International Financial Management

P G Apte
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 Introduction
• Focus on the risk management process and the issues
involved in setting up and implementing an exposure
management system
• Issues to be addressed
– The company's strategic business posture, attitude
towards risk and its risk tolerance
– Organizational design to implement a coherent policy
– Monitoring and control mechanisms
– Implications for managerial performance evaluation
– Possible conflict of interest between a parent company
and its global subsidiaries

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 The Risk Management Process
• Four major tasks
– Selection of a target performance variable
– Identification of those environmental factors that might
have significant impact on a firm's performance
– Assessing and, if possible quantifying the impact of
each of the environmental risk factors on the target
performance variable
– Choice of an appropriate mechanism or instrument to
reduce or shift the risk

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 The Risk Management Process
• Risk management can be viewed as a sequential
process consisting of the following steps
– Choose an appropriate performance measure
– Identify the key risk factors and assess the sensitivity of
the performance measure to each of them
– Estimate the risk profile of the performance measure
– Determine the desired risk profile
– In many cases, a firm may have natural hedges and
does not need to execute a hedge transaction
– Choice of the risk reduction mechanism
– Execute the selected transaction
– Monitor the performance of the selected risk reduction
mechanism
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 The Risk Management Process
• Value At Risk (VAR) is a single, summary
statistical measure of possible loss in value of the
portfolio due to normal market movements in the
underlying risk factors over a given time horizon
• Industrial firms should utilise a similar measure
called Cash Flow at Risk (CFAR) which attempts
to link cash flows to the environmental risk factors
• These methodologies cannot incorporate risk of
extreme events.

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 Objectives of Hedging Policy
• Treasury staff must have a clear understanding of the
following aspects
– Whether the risk management posture is to be
conservative or aggressive
– The appropriate performance measure in terms of
which the efficacy of risk management will be
evaluated
– The time horizon to be adopted in making risk
management decisions
– Benchmark against which their performance would be
judged

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 Organizational Issues
• The three main considerations
– Who should get involved in the establishment and
implementation of risk management policy
– What are the roles and responsibilities of the various
participants
– Performance measurement and control systems
• Senior executives in other functional departments must be
intimately involved
• Effective risk management is predicated upon the
existence of structures and systems which facilitate
information flows, allocation of responsibility and
authority and performance evaluation
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 Organizational Issues
• For multinational corporations a critical issue is
whether to centralize exposure management
• Advantages of centralization
– It minimizes duplication and permits economies of
scale
– Transactions costs can be minimized
– A centralized exposure and cash management center
located in a major, efficient money market center can
access a wide variety of instruments
– Managing translation exposure when global
consolidation is required can be done more effectively
from a centralized location
–

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 Organizational Issues
• Disadvantages of centralization
– The centralized staff may not be able to
appreciate the operational constraints and
environment of local subsidiaries
– Local managers handling their own exposures
would be able to develop closer relations with
local banks
– Performance appraisal becomes more
complicated

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 Organizational Issues
• Measurement of hedging performance is a complex issue
• Statistically, the performance of a particular hedging
program can be assessed by comparing the mean and
variance of the operating cash flows attained with the
chosen strategy with the mean and variance which would
have been obtained by an alternative benchmark strategy
• “Budget Rate” is a kind of target exchange rate which
would be used among other things as a benchmark for
assessing the effectiveness of treasury risk management
activities
Choice of Budget Rates : Current spot rate, relevant forward
rate, a “forecast” rate.
The correct choice is the relevant forward rate.

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 Organizational Issues
• The current spot rate is totally irrelevant
• Forward rate is a rate which can actually be locked
in if the treasurer chooses to do so.
• While the decision in respect of whether to hedge
or not to hedge, or hedge partially can certainly be
guided by management's currency views, the
responsibility for forecasting errors should not be
assigned to the treasury manager responsible for
hedging unless it is an in-house forecast

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 Information System for Exposure
Management
• Requires a well designed management information system
(MIS)
• The three types of exposures – transactions, translation and
operating must be clearly separated
• Evolve a procedure for assessing the risk associated with
these exposures by adopting a clearly articulated
forecasting method
• If a discretionary hedging posture is to be adopted, stop-
loss guidelines must be clearly articulated
• All exposed positions including their hedges if any should
be monitored at frequent intervals

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 Information System for Exposure
Management
• When a particular exposure is extinguished, a
performance assessment must be carried out by
comparing the actual all-in rate achieved with the
benchmark
• Periodic reviews must be carried out

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 Summary
• The risk management process involves several
steps starting with identification and assessment of
risk and leading up to the choice of specific risk
reduction devices and their execution
• Exposure management policy must be guided by
clearly defined objectives including the firm's risk-
return tradeoff and relevant horizon for risk
management
• The choice of benchmarks for assessing the
effectiveness of hedging is a complex and
important issue
• Another important issue is whether to centralize
the exposure management function
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