentation in foreign trade is supposed to assure that the exporter will receive the payment and the importer will receive the merchandise Many of these documents are used to eliminate non completion risk, to reduce forex risk and finance trade transactions A draft or bill of exchange is an order written by an exporter that requires an importer to pay a specified amount of money at a specified time Through the draft, the exporter may use its bank as the collection agent on accounts that the exporter finances A bill of lading is a shipping document issued to an exporting firm or its bank by a common carrier which transports goods It is simultaneously a receipt, contract and a document of title As a receipt, the bill of lading indicates that specified goods have been received by the carrier As a contract, it is evidence that the carrier is obliged to deliver the goods to the importer in exchange for certain charges As a document of title, it establishes ownership of the goods Bill of lading can be used to insure payment before the goods are delivered Letter of credit is a document issues by a bank at the request of an importer In this, the bank agrees to honor a draft drawn on the importer if the draft accompanies specified documents such as the bill of lading The importer asks that his local bank write a letter of credit In exchange for the bank’s agreement to honor the demand for payment that results from the import transactions, the importer promises to pay the bank the amount of the transaction and a specified fee A letter of credit is advantageous to both exporters and importers because it facilitates foreign trade 728 Financial Management & International Finance 10.4 International Financial Services and Insurance: Important Issues and Features This Section includes : Implications of a large, rapidly growing home market for International Financial Services (IFS) in India: What drives the demand for IFS? The impact of globalization on IFS demand and on IFCs: Projections for revenue potential of Mumbai as an IFC Insurance Integration and Globalization of Financial Services: INTRODUCTION : The term financial services refers to services provided by the finance industry The finance industry encompasses a broad range of organizations that deal with the management of money Among these organizations are commercial banks, investment banks, asset management companies, credit card companies, insurance companies, consumer finance companies, stock brokerages, and investment funds IMPLICATIONS OF A LARGE, RAPIDLY GROWING HOME MARKET FOR INTERNATIONAL FINANCIAL SERVICES (IFS) IN INDIA : A little appreciated aspect of India’s impressive growth from 1992 onwards is that it has resulted in even faster integration of India with the global economy and financial system There has been a rapid escalation of two-way flows of trade and investment Since 1992, India has globalised more rapidly than it has grown, with a distinct acceleration in globalisation after 2002 Capital flows have been shaped by: (a) global investors in India (portfolio and direct); and (b) Indian firms investing abroad (direct) Indian investors - corporate, institutional and individual - have as yet been prevented from making portfolio investments abroad on any significant scale by the system of capital controls By the same token, Indian firms have borrowed substantially abroad But foreign firms and individuals have yet to borrow from India Capital controls still preclude that possibility Despite the controls that remain, those substantially increased two-way flows, reflect an increase in demand-supply for IFS related to trade/ investment transactions in India Put Financial Management & International Finance 729 COST-VOLUME-PROFIT ANALYSIS International Monetary Fund and Financial System another way, there has been an increase in IFS consumption by Indian customers and by global customers in India Demand for IFS from both has been growing exponentially Cumulative two-way flows in 1992-2005 were a multiple of such flows in 1947-92 The degree of ‘globalisation-integration’ that has occurred in the last 15 years, since reforms began in earnest, is much larger than in the 55 years between independence and India embarking on ‘serious’ reforms We have made up for six lost decades of economic interaction with the world in a decade and a half Still, what has happened over the last 15 years is a small harbinger of what is to follow over the next twenty: particularly if the current growth rate of 8% per annum is accelerated to 9-10% as is evocatively being suggested, and if India continues to open up the economy on both trade and capital flows The typical discussion about an Indian International Financial Services Centre (IFC) exporting IFS (especially made by those arguing for locating such an IFC in a SEZ) has been analogous to that for software exports: i.e., a sterile relationship between Indian producers and foreign customers of ‘support services’ However, in the case of IFS, India is itself a large, fast growing customer of IFS Conservative estimates of IFS consumption in India just a few years out, amount to $48 billion a year That is more than the output of many Indian industries today WHAT DRIVES THE DEMAND FOR IFS? An understanding of what drives rapidly the growing demand for IFS in India needs to take into account two features: IFS demand is driven by increases in gross two-way financial flows that have occurred in transactions with the rest of the world It is not driven by net flows Demand for IFS by Indian customers - as well as foreign firms trading with and investing in India - is driven by imports and exports India-related purchases of IFS are related to inbound and outbound FDI/FPI The annual growth of gross flows has accelerated dramatically in recent years India’s external linkages have been transformed since 1991-92 But that transformation has been more radical since 2002 The Indian economy is now exhibiting signs of a’takeoff’ both in growth and even more rapidly in its globalisation (or integration with the world economy) Hong Kong and China Hong Kong evolved as an enclave IFC to provide IFS for traders dealing with a closed China In the 1970s and 1980s, Hong Kong had superior institutions, and provided IFS to North Asia (China, Taiwan and Korea) as well as part of ASEAN (the Philippines and Vietnam which are closer to Hong Kong than to