Homework 8 Assignment 1 International Finance

Homework 8 Assignment 1: International Finance

Name:

Professor’s Name: Dr. James Glenn

Course Title: FINN535

Date: May 30, 2016

1. Summarize the business that you have chosen, and provide a two to three (2-3)

paragraph justification as to why China would be a viable market for the selected

business.

Ross Stores, Inc. is the largest off-price apparel and home fashion chain in the United

States with nearly 54% market shares. As of May 26, 2016 at 4:00 pm Eastern Time, the share

price was $53.88. Ross Stores, Inc. which is headquartered in Dublin, California, was established

in 1982, with six junior department stores together and converted to Ross Dress for Less off-

price format. The company first went public in August 1985, trading on NASDAQ under the

symbol “ROST.” The company expanded rapidly and ended fiscal 1986 with total sales of $534

million and 121 stores in 16 states. Since then the company has seen a steady growth in 34 states

with 1,274 locations, including the District of Columbia and Guam. The company operates 172

discount stores in 15 states. Ross, Inc. is a publicly traded company and pays dividends to its

shareholders. It is expected to pay $.14 dividends to its shareholders as of June 3, 2016.

Ross Stores, Inc. offers first-quality, in-session, name brand and designer apparel,

accessories, footwear and home fashions for family saving them up to 20%-60% off department

and specialty stores regular prices on a daily basis. As of December 2015, the number of

discount stores operated by Ross grew to 172 stores in 15 states. Those discount stores feature a

more moderately-priced assortment of first-quality, in-session, name brand apparel, accessories,

footwear and home fashion for family who cannot afford the prices offered by department and

specialty stores. It is believed that Ross will continue its steady growth in years to come, all other

things being constant.

China is the world’s second largest economy with population for over 1.37 million.

According to Earnest and Young, China has a little over 150 million people earning at least $100

a day and as the Chinese government continues to make the necessary economic reforms the

number will continue to grow in the coming years. Earnest and Young further predicts that by

2030 around one billion people in China could become middle class and Ross Stores, Inc.

investing now in China would give the company strategic advantage in the retail industry.

Furthermore, doing business in China is becoming easier and many of its regions are enjoying

foreign investments through tax incentives and removal of previous legal restrictions. That

means Chinese household incomes are raising and they can now afford to buy clothes and

household materials for themselves. Ross Stores, Inc. stands to benefit from the relatively low

labor costs in China which could really open more opportunities for the company to gain access

to the growing Chinese market share. The company can use the cheaper merchandise from its

subsidiary in China to supply its stores in the United States thus by saving more in costs.

2. Examine the exchange rate of the U.S. dollar and the Chinese Yuan for the last 24

months. Explain the major overall changes that have occurred and speculate on the

key economic variables that most likely have influenced the exchange rate

movements. Provide a rationale for your response.

This is the U.S. dollar to Chinese Yuan (CNY) exchange rate history for the past 24

months from June 2014. As the close of May 27, 2016 U.S. $1.00 was being exchange for

6.558947 Chinese Yuan. From the graph above, it will be safe to say that the Chinese Yuan is a

very volatile currency. It is therefore very important that when contemplating an FDI in China

management should carefully analyze the exchange rate. Ideally, it would be to the company’s

financial advantage to invest in China when the Chinese currency is weak against the US dollar

as shown by the exchange rate above. That means Ross cost of borrowing from the local bank in

Chinese would be cheaper than borrowing from here in the US.

In-spite of the economy slowing down for the past couple of years, the Chinese economy

has been growing at a modest rate by 7 percent in the first and second quarters of 2015. The new

government’s decision to introduce new reforms has helped stabilized growth and promote

consumptions and a more vibrant economy. The Chinses Central government continued to

advocate for a more progressively economic growth driven by private consumptions instead of

fixed asset investments. This dynamic shift in strategy has given rise to a more stable economy

This could surely give Ross Stores, Inc. the opportunity to gain more market shares as the

Chinese economy moves in an upward trajectory.

This is the right time for Ross to invest in China and establish strong community links to

be able to fully enjoy the benefits that will be gained from these changes. Companies that

establish their present now will be able to build strong community links, solidify their market

share, and build positive brand awareness as China reverses its economic deceleration in the

coming years.

