International Financial Markets

Various international financial markets have been developed due to growth in

international business over the last 30 years. Financial Managers of MNCs must
understand the various international financial markets that are available so that
they can use those markets to facilitate their international business transaction.

The following are the international markets-

i. Foreign Exchange Markets

ii. Euro currency markets
iii. Euro credit market
iv. Euro bond market
v. International stock markets.

Motives for using international financial markets-

Various barriers prevent the markets for real or financial assets from becoming
completely integrated. These barriers include ten differential tariffs, quotas,
labour immobility cultural differences financial reporting differences and
significant cost of communicating information across countries.

The barriers can also create unique opportunities for specific

geographic markets that will attract foreign creditors and investors. As for
example, barriers such as tariffs, quotas and labour immobility can cause a
given country’s economic conditions to be districtly different from others.

Investors and creditors may want to do business in that country to capitalise on

favourable conditions unique to that country. The existence of imperfect
markets has precipitated the internationalisation of financial markets.

Motives for investing in foreign markets-

1. Economic condition- investors may expect firms in a particular foreign

country to achieve more favourable performance than those in the
investor’s home country. For ex- the loosening of restriction in Eastern
European countries create favourable economic condition. These such
conditions attracted foreign investors and creditors.
2. Exchange rate expectations-
Some investors purchase financial securities denominated in a currency
that is expected to appreciate against their own. The performance of such
 an investment is highly dependent on the currency movement over the
investment horizon.
3. International diversification- investors may achieve benefits from
internationally diversifying their asset portfolio. When an investor enter
in portfolios does not depend solely on a single country’s economy, cross
border differences in economic condition can allow for risk reduction
benefits. A stock portfolio representing firms across European countries
less risky than a stock portfolio representing firms in any single European
country. Further more, access to foreign markets allows investors to
spread their funds across a more diverse group of industries than may be
available domestically. This is especially true for investors residing in
countries these firms are concentrated in a relatively small member of
industries.

Motives for providing credit in foreign markets-

Creditors have one or more of the following motives for providing credits in
foreign markets are-

- High foreign interest rates

- Exchange rate expectation
- International diversification

Motives for borrowing in foreign markets-

Borrowers may have one or more of the following motives for borrowing in
foreign markets.

- Low interest rates

- Exchange rate expectations

The existence of market imperfections prevents markets from

being completely integrated. Consequently, investors and creditors can attempt
to capitalize on unique characteristics that make foreign markets more attractive
than domestic markets. This motivates the international flow of funds and
results in the development of international financial markets.
The foreign exchange markets-

It allows currencies to be exchanged in order to facilitate international trade or

financial transaction. Commercial banks saves financial intermediaries in this
markets. They stand ready to exchange currencies on the spot or at a future
point in time with the use of forward contracts.

The Eurocurrency markets- is composed of several large banks that accept

deposits and provide short-term loans in various currencies. This market is
primarily used by govt. and large corporations.

The Euro credit markets- is composed of the same commercial banks that serve
the Eurocurrency markets. These banks convert some of the deposits received
into Euro-credit loans (for medium-term periods) to govt. and large
corporations.

The Eurobond markets facilitates international transfers of long-term credit

thereby enabling govt. and large corporations to borrow funds from various
countries. Eurobonds are underwritten by a multinational syndicated
investment banks and are placed in various countries.

International stock markets enable firms to obtain equity financing in foreign

countries. Thus, these markets have helped MNCs finance their international
expansion.

Currency forward, future and option

Currency forward – a forward market facilitates the trading of forward

contract on currencies.

A forward contract is an agreement between a corporation and a commercial

bank to exchange a specific amount of a currency at a specific exchange rate
(forward rate) on a specific date in the future.
When multinational corporation (MNC’s) anticipated a future need for a foyer
receipt of a foreign currency they can set up a forward contract to lock in the
rate at which they can purchase or sell a particular foreign currency. Virtually
all large MNC’s use forward contract some MNC’s such as TRW have forward
contract outstanding worth more than $100 million to hedge various position
forward contract normally are not used by consumer or small firm.
The most common forward contract are 30, 60, 90, 180 and 360 days although
foyer period (including longer period) are available. The forward rate of a given
currency will typically vary with the length (number of days) of the forward
period. MNC”s use forward contract to hedge imports. They can lock in the rate
at which they obtain a currency needed to purchase import.

Currency future - Currency future contract are contract specifying a standard

volume of a particular currency to be exchanged on a specific settlement date.
They are commonly used by MNC:s to hedge their foreign currency position in
addition they are traded by speculations who hope to capitalize on their
expectation of exchange rate movement. A buyer of a currency future contract
locks in the exchanger rate to be paid for a foreign currency at future point in
time.

