Foreign Direct Investment, Portfolio Investment And Risks In International Financial Management

Foreign Direct Investment vs. Portfolio Investment

1. Given information are as follows:

• Domestic Country is Peru (PEN)
• Foreign Country is Canada(CAD)
• Spot Price = 0.40 PEN/CAD
• Put options on sole has 1year expiration period
• Exercise Price = 0.45 PEN/CAD
• Premium = CAD 0.07 per unit
• 1million Peruvian Soles
• Annual Interest Rates:
• Peru = 5%
• Canada = 3%
• Annual Inflation Rates:
• Peru = 3%
• Canada = 2%

1. Forward Contract Hedge:

In forward Contract, an exchange rate is quoted today for settlement at a future date.

E (S₁) = Exercise Price * No. of units

Taken information from above figures, expected amount of CAD received after one year using forward contract hedge = 10,00,000 * 0.45 = CAD 4,50,000

1. Purchasing Power Parity (PPP):

Purchasing power parity focuses on ‘inflation-exchange rate’ relationship.

E (S₁) = Current Spot rate * expected difference in inflation rates

E (S₁) = S_o *(1 + I_d)

                    (1 + I_f)

Where

E (S₁) = Expected Spot Rate at end of expiration period i.e. 1year

S_o = Current Spot Rate i.e. 0.40 PEN/CAD

I_d = Inflation rate in domestic currency i.e. 3%

I_f = Inflation rate in foreign currency i.e. 2%

Thus, expected amount of CAD received after one year using PPP:

E (S₁) = 0.40 * (1 + 3%)     = 0.4039 PEN/CAD

                        (1 + 2%)

E (S₁) = 0.4039 * 10,00,000 = CAD 4,03,900

1. Put option Hedge:

In put option, gives buyer the right, but not the obligation, to sell a specified no. of units of commodity or currency to seller of option at a fixed price on or up to a specified date.

Premium is also paid by the buyer at the inception of the contract.  

Therefore, Premium Amount received = CAD 0.07 per sole * 10, 00,000 soles = CAD 7,00,00

If Expected spot price is greater than exercise price, then buyer do not exercise put option but where Expected spot price is less than exercise price, then buyer exercise put option. In both cases, Buyer has to pay premium amount.

1. Below is the explanation of transaction exposure and Economic exposure with examples and measures to reduce transaction and economic exposures in Multi-national companies:
2. Transaction Exposure: Transaction exposure measures the exchange gains and losses in cash flows in the value of domestic currency, which is denominated in foreign currency (Shapiro, 2010).

Transaction exposure is also called as Transaction risk.

Example: Suppose that a company based in US signs a contract with a company based in Belgium to purchase a product. The contract states that payment should be made on supplier’s country currency i.e. Payment should be made in Euros (€). US Co. agrees to pay to Belgium co. $1.5/€ for every product purchased. After the completion of agreement, sale might not take place immediately then there is a possibility of change in ratios of dollars to Euros (which could be favorable change or adverse change or no change) before the final sale is happened. Thus, this risk of change is the transaction exposure.

In other words, greater the time between agreement and settlement of contract, greater is the risk of Transaction Exposure.

Measures to reduce Transaction Exposure in MNC: Multi-national Corporation should enter a contract in forward exchange rate, which lowers the risk of transaction exposure.

1. Economic Exposure: Economic exposure measures the impact of exchange rate fluctuations on operating cash flows through the sales price, sales volume and production cost (Shapiro, 2010).

Impact on Economic Growth

Economic Exposure is also called as Operating Exposure.

Example: Suppose a small European Company only sell the products in their local market and do not export their exports, then also company would be adversely affected because of high value of Euros it make imports from other countries cheaper which increases competition in European markets.

In other words, Economic exposure deals with unanticipated fluctuations in foreign exchange rates which can have a significant impact on company’s market value.

Measures to reduce Economic Exposure in MNC: Economic exposure can be reduced either through operational strategies such as diversification of finance sources, product markets, production facilities etc or through currency risk strategies such as currency swaps etc. (Source: DFPT)

1. Below are the differences between Foreign Direct Investment (FDI) and Portfolio Investment (PI):

Foreign Direct Investment                       (FDI)	Portfolio Investment            (PI)
FDI refers to making investments in acquisition and control of physical assets in another country.	PI refers to making investments in financial securities such as equities, debt instruments including investments in mutual funds etc.
FDI carries the seeds that can lead to consistent economic growth.	High Volatility of PI’s cannot ensure stable economic growth.
FDI projects are managed with great efficiency.	PI projects are less efficiently managed.
Both Ownership and management rights obtained by FDI investors.	Only Ownership rights are gained by PI investors.
In FDI, Investors do not sell their stake easily.	In PI, investors can easily sell their stake in financial assets.
FDI results in transfer of funds.	PI results in capital inflows.
In FDI, investors can invest in both financial as well as in non-financial assets.	In PI, investors only invest in financial assets.
FDI investors have substantial interest in the firm.	PI investors only have short-term interest in the firm.
At end of 2015, FDI has only 24% of total foreign investment in Australia. (Source: ABS Data).	At end of 2015, PI has only 54% of total foreign investment in Australia. (Source: ABS Data)

