Bank Insurance Programs - Encyclopedic Dictionary

EX-IM bank offers several insurance policies to banks.

• The Bank Letter of Credit Policy. This policy enables banks to conﬁrm letters of credit issued by foreign banks supporting a purchase of U.S. exports. Without this insurance, some banks would not be willing to assume the underlying commercial and political risk associated with conﬁrming a letter of credit. The banks are insured up to 100% for sovereign (government) banks and 95% for all other banks. The premium is based on the type of buyer, repayment term, and country.

• The Financial Institution Buyer Credit Policy. Issued in the name of the bank, this policy provides insurance coverage for loans by banks to foreign buyers on a short- term basis. A variety of short-term and medium-term insurance policies are available to exporters, banks, and other eligible applicants. Basically, all the policies provide insurance protection against the risk of nonpayment by foreign buyers. If the foreign buyer fails to pay the exporter because of commercial reasons such as cash ﬂow problems or insolvency, EX-IM bank will reimburse the exporter between 90 and 100% of the insured amount, depending upon the type of policy and buyer.

If the loss is due to political factors, such as foreign exchange controls or war, EX- IM bank will reimburse the exporter for 100% of the insured amount. The insurance policies can be used by exporters as a marketing tool by enabling them to offer more competitive terms while protecting them against the risk of nonpayment. The exporter can also use the insurance policy as a ﬁnancing tool by assigning the proceeds of the policy to a bank as collateral. Certain restrictions may apply to particular countries, depending upon EX-IM bank’s experience, as well as the existing economic and political conditions.

• The Small Business Policy. This policy provides enhanced coverage to new exporters and small businesses. Firms with very few export credit sales are eligible for this policy. The policy will insure short-term credit sales (under 180 days) to approved foreign buyers. In addition to providing 95% coverage against commercial risk defaults and 100% against political risk, the policy offers lower premiums and no annual commercial risk loss deductible. The exporter can assign the policy to a bank as collateral.

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• The Umbrella Policy. Issued to an “administrator,” such as a bank, trading company, insurance broker, or government agency, the policy is administerd for multiple exporters and relieves the exporters of the administrative responsibilities associated with the policy. The short-term insurance protection is similar to the Small Business Policy and does not have a commercial risk deductible. The proceeds of the policy may be assigned to a bank for ﬁnancing purposes.

• The Multi-Buyer Policy. Used primarily by the experienced exporter, the policy provides insurance coverage on short-term export sales to many different buyers.

Premiums are based on an exporter’s sales proﬁle, credit history, terms of repayment, country, and other factors. Based upon the exporter’s experience and the buyer’s creditworthiness, EX-IM bank may grant the exporter authority to preap- prove speciﬁc buyers up to a certain limit.

• The Single-Buyer Policy. This policy allows an exporter to selectively insure certain short-term transactions to preapproved buyers. Premiums are based on repayment term and transaction risk. There is also a medium-term policy to cover sales to a single buyer for terms between one and ﬁve years.

EX-IM bank, in addition to other federal support programs for export ﬁnance and promo- tion, can be viewed as a competitive weapon provided by the U.S. to help match export marketing advantages with those extended by foreign governments on behalf of their exporters and U.S. ﬁrms’ foreign competition. Another advantage is that the EX-IM bank has a wealth of information on foreign buyers as a result of its insurance, guarantee, and lending activities.

Information that has been given in confidence to the EX-IM bank will not be divulged; however, general information about the repayment habits of buyers insured or funded by EX-IM bank is available. You can call or fax Credit Services at EX-IM bank for further information. EX- IM bank’s Washington headquarters are at 811 Vermont Avenue NW, Washington, D.C. 20571, and its toll-free number for general information is 1-800-565-3946, fax (202) 565-3380. There are five regional offices in New York, Miami, Chicago, Houston, and Los Angeles.