Alternatively a seller of a currency future contract locks in exchange rate

at which a foreign currency can be exchanged for the home currency. In the US
Currency future contract are purchased to lock in the amount of dollarsneeded
to obtain a specific amount of a particular foreign currency they are sold to lock
in the amount of specified amount of a particular currency. Currency future
contract are available for several widely traded currency at the Chicago
mercantile exchange and the contract for each currency specifies a standardized
number of units.

Currency future contract are sold on a exchange while each forward

contact negocoated between a firm ND a commercial bank over a
telecommunication network. Forward contract can be tailored to the needs of
the firm while the currency future contract isstandardized.

Currency option – a Currency option is an alternative type of contract that can

be purchased or sold by speculator and firm.
A Currency call option grants the right to buy a specific currency at specified
price at specified date the price at which the owner is allotted to exercise price
or strike price and there are monthly expectation dates for each option. Call
option are describe when one wishes to lock in a maximum price to be paid for
a currency in the future. If the spot rate of the currency risk above the strike
price owners of call option can exercise then option by purchasing the currency
at the stake price which will be cheaper than the prevailing spot rate this
strategy is some what similar to hat used by purchase of future contract but the
future contract require an obligation, which the currency option does not the
owner can choose to let the option expire on the expiration date without even
exercising it owners of expired call option will have lost the premium they
initially paid but that is the most they can lose.

Some option are listed as “European style” which means that they can be
exercised only upon expiration.

A currency call option is said to be in the money when the present exchange
rate exceeds the strike price and out of the money when the present exchange
rate is less than the strike price. For a five currency and expiration date an in the
money call option will require a higher premium than option that are at the
money or out of money.

Currency put option – the owner of a Currency put option recovers the right to
sell a currency at a specified price within specified time period of time. The
owner of a put option is not obligated to exercise the option therefore the
maximum potential loan to the owner of the put option is the price (or premium)
paid for the option contract.

A Currency put option is said to be in the money when the present

exchanger rate is less than the strike price at the money when the present
exchange rate are equal the strike price and out of the money when the present
exchange rate exceeds the strike price for a given currency and expiration date
an in the money put option will require a higher premium at the money or out of
the money.

Foreign Exchange Markets – the Foreign Exchange Markets allow currencies

to be exchanged in order to facilitate international trade or financial transaction
MNC’s rely on the foreign exchange market to exchange their home currency
for a foreign currency that they need to purchase imports or use for direct
foreign investment.Alternatively they may need the foreign exchange market to
exchange a foreign currency that they receive into their home currency. The
system for establishing exchanged rate has exchange time.

Interest rate parity – once market forces cause interest rate and exchanged rate
to adjust such that covered interest arbitrage is no longer feasible there is an
equilibrium state referred to as IRP. In equilibrium the forward rate differs from
the spot rate by a sufficient amount to offset the interest rate diffencial between
two currency.

Covered interest arbitrage is the process of capitalizing on the interest rate

differential between two countries while coving your exchange rate risk. The
logic of the term term cover interest rate arbitrage becomes clear.

IRP specifying that the forward premium (or discount) is equal to the interest
rate differential between the two currencies.

Inflation, interest rate and exchange rate – changes in relative inflation rate can
effect international trade actively which influence the demand for and supply of
currencies and there fore influence exchange rates

Changes in relative interest rate affect investment in foreign securities

which influence the demand and supply of currencies and therefore influence

Exchange rates – the key economic factors that can influence exchange rate
movement through their effect on demand and supply condition are relative
influence rates interest rate and income level and as well as Govt. contract.

As these factors cause as change in international trade or financial flow they

affect the demand for a currency or the supply of currency for the sale and
therefore affect the equilibrium exchange rate.

When a country’s inflation rate risk the demand for it currency decline as it
export decline (due to its higher price) consumer and firm in that country tend to
increase their importing.
Purchasing power parity (PPP) theory attempts to quantity inflation exchange
rate relationship.

Fisher effect – nominal risk free interest rates contain a real rate of return and
anticipated inflation

International Fisher effect theory (IFE) – it uses interest rate rather than
inflation rate differential to explain why exchange rate change overtime but it is
closely related to the PPP theorybecause interest rate are often highly correlated
with inflation rates specifies a precise relation between relative interest rate of
two countries and then exchange rate.

Exchange rate Forecasting – MNC need exchange rate forecast to make

decision on hedging payable madreceivable, short term financing and
investment, capital budgeting and long term financing.

The most common forecasting technique can be classified as

(i) Technique
(ii) Fundamental
(iii) Market based
(iv) Mixed

Unfortunately these technique have generally performed rather poorly

increase years yet due to high variability in exchange rate. It should not be
surprising that forecast are not always accurate.