Singapore) But, as a colonial artifice, Hong Kong’s role as an IFC was compromised, if not damaged, as China opened up and connected itself to the world through Shanghai and Beijing Since the 1980s, China has not required its economic partners to deal with it exclusively through Hong Kong With the gradual rise of Shanghai as an IFC, Hong Kong’s role as an 730 Financial Management & International Finance IFC serving China is diminishing, although it is unlikely to be completely eclipsed At the same time ASEAN regional finance has gravitated decisively toward Singapore THE IMPACT OF GLOBALIZATION ON IFS DEMAND AND ON IFCS : When the economy of a country or region (e.g., the EU or ASEAN) engages with the world through its current and capital accounts, a plethora of IFS are purchased as part-and-parcel of these cross-border transactions The hinterland effect of a rapidly growing national or regional economy has been a crucial driver of growth in IFCs The 21st century has yet to unfold But the emergence of China and India as global economic powers is likely (as in the US, EU and ASEAN) to provide the same raison d’etre for these two economies evolving their own IFCs to interface with those that serve other regions History suggests that no country or regional economy can become globally significant without having an IFC of its own But the emergence of IFCs has not always been a tale of growth potential and start-up followed by prolonged competitive success in exporting IFS to global markets The trajectories of IFCs can wax and wane depending on how world events unfold Growth in Indian IFS demand is driven by the progressive, inexorable integration of the Indian economy with the world economy As such integration deepens and it triggers a variety of needs for IFS For example: Current account flows involve payments services, credit and currency risk management Inbound and outbound FDI (as well as FPI like private equity and venture capital) involves a range of financial services including investment banking, due diligence by lawyers and accountants, risk management, etc Issuance of securities outside the country involves fees being paid by Indian firms to investment bankers in IFCs around the world The stock of cross-border exposure (resulting from accumulation of annual flows) requires risk management services to cover country risk, currency risk, etc This applies in both directions: foreign investors require IFS to protect the market value of their exposure in India while Indian investors require the same services to protect the market value of their exposure outside the country The shift to import-price-parity (owing to trade reforms) implies that Indian firms that not import or export are nevertheless exposed to global commodity price and currency fluctuations These firms require risk management services Many foreign firms are involved in complex infrastructure projects in India Indian firms are involved in infrastructure projects abroad These situations involve complex IFS The same applies to structuring and financing privatizations (especially those Financial Management & International Finance 731 COST-VOLUME-PROFIT ANALYSIS International Monetary Fund and Financial System involving equity sales to foreign investors) and public-private partnerships which are becoming a growing feature in infrastructure development around the world The growth of the transport industry (shipping, roads, rail, aviation, etc) involves financing arrangements for fixed assets at terminals (ports, etc.) as well as for mobile capital assets with a long life: i.e., ships, planes, bus and auto fleets, taxis, etc That is done by specialised firms engaged in ‘fleet financing’ India is now one of the world’s biggest customers of aircraft buying roughly 40% of the world’s new output of planes in 2006 This requires buying 40% of the world’s aircraft financing services Indian individuals and firms control a growing amount of globally dispersed assets They require a range of IFS for wealth management and asset management Outbound FDI by Indian firms in joint ventures and subsidiaries abroad has increased since 2004-05 as they have globalised Foreign investments by Indian firms began with the establishment of organic presence, and acquisitions of companies, in the US and EU in the IT-related services sectors Now they encompass pharmaceuticals, petroleum, automobile components, tea and steel And, geographically, Indian firms are spreading well beyond the US and EU by establishing a direct presence or acquiring companies in China, ASEAN, Central Asia, Africa and the Middle East Such outward investments are funded through: draw-down of foreign currency balances held in India, capitalization of future export revenue streams, balances held in EEFC accounts, and share swaps Outward investments are also financed through funds raised abroad: e.g., ECBs, FCCBs and ADRs/GDRs Leveraged buy-outs related to these investments and executed through SPVs abroad are not captured in the overseas investment transactions data The Tata Steel-Corus transaction, for example, involved substantial IFS revenues going to financial firms in Singapore and London When two firms across the globe agree to undertake current or capital account buy-sell transactions, the associated IFS are usually bought by the firm with better access to high quality, low cost IFS Consider the example of an Indian firm exporting complex engineering goods to a firm in Germany It can contract and invoice in: INR, USD or EUR Because India has limited IFS capabilities, and a stunted currency trading market, the transaction is likely to be contracted in INR or USD But the German importer generates revenues in EUR It has to buy INR or USD to pay the Indian firm It may have to use a currency derivative (future, forward or option) to cover the risk of a movement in the exchange rate of the INR or USD vs the EUR between placing the order and receiving the goods This would typically be done in London However, if India had a proper currency spot and derivatives market, the Indian exporter would be able to invoice in EUR Local IFS demand would be generated by this local firm converting locked-in future EUR revenues into current INR revenues at a known exchange rate Indian exporters are not as flexible as they wish to be in their choice of the INR or of global currencies for invoicing (i.e., USD, JPY, EUR or GBP) - or