Ross Stores, Inc. had an ideal business model that can provide a valuable apparel to low

income and middle class customers in the US and such business practice would empower the

growing middle class in China. Since the yuan is weak against the dollar, it would be wise for

Ross to invest now and if the value of the Yuan appreciates in the price within the next couple of

years it would help Ross with its payment of the loan from the local bank in China. Already there

are some other countries that are now converting some of their foreign currency reserves to the

Chinese Yuan and Ross Stores, Inc. doing the same would benefit their shareholders because

they will be paying less of the Chinese currency than they converted the US dollar to invest

there.

Analyze the major exchange rate risks associated with transaction and translation

exposure within the Chinese market. Based on what you have gleaned from your analysis,

predict the major changes that you believe will occur in the next 24 months. Justify your

response.

Exchange rate risk management is an integral part in every firm’s decisions about

foreign currency exposure (Allayannis, Ihrig, and Weston, 2001). Multinational firms are

participants by virtue of their international operations. As such, MNCs should pay more attention

to these risks and find more applicable methods to reduce them. A common definition of

exchange rate risk relates to the effect of unexpected exchange rate changes of the firm (Madura,

1989). China’s balance of payment (BOP) depends critically on remittances, service exports

(forming part of invisibles) and of course capital flows, both Foreign indirect investment (FII)

and foreign direct investment (FDI). It is important that Ross and all market participants,

including banks and other intermediaries, be shown the process to undertake forex risk

management in a specific way. The fundamental principle of accessing domestic foreign

exchange markets is hedging of underlying foreign exchange exposures.

In doing so, MNCs used traditionally available such as a booking of forward contracts and

some newer hedging instruments added as the domestic forex markets evolved and acquired

depth and volumes. Newer hedging instruments such as swaps and options have been included in

exchange to the foreign exchange forwards. However, to a greater extent hedging was permitted

only against “Crystalized foreign currency exposures.” Meaning that only where there is an

underlying forex risk arising out of a ‘genuine transaction, say an import, will the

covered(hedging) be allowed. The extension of hedging options will help Ross Inc. with the

major exchange rate risk associated with transaction and translation exposure within the Chinese

market.

Recommend key steps that the chosen MNC could take in order to mitigate or eliminate

exchange rate risk. Suggest one (1) method that the MNC in question could use with

derivatives in order to mitigate, or eliminate such risks. Provide a rationale for your

response.

The spot foreign exchange (also known as sport FX on forex) market is the largest market

in the world, with more than a trillion of U.S. dollars traded daily. The forex derivatives of this

market is the forex futures market consisting of only about the hundredth of the total sales.

My recommendations to Ross Inc. would be to use the speculating and hedging

techniques in order to mitigate or eliminate exchange rate risk. Speculating and hedging are two

key tools used in the forex derivatives. “Hedging” is used by MNCs forex financial contracts

futures to help minimize or eliminate risk by shielding themselves against a future price swings.

In contrast, speculators take risks in order to realize a profit. The two are main techniques that

can be used by Ross Inc. as forex derivatives.

Most MNCs use speculation for profit reason. In the foreign exchange market, future and

spot foreign exchange do not differ too much from each other. So why would you want to

identify trade opportunities, in the future market instead of the spot market? So, there will be

advantages and disadvantages about dealing with forex financial contracts in the future market.

The advantages of using the future market as a FX derivative are lower spread (2-3), the

lower transaction costs, and more leverage. Often as much or more over 500 dollars a contract.

The advantage of using the future markets as a type of foreign exchange derivatives facts that it

is limited to the foreign exchange session times, and that fees may applicable to that.

The trade opportunity strategies employed for speculating as much the same as those

used in spot markets. The most wildly used foreign currency derivatives strategies are based on

regularly used forms of technical chart analysis since these FX market tend to trend well.

Alternatively, some foreign currency derivatives speculators use more intricate strategies, such

as arbitrage.

There are several reasons why MNCs utilize hedging strategies in the forex future

market. The goal is to neutralize the currency fluctuation effects on sale revenue. For example, if

Ross operating China wants to find out how much revenue it will get from its Chinese stores (in

U.S. dollars), it could purchase a future forex financial contract. The contract will be the same

amount of its proposed sales to try and eliminate the effect of currency fluctuations.