Forecasting method can be evaluated by comparing the actual value of

currency to the value predicted by the forecasting method. To be meaningful
that comparison should be conducted over several period two criteria used to
evaluate performance of a forecast method are bias and accuracy. When
comparing the accuracy of forecast for two currencies, the absolute forecast
error should be divided by the realized value of the currency to control for
differential in the relative value of currencies.
Why firms forecast exchange rates – virtually every operation of an MNC
can be influenced by changes in exchange rates.

The following are some of the corporate function for which exchange rate
forecast are necessary :

(i) Hedging decision – MNC’s constantly face the decision of whether to

hedge future payment and receivables in foreign currencies whether a
firm hedge may be determined by its forecast of foreign currency
valve.
(ii) Short term financing decision –when large corporation borrow, they
have access to several different currencies the currency they borrow
will ideally (1) exhibit a low interest rate and (2) weaken in value over
the financial period.
(iii) Short term investment decision – corporation some times have a
substantial amount of exceedscash available for a short term period.
Large deposit can be established in several currencies the ideal
currency for deposits will (1) exhibit a high interest rate and (2)
strengthen in value over the investment period.
(iv) Capital budgeting decision – when an MNC’s parent assesses whether
to invest funds in a foreign project may periodically require the
exchange of currencies. The capital budget analysis can be completed
only when all estimated cash flow is measured in the parent local
currency.
(v) Long term financial decision – corporations that issue bonds to secure
long term funds may consider denominating the bonds in foreign
currency borrowed depreciate over time against the currency they are
receive from sales to estimate the cost of issuing bonds denominated
in a foreign currency, forecasts of exchange rates are required.
(vi) Earning assessment – when earning of an MNC are reported
subsidiary earning are consolidated and translated into the currency
representing the parent firm’s home country.

Forecasting technique - thenumerousmethods are available for

forecasting exchange rate can be categorized into from general group
(1) technical (2) fundamental (3) market based (4) mixed
Technical forecasting - Technical forecasting involves the use of
historical exchange rates data to predict future value.

Fundamental analysis – it is based on fundamental relationship

between economic variable and exchange rates. Given current value of
that variable along with their historical impact on a currency’s value
corporations can develop exchange rate projection.

A forecast may arise simply from a subjective assessment of the

degree to which general movement in economic variable in one
country are expected to affect exchange rates. From a statistical
perspective measured impact of factors on exchange rates.

Market based forecasting – the process of developing forecast from

market indicators known as market based forecasting is usually based
on either (1) the spot rate or (2) the forward rate.
Use of spot rate today’s spot rate may be used as a forecast of the
spot rate that will exist on a future date.
Use of forward rate a forward rate quoted for s specific date in the
future is commonly used as the forecasted spot rate on that future date.

Mixed forecast –as on suitable forecasting technique has been formed

to be consistentlysuperior the other some MNC’s prefer to use
combination of forecasting technique. Various forecasting for a
particular currency value are developed using several forecasting
technique then technique used are assisted weight in such a way that
weight are 100 per cent with the technique considered more reliable
being assessed higher weights. The actual forecast the currency is a
weighted average of the various forecast developed.

Performance of forecasting service - given the recent vitality in

foreign exchange market it is quite difficult to forecast currency value.
One for a corporation to determine whether a forecasting service is
valuable is to compare the accuracy of its forecast to that of publicly
available and free forecast. The forward rate serves as a benchmark for
comparison here suite it is quoted in many news paper and
margarines.
Some studies have compared several forecasting service forecast for
different currencies to the forward rate a small percentage of the
forecast for one month ahead were more accurate that the forward rate.
The result were similar than assessing forecast for three month ahead,
such result are forecasted for the corporation that have paid substantial
amount for expect opinion.

Forecasting service –the corporate need to forecast currency value

has prompedthe evergence of business international currency prede X
and whotson econometric forecasting associats in addition some large
investment investment bank such as Goldman sacls and commercial
bank such as Citibank ofer forecasting servoice. Many consisting
service use atleast two different type of analysis to generate separate
forecast and determine the weighted coverage of the forecast.
Some forecasting servive such capital techniqyue, FX concept, and
preview Economics focus on tecjnoque forecasting, while others
service such as corporate treasury consitants ltd. And WEFA, focus on
fundamental forecasting many services such as forexia Ltd. Use both
forecasting. Forecast is even provided for currencies that are not
widely traded. Firms provides forecast on any currency for time
horizon of interest to their clients ranging from one day to ten years
from now. In addition some firms offer advice on international cash
management assessment of exposure to exchange rate risk and
hedging. Many of the firm provide their client with forexast and
recommendation monthly, or even weekly for an annual fee.

Evaluation of forecast performance – an MNC that forecast

exchange rate must monitor its performance overtime to fetermine
whether the forecasting process is satisfy for the porpuse, or
measyrement of the forecast error is requird there are various ways
compleat forecast errors.