EXPOSURE NETTING

Exposure netting is the acceptance of open positions in two or more currencies that are considered to balance one another and therefore require no further internal or external hedging. Thus, exposures in one currency are offset with exposures in the same or another currency.

An open position exists when the ﬁrm has greater assets than liabilities (or greater liabilities than assets) in one currency. A closed, or covered, position exists when assets and liabilities in a currency are identical.

EXPROPRIATION

Expropriation is the forced seizure or takeover of the host government of property rights or assets owned by a foreigner or foreign corporation without compensation (or with inadequate compensation). Such an action is not in violation of international law if it is followed by prompt, adequate, and effective compensation. If not, it is called confiscation.

EXTRACTIVE FDI

A form of foreign direct investment (FDI) adopted by the MNC for the sole purpose of securing raw materials such as oil, copper, or other materials.

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F

FACTOR

1. The basis on which a shipping charge is based such as a rate per mile the cargo is transported.

2. A firm that buys accounts receivable from exporters using short-term maturities of no longer than a year and then assumes responsibility for collecting the receivables. This usually involves no recourse, which means the factor must bear the risk of collection.

Some banks and commercial finance companies factor (buy) accounts receivable. The purchase is made at a discount from the account’s value. Customers remit either directly to the factor (notification basis) or indirectly through the seller.

FACTORING

Discounting without recourse an account receivable by an intermediate company called a factor. The exporter receives immediate (discounted) payment, and the factor receives even- tual payment from the importer.

FADE-OUT

Fade-out is a host government policy toward foreign direct investment (FDI) that calls for progressive divestment of foreign ownership over time, ending with either complete local ownership or limited foreign ownership share. For example, a joint venture may have served the goal of helping a firm acquire local experience in the initial entry state but no longer serves this need at a later stage.

FAIR VALUE

1. The theoretical value of a security based on current market conditions. The fair value is such that no arbitrage opportunities exist.

2. Price negotiated at arm’s-length between a willing buyer and a willing seller, each acting in his or her own best interest.

3. The fair market value of a multinational company’s activities that is used as a basis to determine tax.

4. The “proper” value of the spread between the Standard & Poor’s 500 futures and the actual S&P Index that makes no economic difference to investors whether they own the futures or the actual stocks that make up the S&P 500. Their buy and sell decisions will be driven by other factors. Through a complex formula using current short-term interest rates and the amount of time left until the futures contract expires, one can determine what the spread between the S&P futures and the cash “should be.” The formula for determining the fair value

where F= break-even futures price, S= spot index price, i= interest rate (expressed as a money-market yield), d= dividend rate (expressed as a money-market yield), and t= number of days from today’s spot value date to the value date of the futures contract.

F = S[1+(i–d)t/360]

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FAS

See FREE ALONGSIDE.

FASB NO. 8

See STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 8.

FASB NO. 52

See STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 52.

FDI

See FOREIGN DIRECT INVESTMENT.

FIAT MONEY

Fiat money is nonconvertible paper money backed only by full faith that the monetary authorities will not cheat (by issuing more money).

FINANCE DIRECTOR

The finance director is the financial executive responsible for the finance function of the company. The finance director may be a controller, treasurer, or Chief Financial Officer (CFO).

A group finance director of an MNC typically reports to the Chief Executive Officer (CEO) and the member of the main board of directors with responsibility for leading the finance function and contributing actively to the overall strategy and development of the business.

This involves a blend of hands-on operational involvement and high level influencing/nego- tiating with banks, venture capitals, and strategic alliance partners/suppliers.