When hedging, foreign exchange traders often make a choice between futures and

forward contracts. They have several differences, but the two most import differences is that

forward allows more flexibility in selecting dates and contract sizes. The cash that backs a

forward contract will not be paid until the contract expiration whereas cash generated by a future

contract is calculated on a daily basis.

3. Recommend one (1) hedging technique geared toward managing economic,

transaction, and translation exposure in the Chinese market. Justify your response.

Economic Exposure:

Economic, transaction and translation exposures can affect the value of the company. Any

adverse exchange rate fluctuation will reduce the present value of all future cash flow, thus by

reducing the value of the company. It is difficult to measure the actual dollar value effect on the

value of the firm. For example, let say Ross Stores, Inc., a US firm is operating in China through

a subsidiary. If China devalues its currency unexpectedly, this will be bad for the parent firm in

the United States. This is because every local currency unit of profit earned would now be

worthless when sending it back to the US which is the home country of the Ross Stores, Inc.

On the other hand, it could be a good news as Ross’ subsidiary in China might now be

able increase its exports because the exports will be cheaper to the rest of the world. If Ross

manufactures all its products in China and the exchange rate of the Chinese Yuan strengthens

then the firm will find its export expensive to the rest of the world. Sales will decrease thus by

lowering cash flow and value of the firm. On the other hand, if a Ross, Inc. has decentralized

production facilities around the world and bought its input from all over the world, it is unlikely

that the currencies of all its operations would be devalued at the same time.

It would therefore, find that although it was losing exports from some of its production

facilities, but this would not be the case in all of them. When borrowing in more than one

currency, firms must be aware of foreign exchange risk. Therefore, Ross management should

know that when a firm borrows in U.S. currency then it must settle this liability in the home

currency and this can make interest and principal repayment far more expensive when the

subsidiary’s home currency is devalued.

Transaction Exposure Risk: In the real world scenario, one transaction (sales and

receipt) may take several days or months. For instance, let say you sold goods to a foreign

customer in Japan on 15 May 2016, and the Japanese customer promised payment after 45 days.

Now during the 45 days, the exchange rate may fluctuate on either side and this could result in

exchange gain or loss. These transactions may include import or export of goods on credit terms,

borrowing or investing in foreign currency receipt of dividend from foreign subsidiary, or trying

to sell existing business in a foreign country. This type of exposure can be safeguarded by using

hedging instruments.

Translation Exposure Rate: When a business has several subsidiaries located in

different foreign land, then it need to consolidate its financial results of the overall operations.

Translation exposure affects the finances of the group when it translates its assets, liabilities and

income to home currency from various currencies. The widely means of protecting against

translation exposure is by hedging. The company can protect itself against translation risk by

purchasing foreign currency, by using currency swaps, using currency futures, or by using the

combination of these hedging techniques. The reason MNCs often hedge translation risk is

because if they have large proportion of overseas subsidiaries it will reflect in their share price.

For instance, if Ross had 35% of its revenue from China subsidiaries, then a large depreciation of

the Chinese Yuan would probably result the price of the share. This is why it is a good idea for

MNCs, such as Ross Inc. to use hedging to protect against this risk.

In order for a firm to protect its foreign currency dominated assets if it fears a devaluation

of foreign currency, it should seek for loans in the local currency and slow down payment to

creditors. Although this may increase the firm’s liabilities but it will help avoid this kind of risk

in the future. This may help the firm to equate its foreign currency assets and liabilities with no

net exposure to changes in the exchange rate. The best option to deal with translation exposure is

by spreading the firm’s borrowing across several currencies because it is unlikely they will a

move in the same direction upward or downward and economic exposure will be reduced to a

greater extent. Borrowing in foreign currency should only be justified if returns will then be

earned in that currency to settle repayment of the loans.

4. Conduct a country risk assessment to ascertain whether or not management should

support the proposal for your chosen MNC to enter into the Chinese market. Based

on Geert Hofstede’s six (6) dimensions of culture, predict three (3) likely problems

posed by the cultural differences between the chosen MNC’s culture and the

Chinese culture. Provide a rationale for your response.