Absolute forecast error as a % of realized value

= (forecasted value – realized value)/ realized value
Forecasted accuracy overtime –MNC’s are likely to have more
confidence in their measurement of the forecast error when they
measure it over each of several periods.

Forecast accuracy among currencies – the ability to currency

forecast may vary with the currency concern. The maen forecast error
for major currency may be derived form 90 days forward contarct.

Search for forecast bias – the difference between the forecasted and
realized exchange rate for a given point in time is a nominal forecast
error negative error overtime indicate underest mainly while positive
error indicate overestimating if the error are consistentaly positive or
negative overtime then a bias in forecasting procedure does exists.

Statistical test of forecast bias – it the forward rate is a biased

predictor of the future spot rate this implies there is a systematic
forecast error, which could be corrected to improve forecast accuracy
if the forward rate is unbiased, it fully reflect all avalible information
about the future spot rate. In any case any forecast error would be the
result of events that covered not has been anticipated from exiting
information at the time of the forecast.
A conventional method of testing for a forecast bias is to apply the
regression model to historical data.
St =a0 +a1Ft-1 +ut
Where
St= spot rate at time t
Ft-1= forward rate
Ut = error term
a0 = intercept
a1 = regression co efficient

If the forward rate is unbiased the intercept should equal to

zero and the regression co efficient and should equal to 1.
t = (a1 – 1)/standard error of a1

if a0 = 0 and a is significantly less that 1 this implies that the forward

rate is systematically overestimating the spot rate. For example if
a0 = 0 and a1 = 0.90 the future spot rate is estimated to be 90% of the
forecasted generated by the forecast rate.
Conversely if a0 = 0 and a issignificantly greater than 1 this
implies that the forward rate is systematically underestimating the spot
rate. For example if a = 0 and a1 = 1.1 the future spot rate is
estinmated to be 1.1 times the forecast generated by the forward rate.
When a bias as detected and anticiapated to persist in future forecast
may incorporate that, bias for example if a1 = 1.1 future forecast of
the spot rate may incorporate their inflation by 1.1 to create a forecast
of the future spot rate.
By detecting a bias an MNC may be able to adjust for the bias so
that it can improve its forecasting accuracy for example if the errors
are consistacly positive could adjust today’s forward rate downward to
reflect the bias overtime a forecasting bias can change (from
underestimstimg to overestimating or vice versa). Any adjustment to
the forward rate used as a forecast would need to reflect the
anticipated bias for the period of concern.

Graphic evaluate of forecast performance – forecast performance

can be examised with the use of a graph that campars forecasted value
with the realized valye for various time periods.

Comparision of forecasting technique – when an MNC evaluate its

forecasting performanbe, it must realize errors will commonaly occurs
to at least minimize the error it may derive to compare forecasting
errors of the available methods. This can be derived by plotting the
point relating to two methods on graph the points performing to each
method can be distinguise by a particular month of glone.
The performance of two methods can be evaluated by comparing
distance of point from the 45 degree.
 Exchange rate volatility – MNC’s recognize that it is nearly
inposition to predict future exchange will may specify a range around
their forecast.

Methods of forecasting exchange rate volatility –the volatility of

exchange rate movement for a future period can be forecast using
(1) Recent exchange rate volatility
(2) Historical time series of volatility
(3) The implied standard deviation on derived from currency option
prices.

Application of exchange rate forecasting to the Asian crisis – just before the
asian crisis the spot rate (in dollor) would have served as a reasonable predictor
of the future spot rate because the central bank were maintain a some what
stable value for their respective currency the forward rate of these some what
Asian currency would not have been accurate because it would have exhibits a
discount to reflect the differential between the south east Asian countries
interest rate (based on interest rate parity). The currency depreciated by much
more than would have been predicted according to the forward rate.

Two key factor that led to sustainable decline in currency value were-

1. The large amount of foreign investment prior to the crisis

2. Fear of a massive sell off of the currencies which perpetuated the
problem. These 2 factors cannot easily be incorporated in a fundamental
forecasting model in a manner that will precisely identify the timing and
magnitude of a major decline in a currency value.

How exchange rate forecasting affects a MNCs value-

Exchange rate forecasting affects the value of an MNC. The forecasts lead to
decisions about whether the firm should remain exposed to exchange rate
fluctuations a hedge its foreign currency position. The forecasts can affect the
expected foreign currency cash flows if those cash flows are partially generated
by foreign subsidiaries from transactions with other countries.
The forecasts have a direct effect on the expected values of the exchange rates
at which the foreign currency cash flows will be converted into dollars when
those cash flows are remitted to the U.S. parent suice the forecasts lead to
decision about whether to hedge they influence the actual exchange rate at
which the future foreign currency cash flows will be converted to dollars when
remitted to the U.S parent. Thus, they determine the expected dollars when
remitted to the U.S parent. Thus, they determine the expected dollar cash flows
to be received by the U.S parent.

