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Currency Management for Business

What new problems and factors are encountered in international as opposed to domestic financial management?

Financial Managers are faced with a wide variety when doing business internationally. First, many countries use different currencies, such as the Euro or Yen, which complicate transactions between these countries. The value of international currencies is constantly fluctuating and financial managers must time transactions for the best possible results. The return on a foreign investment cannot be accurately predicted because the fluctuating exchange rate will impact the net gain or loss. Domestic financial management is done exclusively with the US dollar and exchange rates have no impact on decision making.

A financial manager must take into consideration the different accounting standards and financial regulations of foreign governments. Laws can vary greatly among each country, and must be followed closely and interpreted accurately. For example, looser accounting standards in a developing country could lead to misrepresented financial statements. If the financial manager does not take this into account, it could cause poor decision making. This is also true for the taxation laws set by foreign governments. Not only is taxation done in different currencies, but the tax rates can differ substantially. In many cases a financial manager can reduce taxes by doing business internationally. 

What does the term arbitrage profits mean?

An Arbitrageur is an individual that works directly with the process of purchasing and selling stocks in the exchange market. The arbitrageur monitors the exchange rate and when the market if out of line. Then the Arbitrager will sell the stock that he as purchased in a previous market and will exchange the stock in a different market were the stock exchange is at ha higher rate.  This process allows the arbitrageur to make a riskless profit on the money that he exchanged; this process is called arbitrage profits.   The difference in exchanges rates allow the arbitrageur to earn a profit.

What can a firm do to reduce exchange risk?

The main tool available to a firm to reduce exchange risk is using a forward exchange contract. As defined by Keown et al, the forward exchange contract “…requires delivery on a specified future date of one currency in return for a specified amount of another currency.”

Firms may also reduce their exchange risk through a money-market hedge.  A money market hedge can help a firm who is in an expose liability or asset position.  In general, a firm with a future liability in terms of foreign currency will not know what this liability equates to in U.S. currency.  Therefore, the firm is in an exposed liability position.  If the foreign currency weakens then the firm stands to pay fewer U.S. dollars in the future.  However, there is the risk that the foreign currency will get stronger and the firm will pay more in the future than they would today.  To offset this issue firms can purchase currency at the spot rate domestically and invest it in a money market with a maturity equal to the date the liability is due.  The invested funds should gain the same rate as the spot rate, which will hedge the firm’s liability against future loss. 

What are the differences between a forward contract, a futures contract, and options?

Futures contracts are similar to a forward contract in many respects but differ in the following ways. A futures contract is traded in standard amounts that have standard maturity dates. Futures are traded in an organized exchange like the NYSE while forwards are typically traded by banks. Futures contracts have a margin requirement of 10 to 15% and a forward contract requires good credit standing with the bank.)
An Option is a contract that gives the buyer the right to buy or sell a specified quantity of a stock or commodity. This will be in the form of a contract and will only be valid for a certain amount of time. They are referred to as puts and calls when referring to selling and buying, respectively.

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