FINANCIAL DERIVATIVE

A transaction, or contract, whose value depends on or, as the name implies, derives from the value of underlying assets such as stocks, bonds, mortgages, market indexes, or foreign currencies. One party with exposure to unwanted risk can pass some or all of that risk to a second party. The first party can assume a different risk from the second party, pay the second party to assume the risk, or, as is often the case, create a combination. The participants in derivatives activity can be divided into two broad types—dealers and end-users. Dealers include investment banks, commercial banks, merchant banks, and independent brokers. In contrast, the number of end-users is large and growing as more organizations are involved in international financial transactions. End-users include businesses; banks; securities firms;

insurance companies; governmental units at the local, state, and federal levels; “supernational”

organizations such as the World Bank; mutual funds; and both private and public pension funds. The objectives of end-users may vary. A common reason to use derivatives is so that the risk of financial operations can be controlled. Derivatives can be used to manage foreign exchange exposure, especially unfavorable exchange rate movements. Speculators and arbi- trageurs can seek profits from general price changes or simultaneous price differences in different markets, respectively. Others use derivatives to hedge their position; that is, to set up two financial assets so that any unfavorable price movement in one asset is offset by favorable price movement in the other asset. There are five common types of derivatives:

options, futures, forward contracts, swaps, and hybrids. The general characteristics of each are summarized in Exhibit 40. An important feature of derivatives is that the types of risk are not unique to derivatives and can be found in many other financial activities. The risks for derivatives are especially difficult to manage for two principal reasons: (1) the derivative products are complex, and (2) there are very real difficulties in measuring the risks associated derivatives.

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It is imperative for financial officers of a firm to know how to manage the risks from the use of derivatives. Exhibit 40 compares major types of financial derivatives.

See also CURRENCY OPTION; FORWARD CONTRACT; FUTURES; OPTION; SWAPS.

FINANCIAL FUTURES

Financial futures are types of futures contracts in which the underlying commodities are financial assets. Examples are debt securities, foreign currencies, and market baskets of common stocks.

FINANCIAL MARKETS

The financial markets are composed of money markets and capital markets. Money markets, also called credit markets, are the markets for debt securities that mature in the short term (usually less than one year). Examples of money-market securities include U.S. Treasury bills, government agency securities, bankers’ acceptances, commercial paper, and negotiable certificates of deposit issued by government, business, and financial institutions. The money- market securities are characterized by their highly liquid nature and a relatively low default risk. Capital markets are the markets in which long-term securities issued by the government and corporations are traded. Unlike the money market, both debt instruments (bonds) and equity share (common and preferred stocks) are traded. Relative to money-market instruments, those of the capital market often carry greater default and market risks but return a relatively high yield in compensation for the higher risks. The New York Stock Exchange, which handles the stock of many of the larger corporations, is a prime example of a capital market. The American Stock Exchange and the regional stock exchanges are yet another example. These exchanges are organized markets. In addition, securities are traded through the thousands of brokers and dealers on the over-the-counter (or unlisted) market, a term used to denote an informal system of telephone contacts among brokers and dealers. There are other markets including (1) the foreign exchange market, which involves international financial transactions between the U.S. and other countries; (2) the commodity markets which handle various commodity futures; (3) the mortgage market that handles various home loans; and (4) the insurance, shipping, and other markets handling short-term credit accommodations in their operations. A primary market refers to the market for new issues, while a secondary market is a market in which previously issued, “secondhand” securities are exchanged. The New York Stock Exchange is an example of a secondary market.

EXHIBIT 40

General Characteristics of Major Types of Financial Derivatives

Type Market Contract Definition

Option OTC or

Organized Exchange

Custom*

or Standard

Gives the buyer the right but not the obligation to buy or sell a specific amount at a specified price within a specified period

Futures Organized Exchange

Standard Obligates the holder to buy or sell at a specified price on a specified date

Forward OTC Custom Same as futures

Swap OTC Custom Agreement between the parties to make periodic payments to each other during the swap period

Hybrid OTC Custom Incorporates various provisions of other types of derivatives

* Custom contracts vary and are negotiated between the parties with respect to their value, period, and other terms.