THE MEASUREMENT OF EXCHANGE RATE RISK

Exchange rate risk can be broadly defined as the risk that a company
performance, will be affected by exchange rate movements. MNC closely
monitor their operations to determine how they are exposed various forms of
exchange rates risk. Financial managers must understand how to measure the
exposure of their MNCs to exchange rate fluctuations. So that, they can
determine whether and how to protect their companies from that exposure.

EXCHANGE RATE RISK IS IRRELEVANT BECAUSE OF-

1. Purchasing power parity argument- According to PPP theory, exchange

rate movements are just a response to differentials in price changes
between countries. Therefore, the exchange rate effect is offset by the
changes in price.
2. The investor hedge arguments- Investors in MNCs can hedge this risk on
their own.
3. Currency diversifications argument- If a US based MNC is well
diversified across numerous countries its value will not be affected by
exchange rate movements because of offsetting effects.
4. Stakeholder diversification argument- If creditors or stockholders are
diversified they will be somewhat insulated against losts experienced by
an MNC due to exchange rate risk. In 1988 numerous US based MNCs of
Asian currencies against dollar. In 2000, some MNCs were adversily
affected by the depreciation of European currencies against the dollar.
 5. Response from MNCs- MNCs like colgate Palmolive, Eastman Kodak,
have attempted to stabilize their earnings with hedging strategies- an
medication that they believe exchange rate risk is relevant.

TYPE OF EXPOSURE-

Exposure to exchange rate fluctuations comes in three forms-

1. Transaction exposure
2. Economic exposure
3. Translation exposure

Transaction Exposure

The degree to which the value of future cash transactions can be affected by
exchange rate fluctuations is referred to as transaction exposure. The value of a
firms cash inflows received in various currencies will be affected by the
respective exchange rates of these currencies when they are converted into the
currency desired. Similarly, the value of a firms cash outflows in various
currencies will be dependent on the respective exchange rate of these
currencies.

Economic Exposure

The degree to which a firms present value of future cash flows can be
influenced by exchange rate fluctuations is referred to as economic exposure to
exchange rates. All type of transactions that cause transaction exposure also
cause economic exposure because these transactions represent cash flows that
can be influenced by exchange rate fluctuations. In addition, other types of
business that do not cause transaction exposure can cause economic exposure.

Measuring Economic Exposure- classify the cash flows into different income
statement in terms and subsectively predict each income statement item based
on a forecast of exchange rates. There are alternative considered and the
forecasts for the income statement items revised. This procedure is especially
for firms that have more expense than revenue in a particular foreign currency.
Translation Exposure – an MNC creates its financial statements by
consolidated all of its individual subsidiary’s financial statement. A subsidiary
financial statement is normally measured in it local currency. To be
consolidated each subsidiary financial statement must transfer into currency of
the parent since the exchange rate change over time, the translation of the
subsidiary’s financial statement into a different currency is affected by
exchange rate movement the exposure of MNC’s consolidated financial to
exchange rate fluctuation is known as translation exposure particular subsidiary
earning translated into the reporting currency on the consolidated income
statement and subject to changing exchange rate.

Cash flow perspective – translation of financial statement for consolidated

reporting purpose does not affect an MNC’s cash flows. For the reason some
analysis suggest that translation exposure is not relevant.

Stock price perspective – many investor tend to use earning when valuing
firm, either by deriving estimate of expected cash flow from previous earning or
by apply a P/E ratio to expected annual earning to derive a value per share of
stock since an MNC’s translation exposure affect its consolidated earning it can
affect the MNC’s valuation.

Determining of translation exposure –dependent on following

(i) The proportion of its business conducted by foreign subsidiary

(ii) The location of its foreign subsidiary
(iii) The accounting method that it use

Managing exchange rate risk

Transaction exposure – a MNC is exposure to exchanger rate

fluctuation in there ways
(i) transaction exposure
(ii) economic exposure
 (iii) translation exposure
by managing translation exposure financial manager may be
able to increase cash flows and enhance the value of their
MNC’s
transaction exposure exits when the future cash flow transaction
of a firm are affected by exchange rate fluctuation.

Technique to eliminate transaction exposure

(i) future hedge
(ii) forward hedge
(iii) currency option hedge
(iv) money market hedge

Future hedge – currency future can be used by a firm that desire to hedge
transaction exposure

Purchasing currency system – a firm that buy a currency future contract is

entitled to receive a specified amount in specified currency for a stated price on
a specified date.

Selling currency future – a firm that sells a current future contract is entitled to
sell a specified amount in a specified currency for a stated price on specified
date.

