International Finance & Foreign Exchange: Rates, Risks & Strategies

TAKEAWAYS:

• Multinational financial management adds currency risk, political instability, and tax complexities beyond domestic finance.
• Exchange rates (spot, forward, cross) determine transaction costs and hedging needs for imports/exports.
• Foreign exchange markets (spot, forward, futures, swaps) let firms lock in rates or speculate on volatility.
• Currency risk (transaction, economic, translation) can be mitigated via hedging (forward contracts, options, natural hedges).
• Nepal’s trade deficits (e.g., fuel imports) and remittances (NPR 100+ billion/year) expose businesses to FX volatility.
• International capital budgeting adjusts for country risk, tax differences, and political stability (e.g., Daraz’s expansion into India vs. Bangladesh).

1. Introduction to International Finance

International finance deals with financial decisions and transactions across borders, including:

• Multinational financial management (MNFM): Managing cash flows, investments, and financing in multiple countries.
• Foreign exchange (FX) markets: Where currencies are traded to facilitate global trade.
• Currency risk: Uncertainty arising from fluctuations in exchange rates.

How MNFM Differs from Domestic Finance

2. Foreign Exchange (FX) Markets

FX markets enable the conversion of one currency into another. Key participants:

• Commercial banks (primary dealers, e.g., NMB, Global IME Bank in Nepal).
• Central banks (e.g., Nepal Rastra Bank manages NPR/USD rates).
• Corporations (importers/exporters like NTC, Ncell, or Daraz).
• Hedge funds & speculators.

Types of Exchange Rates

1. Spot Rate: Immediate exchange rate (e.g., USD 1 = NPR 120.05 as of July 2020).
2. Forward Rate: Agreed rate for future delivery (used to hedge against rate changes).
3. Cross Rate: Exchange rate between two non-USD currencies (e.g., EUR/INR).

Example (Spot vs. Forward):

• Spot Rate (USD/NPR): 1 USD = 120.05 NPR (as of July 2020).
• 6-Month Forward Rate: 1 USD = 118.50 NPR (if expected depreciation of NPR).

3. Determinants of Exchange Rates

Exchange rates are influenced by:

• Interest Rate Differentials: Higher interest rates attract foreign capital (e.g., NPR bonds vs. USD bonds).
• Inflation Rates: High inflation erodes currency value (e.g., NPR depreciated vs. USD in 2022).
• Government Policies: Capital controls (e.g., Nepal’s FX restrictions on remittances).
• Trade Balance: Chronic trade deficits (e.g., Nepal imports more than it exports) weaken the currency.
• Political Stability: Unstable governments (e.g., Afghanistan’s AFN) face higher risk premiums.

Worked Example: Nepal’s Trade Deficit

• Imports (2023): NPR 1.2 trillion (fuel, machinery, electronics).
• Exports (2023): NPR 300 billion (textiles, tourism, remittances).
• Result: Trade deficit of NPR 900 billion → NPR depreciates against USD.

Mermaid Diagram: Trade Balance Impact

flowchart TD
    A["Trade Deficit: Imports (NPR 1.2T) > Exports (NPR 0.3T)"] -->|"Excess USD demand"| B["NPR Depreciates vs. USD"]
    B -->|"Higher USD price"| C["Importers pay more NPR"]
    C -->|"Cost pressure"| D["Trade deficit worsens"]

4. Foreign Exchange Transactions

(a) Direct vs. Indirect Quotation

(b) Exchange Rate Quotation (July 2020 Data)

(c) Cross Exchange Rate Calculation

Example: Find EUR/GBP rate given:

• 1 EUR = 140.46 NPR
• 1 GBP = 155.49 NPR

Solution:

1. Convert EUR to GBP via NPR: $1\text{ EUR}=140.46\text{ NPR}$ $1\text{ GBP}=155.49\text{ NPR}$
2. Cross-rate: $1\text{ EUR}=\frac{140.46}{155.49}\text{ GBP}\approx 0.903\text{ GBP}$

5. Foreign Exchange Risks

Three types of currency risk:

1. Transaction Risk: Loss from unpaid obligations due to exchange rate changes.
   • Example: A Nepalese exporter sells goods to India in USD but waits 6 months to receive payment. If NPR depreciates, the exporter loses.
2. Economic Risk: Long-term impact on cash flows from FX changes.
   • Example: Daraz’s Indian subsidiary faces higher costs if INR strengthens against USD.
3. Translation Risk: Accounting losses from revaluing foreign subsidiaries’ books.
   • Example: A USD-denominated subsidiary’s assets appear worth less in NPR if NPR strengthens.