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FISHER EFFECT

The Fisher effect, named after Irving Fisher, states that that nominal interest rates (r) in each country equal the required real rate of return (R) plus a premium for expected inflation (I) over the period of time for which the funds are to be lent (i.e., r=R+I). To be precise,

which is approximated as r=R+ I. The theory implies that countries with higher rates of inflation have higher interest rates than countries with lower rates of inflation. Note: The equation requires a forecast of the future rate of inflation, not what inflation has been.

EXAMPLE 47

If you have $100 today and loan it to your friend for a year at a nominal rate of interest of 11.3%, you will be paid $111.30 in one year. But if during the year inflation (prices of goods and services) goes up by 5%, it will take $105 at year end to buy the same goods and services that

$100 purchased at the start of the year. Then the increase in your purchasing power over the year can be quickly found by using the approximation r=R+ I:

In other words, at the new higher prices, your purchasing power will have increased by only 6%, although you have $11.30 more than you had at the beginning of the year. To see why, suppose that at the start of the year, one unit of the market basket of goods and services cost $1, so you could buy 100 units with your $100. At year-end, you have $11.30 more, but each unit now costs

$1.05 (with the 5% rate of inflation). This means that you can purchase only 106 units ($111.30/$1.05), representing a 6% increase in real purchasing power.

The generalized version of the Fisher effect claims that real returns are equalized across countries through arbitrage—that is, rh and rf where the subscripts h and f are home and foreign real rates. If expected real returns were higher in one country than another, capital would flow from the second to the first currency. This process of arbitrage would continue, in the absence of government intervention, until expected real returns were equalized. In equilibrium, then, with no government interference, it should follow that nominal interest rate differential will approximately equal the anticipated inflation rate differential, or

(Equation 1) 1+Nominal rate = (1+Real rate)(1+Expected inflation rate)

1+r = (1+R)(1+I)

r = R+ +I RI

11.3% = R+5% or r = 11.3%–5% = 6.3%

To be precise, use r = R+ +I RI:

11.3% = R+0.05+0.05R R = 0.06 = 6%

1+rh

1+rf

--- 1+Ih

1+Ih

---

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where rh and rf are the nominal home and foreign currency interest rates, respectively. If these rates are relatively small, then this exact relationship can be approximated by

rh−rf = Ih−If (Equation 2) Note: Equation 1 can be converted into Equation 2 by subtracting 1 from both sides and assuming that rh and rf are relatively small. This generalized version of the Fisher effect says that currencies with high rates of inflation should bear higher interest rates than currencies with lower rates of inflation.

EXAMPLE 48

If inflation rates in the United States and the United Kingdom are 4% and 7%, respectively, the Fisher effect says that nominal interest rates should be about 3% higher in the United Kingdom than in the United States.

A graph of Equation 2 is shown in Exhibit 41. The horizontal axis shows the expected difference in inflation rates between the home country and the foreign country, and the vertical axis shows the interest differential between the two countries for the same time period. The parity line shows all points for which r_h−r_f=I_h−I_f. Point A, for example, is a position of equilibrium, as the 2%

higher rate of inflation in the foreign country (r_h− r_f= −2%) is just offset by the 2% lower home currency interest rate (I_h− I_f=−2%). At point B, however, where the real rate of return in the home country is 1% higher than in the foreign country (an inflation differential of 3% versus an interest differential of only 2%), funds should flow from the foreign country to the home country to take advantage of the real differential. This flow will continue until expected real returns are equal.

EXHIBIT 41 The Fisher Effect

Difference in interest rates

rh–rf equals Expected difference in inflation rates Ih–If

Parity line 5

4 3 2 1

1 2 3 4 5

-1 -1 -2 -3 -4 -5

-2 -3 -4 -5 Interest differential in favor of home country (%)

Inflation differential, home country relative to foreign country (%)

A B

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FIXED EXCHANGE RATES

An international financial arrangement under which the values of currencies in terms of other currencies are fixed by the governments involved and by governmental intervention in the foreign exchange markets.