Forward hedge – forward contract can be used it lock in the future exchange
rate at which a MNC can be or buy a currency. A forward contract is very
similar to future contract hedge expect that forward contract are commonly used
for large transaction, where future contract tend to be used for small amount
MNC;s can request forward contract that specifying the exact number of units
that they desire whereas future contract represent a standardized number of
units for currency.
Money market hedge - Money market hedge involve taking a money market
position to cover a future payment or receivable position money market

Hedge on payment – if a firm has excess cash it can create a short term deposit
in the foreign currency that it will need in the future Hedging of future
receivables with forward sale is similar to borrowing at the foreign interest rate
interesting at the at the home interest rate

Currency option hedge – the currency option has an advantage over the other
hedging in that it does not have to be exercised if the MN would be both off
unhedged. A premium must be paid to purchase the currency option however so
there is a cost for the flexibility they provide.

Hedging payables with currency call option- a currency call option provides
the right to buy a specified amount of a particular currency at a specified price
with a given period of time. The currency call option does not obligate its owner
to buy the currency at that price.

Comparison of techniques to hedge payables- A comparison of hedging

techniques should focus on obtaining a foreign currency at the lowest possible
cost.

Currency swap- A currency swap is a second techniques for hedging long-term

transaction exposure to exchange rate fluctuation. It can take many forms. One
type of currency swap accommodates two firms that have different long-term
needs.

Paralled loan- A paralled loan involves an exchange of currencies between two

parties with a promise to exchange currencies at a specified exchange rates and
future date, it represents two swaps of currencies one swap at the inception of
the loan contract and another swap at the specified future date. A paralled loan
is interpreted by accountant as a loan and is therefore recorded on financial
statements.

Alternative hedging techniques- When a perfect hedge is not available to

eliminate transaction exposure, thefirm should consider methods to at least
reduce exposure, such method include the following-

- leading and lagging

-cross-hedging

-currency diversification

Ledging and lagging- the act of leading and lagging involves an adjustment in
the timing of a payment request or disbursement to reflect expectation about
future currency if a company expects that the pound will soon depreciate against
foreign, it may attempt to expedite the payment to thundery before the pound
depreciates. This strategy is referred to as leading. If a British subsidiary
expects the pound to appreciate against the forint soon, in that case the british
subsidiary may attempt to all its payment until after the pound appreciates. In
this way, it could use fewer pounds to obtain the forint needed for payment, this
strategy is referred to as lagging.

Cross-hedging- cross hedging is a common method of reducing transaction

exposure when the currency cannot be hedged.

Currency diversification- a third method for reducing transaction exposure is

currency diversification, which can limit the potential effect of any single
currency’s movements on the value of an MNC. The coca-cola co, pepsi co.,
Philip Morris.
An MNCs management of transaction exposure can affect its value. Hedging
decision on remitted funds affect the expected value of the exchange rate at
which the funds are converted to dollar and therefore affect the dollar cash
flows. That are ultimately received long the US parent.

Economic Exposure-

Economic exposure represents any impact of exchange rate fluctuation on a

firms future cash flows. Corporate cash flows can be affected by exchange rate
movements in ways not directly associated with foreign transaction. Thus, firms
cannot focus just on hedging their foreign currency payable a receivable but
must also attempt to determine how all their cash flows will be affected by
possible exchange rate movement.

How to assess economic exposure-

An MNC must determine its economic exposure before it can manage its
exposure. It can determine its exposure to each currency informs of its cash
inflows and cash outflows. The income statements for each subsidiary can be
used to derive estimates.

How restructuring can reduce economic exposure-

MNCs may restructure their operations to reduce their economic exposure. The
restructuring involves sniffing the sources of costs or revenue to other locations
in order to match cash inflows and outflows in foreign currencies.

Issues involved in the restricting decision-

Restructuring operations to reduce economic exposure is a more complex task

than hedging any single foreign currency transaction which is why managing
economic exposure is normally perceived to be more different than managing
transaction exposure.
By managing economic exposure the firm is developing a long term solution
because once the restructuring is complete, it should reduce economic exposure
over the long-run.

When deciding how to restructure operations to reduce economic exposure, one

must address the following questions-

1. should the firm attempt to increase or reduce sales in

new or existing foreign markets?
2. Should the firm increase or reduce its dependency on
foreign suppliers?
3. Should the firm establish or eliminate production
facilities in foreign markets?
4. Should the firm increase or reduce its level of debt
denominated in foreign currencies?

MNCs that have production and marketing facilities in various countries may be
able to reduce any adverse impact of economic exposure by shifting the
allocation of then operation.

Nikes economic exposure comes in various forms. First, it is subject to

transaction exposure because of its numerous purchase and sale transactions in
foreign currencies, and thus transaction exposure is a subset of economic
exposure.

TRANSLATION EXPOSURE-

Translation exposure occurs when an MNC translates each subsidiaries

financial data to its home currency for consolidated financial statement.