even the choice of currencies 732 Financial Management & International Finance such as the SGD or CNY for trade with ASEAN and China If they were, that could influence the effective price received by them When goods are sold by an Indian exporter, and a German importer pays IFS charges in London for converting EUR into INR and managing the exchange risk, the net price received by the Indian exporter is lower When the Indian exporter sells in EUR, and local IFS are purchased for conversion of EUR receipts into INR, the price received would be higher These differences are invisible in standard BoP data, which not separate out and recognise charges for IFS being purchased or sold as part and parcel of contractual structures on the current or the capital account For this reason, the standard BoP data grossly understate the size and importance of the global IFS market Focusing on the transactional aspects of trade flows would tend to understate IFS demand since this tends to ignore the risk management business which rides on trade flows PROJECTIONS FOR REVENUE POTENTIAL OF MUMBAI AS AN IFC : The median (base case) projections involve IFS demand in India rising from $13 billion in 2006 to $ 48 billion in 2015 A low-case assumption would see IFS consumption rising from US$ 6.6 to nearly US$ 24 billion over the same period A more optimistic (but not implausible) ‘high-case’ assumption would see it grow from US$ 19.7 to nearly US$ 72 billion INSURANCE : Finance and insurance have much in common Each provides its customers with tools for managing risks The valuation techniques in both finance and insurance are formally same: The fair value of a security and an insurance policy is the discounted expected value of the future cash flows they provide to their owners The definition of risk is the same: The variation of future results (cash flows) from expected values Finally, the management of insurable and financial risks rely on the same two fundamental concepts: risk pooling and risk transfer Since the early 1990’s, we have seen substantial convergence between finance and insurance A shortage of property and liability insurance in the 1980s forced many corporate insurance customers to consider alternatives to traditional insurance, such as selfinsurance, captive insurers, and contingent borrowing arrangements to finance losses Investment bankers and insurance brokers provided many of these alternatives The demand for catastrophe insurance in the 1990s led to the development of options and futures for this type of insurance Investment banks, sometimes with insurance company or insurance broker partners, formed subsidiaries to offer catastrophe and other high-demand coverage through new financing arrangements Life insurers have developed products with embedded options on stock portfolios Insurers have begun to use structured securities, such as bonds with indexed coupons, in their investment portfolios Thus, in the 1990s, financial markets offered products for managing risks traditionally handled by insurers The high demand for catastrophe insurance on property started the movement Financial Management & International Finance 733 COST-VOLUME-PROFIT ANALYSIS International Monetary Fund and Financial System We now see convergence in the investment markets as well as in various new alliances, partnerships and joint ventures INTEGRATION AND GLOBALIZATION OF FINANCIAL SERVICES : Changing customer needs, more knowledgeable and demanding customers, new technology, liberalization, deregulation, and a combination of other forces are blurring the lines between financial products, institutions, sectors, and countries Regulators are responding to market pressures by allowing more inter-sectoral competition Banks, securities firms, insurance companies, and other financial intermediaries increasingly compete with each other by offering similar products and services and by entry into fields previously reserved for one sector only Financial services integration occurs when financial products and services traditionally associated with one class of financial intermediaries and distributed by another class of financial intermediaries Financial services convergence is the tendency of financial products and services traditionally one sector to take on characteristics traditionally observed with financial products and services of another financial services sector Convergence occurs through customer demand across traditional sector lines Examples include the introduction by insurance companies of variable (unit linked) life and annuity products that contain both insurance and securities features Another burgeoning area is the banking industry’s creation of securitized mortgage and corporate debt portfolios, which involves packaging a group of mortgages or other loans into marketable securities that are sold to investors As banks, securities firms, and insurers construct products and offer services that resemble the features of their competitors, product convergence will be an important driving force toward financial services integration This integration gave birth to financial services conglomerates A Financial services conglomerate is a firm or group of firms under common control which offers financial services that extend beyond the traditional boundaries of any one sector The two most commonly discussed arrangements are bancassurance and universal banks Bancassurance describes arrangements between banks and insurers for the sale of insurance through banks, wherein insurers are primarily responsible for production and banks are primarily responsible for distribution Universal banks are financial intermediaries that typically offer commercial and investment banking services, and also insurance 734 Financial Management & International Finance ... 15% Project Management 10% International Finance 10% Sources of International Finance 10 International Monetary and Financial System 5% 5% Overview of Financial Management Finance and Related... finance are closely related Financial Management & International Finance Overview of Financial Management COST-VOLUME-PROFIT ANALYSIS Finance and Production Finance and production are also functionally... analysis, synthesis, and evaluation CONTENTS Overview of Financial Management 10% Financial Management Decisions 15% Financial Analysis & Planning 10% Operating and Financial Leverages 5% Financial Strategy