Communication, competition and the fluctuation in currency could post a greater risk

to Ross if not handled with care. In China, communication is an issue if you don’t speak

Mandarin. Mandarin is the official language but there are regional variations. Most Chinese

people do not speak English so Ross management would need interpreters who understand the

Chinese culture. Chinese households are becoming more and more connected with telephone and

internet links which are good signs of the potential economic growth. The private sector is

growing but competition from financially backed state-supported companies can prove difficult

in some areas. Several regions of this vast country have their own unique economic needs. You

can trade in U.S. dollars but you are at risk of fluctuations in the exchange rate and be aware that

it is hard to exchange Chinese currency out of China.

In political terms, social tensions in the 1990s were particularly volatile, with many

clashes, bombings and assassinations. But with the new government’s reforms policy, these

ethnic tensions are at a standstill. The primary reason for ethnic tensions in the 1990s was due

solely on the frequent confiscation of agricultural land for the benefit of property developers.

This resulted in the mobilization of the villages of Wukan, which brought about in the

organization of municipal elections in March 2012. This was one of the significant turning points

of such social movements in China. Nevertheless, there are still substantial inequalities between

rural and urban areas in China. Furthermore, there were major shortcomings in governance

particularly in terms of access to corporate balance sheets. Indeed, the tightening of conditions

for obtaining financial information on companies, is a central concern, since it could

significantly affect credit sales.

According to the economic figures, many experts believe that India’s economic growth is

set to overtake China’s economic growth in a couple of years. It also said that by 2030, China,

America and India will be the three biggest economies in the world as we are already seeing the

rapid economic growth in China and India. However, these reports listed these findings subject

to some caveats related to country risk analysis.

Before making any investment, it is very important to discuss these caveats and analyze.

According to the 2015 Corruption Perception Index report, China is ranked 83 with the score of

37. Also on the Bribe Payer Index of 2011, China is ranked 27 with the score of 6.5. These

reports indicate that there’s a likelihood that companies operating in China are engaged in

bribery when doing business. Corruption is an impediment to any business venture and MNCs

should study foreign countries thoroughly before making investment. China with the lower

scores on the Corruption Perception Index is still deemed as a country with ease of doing

business. According to the world’s economy ranking on June 2015, China ranks fifth on the ease

of doing business and 22 on enforcing contracts while the United States came 7

on the ease of

doing business and 21 on enforcing contracts (June, 2015, economy rankings). This is vital

information needed to convince Ross Inc. management that investing in Chinese market now will

be a best thing for the company’s growth.

The economic deceleration in China continues to reverberate across global markets, many are

wondering about China’s future growth and what it means for the world. Yet, there are many

people who are optimistic that the economic deceleration in China won’t last for long. As Gary

Cohn, the President and Chief Operating Officer, of Goldman Sachs, simply puts, there’s no

doubt China has been going through a bit of a bumpy road but he believes that China is going to

weather this over the long-term. This optimism by many economists and financial analysts is

what driving investors to China and Ross Stores, Inc. should take advantage of this new business

opportunity to gain access to the emerging Chinese market.

References

Transparency International-The Global Coalition Against Corruption Retrieved May 24, 2016

http://www.transparency.org/country/#CHN

Mariah Brown, J. (n.d.). How Can Cultural Differences Affect Business Communication? Chron.

Retrieved May 29, 2016 http://smallbusiness.chron.com/can-cultural-differences-affect-

business-communication-5093.html

James Palmer, (February 3, 2014) Are Ethnic Tensions on the Rise in China? Retrieved May 20,

2016 http://www.huffingtonpost.com/2014/03/03/china-ethnic-tensions_n_4892675.html

Thailand. (n.d.). The Hofstede Centre, Strategy-Culture-Change. Retrieved on May 25, 2016

https://geert-hofstede.com/thailand.html

Madura, Jeff. (2015). International Financial Management, 12

Edition. [Vital Source Bookshelf

Online]. Retrieved (2016) from

https://strayer.vitalsource.com/#/books/9781305561977/cfi/6/54

Madura, J. (2015). International Financial Management 12th ed. Stamford, CT: Cengage

Learning. http://www.forbes.com/sites/mikemyatt/2013/11/18/top-10-reasons-diversity-

is-good-for-the-boardroom/#3432443f5fda

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