Some people argue that it is not necessary to hedge or even reduce translation
exposure as cash flow is not affected. Some MNCs attempt to avoid translation
exposure by matching foreign liabilities with foreign assets. For example, Philip
Morris uses foreign financing to matching its covers of foreign assets.

Use of forward contract to hedge translation exposure-

MNCs can use forward contracts or futures contracts to hedge translation
exposure. They can sell the currency forward that their foreign subsidiaries
receive as earning. In this, they create a cash outflow in the currency to offset
the earning received in that country. Company’s decision to hedge translation
exposure.

Limitations on hedging translation exposure-

There are 4 limitations in hedging translation exposure-

1. In accurate earnings forecasts

2. In adequate forward contrasts for some currencies.
3. Accounting distribution
4. Increased transaction exposure.

Alternative solutions to hedging Translation Exposure- Some MNCs do not

consider hedging translation exposure because they do not perceive this
exposure to be relevant.

How managing exposure affects a MNCs value-

A MNCs management of economic exposure can affect its value. Suice

transaction exposure is a subset of economic exposure, foreign subsidiaries that
exchange their local currencies follows as part of their normally business must
mange their transaction exposure, which affects their expected foreign currency
cash flows.

An MNCs value is also affected by the way it mange’s other forms of economic
exposure that are unexpected to transaction exposure.

Short term financing in international

Source of Short term financing – MNC parent and their subsidiary
typically use various method of obtain short term funds to satisfy their
liquidity needs.
Euro notes – these are unsecured on their notes are based on LIBOR
(the interest rate Euro banks change on interbank loan). Euro notes
typically have maturities of 1, 3 or 6 month commercial bank
underwrite the notes mores.
Euro commercial paper – MNC’s also issue euro commercial paper
to obtain short term financing .
Dealers issue this paper for MNC’s without the banking of an
under writing syndicate so a selling price is not guarantee to the issues
matereties can be tailored to the issuer performance.
Dealers makes a secondary market by offering to repurchase euro
commercial paper before maturity.

Euro bank loan – direct loan from euro banks which are typically
utilized to maintain a relationship with euro bank & are another
popular source of short term funds for MNC’s. if other source of short
term funds become unavailable MNC’s rely more heavily on direct
loan from euro banks. Most MNC’s maintain credit arrangement with
various banks around the world. Some MNC’s have credit
arrangement with more than 100 foreign and domestic banks.
Internal financing by MNC’s – An MNC’s parent or subsidiary in
need of funds search for outside funding it should cheek other
subsidiary cash flow position to determine whether any internal funds
are available.

Foreign financing to offset foreign currency inflows – a large firm

may finance in foreign currency to offset a net receivables position in
that foreign currency.

Foreign financing to reduce cost – even when an MNC parent or

subsidiary is not attempting to cover foreign net receivable it may still
consider borrowing foreign currency if the interest rates on those
currencies are attractive financing in foreign currency has become
common as a recent of the development of the euro currency market.
The cost of financing can vary with the currency borrowed in the euro
currency market. A euro currency loan may offer a slight lower rate
than a loan in the same currency through the home currency.

Determining the effective financing rate – the value of the currency

borrowed will most likely changed with respect to the borrower’s
local currency over time. The actual cost of financing by the debtor
firm will depend on
(i) The interest rate changed by the bank that provided the
loan and
(ii) The movement in the borrowed currency’s value over the
life of the loan, thus actual or effective financing rate may
differ form the quoted interest rate.

Criteria considered for foreign financing

(i) Interest rate parity
(ii) The forward rate as a forecast
(iii) Exchange rate forecast

Interest rate parity–covered interest arbitrage was described as a

foreign short term investment with a simultaneous forward sale of the
Foreign currency denominating the foreign investment.
from a financing prospective covered interest arbitrage can be
conducted as follows. First borrow a foreign currency and conceit that
a currency to the home currency of ruse
 also, similarly purchase the foreign currency forward to lack in the
exchange rate of the currency needed to pay off the loan if the foreign
currency interest rate is low this may appear to be a feasible strategy.
However such a currency.
normally will exhibit a forward premium that that offset differential
between is interest tare and home interest rate.
this can be shown by recognizing that the financing firm no
longer will be affected by the percentage change in exchange rate but
instead by percentage differential between the spot rate at which the
foreign currency was converted to the local currency and the forward
rate at which the foreign currency was repurchased the difference
reflects the forward premium (animalized)
The forward rate as a forecast exchange rate forecast
recent movement as a forecasting future movements
Actual Regents from foreign financing
The fact that some firm utilized foreign financing suggest that they
believe reduce financing cost can be achieved.
Financing with a portfolio of currencies portfolio diversion effects
Repeated financing with a currency portfolio
The more volatile a portfolio’s effective financing rate overtime the
more uncertainty (risk)
There is about the effective financing rate that will exist is any period
Impact of short tern financing on the MNC’s value
Will enhance the value of MNC
 International cash management cash flow analysis subsidiary
perspective Subsidiary expenses Subsidiary revenue Subsidiary
dividend payment Subsidiary liquidity management Subsidiary
commonly have access to numerous line of credit and overdraft
facility in various countries, therefore they may maintain adequate
liquidity without substantial cash balances.
Centralized cash management
A centralized cash management group may be need to monitor and
possibly manage, the parent subsidiary and inter subsidiary cash
flows.
Technique to optimize cash flows
(i) Accelerating cash inflows
(ii) Minimizing currency conversion cost
(iii) Managing inter subsidiary cash transfers
inn the case of acerbating cash flow is to the accelerate cash inflow,
since the more quickly the inflows are received or used for other
purpose.
the technique for optimizing cash flow movements netting can be
implemented with the joint effort subsidiary or by the Centralized
cashmanagement group the technique optimize can flow by reducing
the administrative and transfer cost that result from currency
conversion.

