Functions of International Finance
1. Debt Crisis Effect on Banks: International Banks were the victims of debt default of many governments in the 80s. When loans are given to international finance corporates, they can be forced into liquidation but not so in the case of the Governments. The Banks have therefore spent time and money to reschedule and recover the money in installments and some debts are written off. The debt crisis weakened the banks but the banking system didn’t collapse. The banks have become more cautious and started lending only to countries with market oriented economies and undergoing structural reforms. The development in International Debt market gave rise to the new instruments and secondary market in many instruments such as scrutinized debt. Debt repaying capacity and foreign exchange earnings and production use of capital are all taken into account it is important functions of international finance.
2. Corporate Financing Decision: Another important functions of international finance is foremost decision is the amount of debt for a given level of equity. The leverage and tax deductibility of Interest Payment and Debt would make the company prefer as much debt as possible. But debt increases the risk and hence there is a trade off between leverage and risk because of the debt risk. The questions that any Corporation Management asks itself are the proper mix of equity and debt,
composition of debt, show medium and long term debt, nature of debt secured and unsecured. Fixed Vs Floating Debt and maturity and terms of debt, what currency or currencies in which debt should be taken etc. The firm should keep its debt should be taken etc. The firm should keep its debt at the optimum level. The debt should be self-liquidating through the returns that it generated. It should be in currencies in which it earns it exporting earnings. One should borrow in currencies, which are likely to be weakened and depreciated.
» Alternatives to Debt Financing:
a) Derivatives and Hybrids in financing
b) Quasi-Equity financing debt with equity
c) Debt with warrants and sweeteners
The value of the company’s shareholders will increase with the leverage enjoyed by debt but the risk associated with the debt is to be hedged to improve the value of the firm.
3. Capital Structure: The Composition of Capital Structure influences the cost of Capital and returns and thus the shareholders value. The composition of debt, its currency, interest rate, maturity and other terms of debts, its currency, interest rate maturity and other terms of debt are relevant valuables to be considered Hedging of the debt risk reduces the risk of financial stress and even crisis. The firms have to match the composition debt to the payment and characteristics of the assets created so as to minimize the probability of financial distress. It pays a company to deviate from the maximum risk debt composition of only the firm can beat the market. This mean hedging of debt risk should be part of the strategy; swap, caps and other derivatives play a role in different ways.
a) To hedge an existing exposure of the Company.
b) Hybrid bonds when used in conjunction with options and other derivatives can be effective way of getting cheaper funds by exploiting the market imperfection.
c) To position the Company to gain from a favorable movement in some market valuables such as interest rates.
The principles for deciding the Capital Structure may be set out briefly as follows:
A. Debt should be used to reduce taxes and costs.
B. Liabilities created should match the assets to reduce the asset liability mismatch.
C. Kinds of debt should be such as to suit the company’s Inflows with Outflows.
D. Foreign Debt should be less costly after taking the hedging costs.
E. Once the forms of debts and types of financing are chosen the firm should employ financing and hedging techniques that achieve the goal at the lowest cost.