1. The leading investor countries in 2014 and 2004 are below:

Countries	2004	% of total
United States of America	368.4	32%
UK	281.6	24%
Japan	43.8	4%
Netherlands	26.0	2%
Hong Kong (SAR of China)	23.4	2%
New Zealand	22.4	2%
Switzerland	20.5	2%
Belgium and Luxembourg	20.4	2%

(Source: Australian Bureau of Statistics, Catalogue 5352.0)

Countries	2014	% of total
United States of America	758.2	27%
UK	484.2	17%
Belgium	226.1	8%
Japan	174.7	6%
Singapore	80.2	3%
Hong Kong (SAR of China)	77.3	3%

(Source: Australian Bureau of Statistics, Catalogue 5352.0)

1. Below are the factors regarding investment of large amounts of FDI in Australia:

Australia is the rich resource country having a high skilled workforce (ranked 6^th in the world, Source: ABS). Australia also promotes competition and it is known for the innovation by bringing new technologies and services to the Australian Market.

Factors:

• Australia has experienced consistent economic growth since 1990-1991.
• Australia has 6^thhighest highly qualified and diverse workforce and friendly environment at the business place.
• Australia has strong geographic, trade and cultural links with fast growing Asia-Pacific-Region.
• Australia has well planned rail and road transports networks.
• As per World Bank development indicators, Australia stands 4^thon no. of new businesses.
• Australian Governance is also best in the world.
• It regulates liquidity market of bonds and stocks.

Therefore, on the basis of above factors, it is suggesting that foreign investment remains a steadily influence on the Australian economy which is important for the benefits of the economy and hence, above countries invests large amount of FDI in Australia.

1. List of investing countries who have revised their Foreign Development investment in Australia as seen from the data of 2004 and 2014:

• As per ABS Data, US remain the largest source of FDI into Australia followed by UK from 2004 to 2014.
• Belgium investment in FDI in Australia is rapidly growing from rank 8^thto rank 3^rd from 2004 to 2014.
• Netherland, New Zealand and Switzerland have decreased their FDI investment from 2004 to 2014.
• Singapore moved to the index of top 8 countries of FDI investment in Australia in 2014.
• Japan remain in top 8 investing countries from 2004 to 2014.

Reasons are as follows:

• Positive Reasons:

FDI proved to be flexible during financial crisis, FDI opens up export opportunities thereby increasing export performance also encourages macroeconomic environment and digital innovation.

• Negative Reasons:

In FDI, investing countries cannot easily have entered as well as exist from FDI and also do not sell their FDI investment easily. FDI’s share is higher in countries with weaker credit ratings.

Hence, from both positive and negative reasons, it is evidenced that FDI has appraised a beneficial impact on economy of the world.

1. As per Kearney, 2006 survey, identifies that most cited reasons for increase in the Foreign Direct Investment are due to availability of high quality investment targets and competitive environment and also the geographical location of Australia also makes it ideal for global business interactions.

Most investments cover 5 sectors these are: Software and IT services, business services, financial services, chemical sector, manufacturing sector etc. In future forecast, it is seen that majority of foreign investment approvals are for New Dwellings.

Thus, future expectations of 5 years over 2014 are that US, UK, Singapore and Japan will remain in the largest source of FDI in Australia. Other major investing countries includes Hong Kong and China. India is also entered the top 10 list of FDI index. This survey indicates Asian Region are most interested in investing Australian FDI.

Thus, Australian FDI is projected to around 46727.90 AUD million in 202 (Source: ARIMA Model).

Hence, foreign investment has contributed to Australia’s sustained economic growth, innovation and ongoing prosperity.

References

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Australian Bureau of Statistics. (2014) 5352.0 – International Investment Position, Australia: Supplementary Country Statistics. [Online]. Available from: https://www.abs.gov.au/AUSSTATS/[email protected]/allprimarymainfeatures/011CD15D6E630B76CA257FAF001A4235?opendocument [Accessed 24 March 2017]

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Kearney, A, T. (2016) The 2016 Foreign Direct Investment (FDI) Confidence Index. [Online]. Available from: https://www.austrade.gov.au/news/economic-analysis/the-2016-foreign-direct-investment-fdi-confidence-index [Accessed 24 March 2017]

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Shapiro, A, C. (2010) Multinational Financial Management. 10^th ed., University of Southern California: Hoffman, G.

Swieringa, J. and Wokker, C. (2016) Foreign Investment and Residential Property Price Growth. Australia: The Australian Treasury.

The Australian Government. (2015). Foreign Investment Reforms Factsheet: Foreign Investment in Australia. [Online]. Available from: https://firb.gov.au/files/2015/09/FIRB_fact_sheet_Foreign_investment_overview.pdf  [Accessed 24 March 2017]

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