Mermaid Diagram: Currency Risk Types

flowchart TD
    A["Transaction Risk"] -->|"Unpaid invoices"| B["Short-term FX volatility"]
    C["Economic Risk"] -->|"Cash flow disruptions"| D["Long-term FX trends"]
    E["Translation Risk"] -->|"Revaluation"| F["Financial statement distortion"]

6. Hedging Foreign Exchange Risks

Firms use hedging to protect against FX volatility:

Worked Example: Forward Hedge for Daraz

• Scenario: Daraz (Nepal) sells INR 100,000 to India in 6 months.
• Spot Rate: 1 INR = 0.015 USD.
• 6-Month Forward Rate: 1 INR = 0.014 USD (expected depreciation).
• Action: Daraz enters a forward contract to sell INR 100,000 at 0.014 USD.
• Outcome: Locks in USD 1,400 instead of risking USD 1,500 (spot rate).

7. International Capital Budgeting

Decisions on foreign investments consider:

• Country Risk: Political instability (e.g., Afghanistan vs. Bangladesh).
• Tax Differences: Double taxation treaties (e.g., Nepal-India).
• Inflation Rates: Adjust NPV for local inflation (e.g., Nepal’s 6% vs. India’s 4%).
• Exchange Rate Fluctuations: Use real options to account for flexibility.

Formula: Adjusted NPV for FX Risk $${\text{NPV}}_{\text{adjusted}}={\text{NPV}}_{\text{local}}-\text{Present Value of FX Loss}$$

• Example: A Nepali firm evaluates a USD 1M project in India. If NPR depreciates 10%, the NPV drops by NPR 100,000.

8. International Working Capital Management

• Cash Flow Timing: Delay payments in strong-currency countries (e.g., pay USD suppliers late if USD weakens).
• Inventory Financing: Use local suppliers to avoid FX risk (e.g., Daraz stocks inventory in India to pay in INR).
• Receivables Management: Invoice in strong currencies (e.g., USD for exports).

Mermaid Diagram: Working Capital FX Strategies

flowchart TD
    A["Strong-currency country"] -->|"Delay payments"| B[USD suppliers
  (if USD weakens)]
    C["Local suppliers"] -->|"Inventory financing"| D[INR payments
  (if INR stable)]
    E["Export invoicing"] -->|"Receivables"| F[USD invoicing
  (if USD strong)]

In the Real World

1. eSewa & Khalti (Nepal)

   • Idea: Cross-border remittances (NPR → USD → local currency).
   • How: Users send NPR to eSewa, which converts to USD via banks, then to recipient’s local account (e.g., BDT in Bangladesh).
   • Risk: eSewa faces transaction risk if NPR depreciates between conversion steps.

2. Daraz (Nepal & India)

   • Idea: Natural hedging for cross-border sales.
   • How: Daraz Nepal sells to India in INR but pays suppliers in NPR. If INR strengthens vs. NPR, the profit margin stays stable.
   • Worked Example: If NPR/INR goes from 2.5 to 2.0, Daraz’s INR revenue covers NPR costs more efficiently.

3. NTC & Ncell (Telecom)

   • Idea: Forward contracts for USD payments.
   • How: NTC buys USD forward to pay for international roaming (e.g., calls to USA). If USD strengthens, NTC avoids higher NPR costs.

Exam Tip

• Spot vs. Forward: Always clarify whether a question refers to spot (immediate) or forward (future) rates.
• Hedging: Expect numerical problems on forward contracts or options. Show calculations step-by-step.
• Country Risk: Mention political stability, tax treaties, and inflation when evaluating international projects.
• Exchange Rate Tables: Memorize buying/selling rates (e.g., NRB’s July 2020 data) for quick calculations.
• Real-World Link: Connect theory to Nepal’s context—e.g., remittances, trade deficits, or multinational firms like Daraz.

Common Pitfalls:

• Confusing direct (1 USD = X NPR) and indirect (1 NPR = Y USD) quotations.
• Ignoring transaction costs (bid-ask spread) in FX conversions.
• Overlooking tax implications of foreign earnings (e.g., Nepal’s withholding tax on remittances).

Final Visual: Nepal’s FX Exposure