Cash flow can be affected by a host govt. blockage of funds which

might occur if the government require all funds to remain with the
country in order to create jobs and reduce unemployment. MNC may
instruct subsidiary to set up a research and development division.
 Which incurs cost and possibly generates revenue for other
subsidiaries.
another strategy is to use transfer pricing a manner that will increase
the experts incurred by the Govt. is likely to be more lenient can
funds set to cover expenses than on earning remitted to the parent.
proper management of cash flow can also be financial to a subsidiary
in need of funds.
complication in optimizing cash flow
(i) Company related characteristics
(ii) Government restriction
(iii) Characteristic of banking system
if one of the subsidiary delays payment to other subsidiary for
supplies received the other subsidiary may be forced to borrow until
the payment arrive.

The existence of Government restriction can disrupt a cash flow optimization

policy. The abilities of banks to facilitate cash transfer for MNC vary among
country bank in the united state are advance the field but banks in some other
countries do not offer service.

Investing excess cash any remaining funds can be invested in domestic or

foreign short term security in some periods, short term security will have higher
interest rate than domestic interest rate.

How to invest excess cash international money markets have grown to

accommodate corporate investment of excess cash. MNC’s may use
international money market in an attempt to achieve higher returns that what
they can achieve domestically.

Centralized cash management the function of optimizing cash flow can be

improved by a centralized approcech since all subsidiary cash position can be
monitored simultaneously.
Centralization when subsidiaries use the same currency the centralized
approach can also facilitate the transfer of funds from subsidiaries with excess
funds to those that need funds.

Determining the effective yield

It is the deposits effective yield not is interest rate, that is mist important to the
cash manager the effective yield of a bank deposit couriers both the interest rate
and the rate of appreciation (or deprecation) of the currency denominating the
deposit and cash therefore be very different from the quoted interest rate on a
deposit denominated in a foreign currency.

Implication of interest rate parity

Covered interest arbitrage is described on a foreign short term investment with a

simultaneous forward sale of the foreign currency denominating the foreign
investment.

uncovered basis (without use of the forward market)

investor cannot lock in a higher return when attempting covered interest

arbitrage if interest rate parity exists.

Use of forward rate a forecast if interest rate parity exists the forward rate can
still be a indicator for the US firm investment decision.

Relation ship with the interest rate and Fisher effect

IFE suggests that the exchange rate of a foreign currency is expected to change
by an amount reflecting the differential between its interest rate and the US
interest rate.

Use of exchange rate forecast

Although MNC’s do not know how a currency’s value will change over the
investment horizon they use use formulator effective yield and plug in their.
Forecast for the percentage change in the foreign currency's exchange rate since
the interest rate if the foreign currency deposit is known the effective yield on a
foreign deposit can their be compared with the yield when investing in the
firm’s local currency.

Use of probability distribution

It is something useful to developing a probability distribution instead of
relaying on a single prediction since even expert forecasts are not always
accurate.

Diversifying cash across currencies

An MNC may prefer to diversify cash among securities denominated in

different currencies because it is not sure how exchange rates will

Change over time. Limiting the percentage of excess cash inversed in each
currency will reduce the MNC’s exposure to exchange rate risk.

the degree to which a portfolio of investment denominated in various currencies

will reduce risk depends on the currency correlation.

Impact of international cash management on MNC’s value

An MNC’s international cash management can affect its value. If an MNC’s

foreign subsidiary can invest its cash the currencies that offer a higher return
that is available from investing in local securities it can increases the level of its
foreign currency cash flows.

Capital budgeting for international project

Multinational capital budgeting – MNC’s evaluate international project by using

Multinational capital budgeting which compare the benefit and cost of these
projects.

the most popular method of capital budging involves determine the present
value of project future cash flow and subtracting the initial outlay required for
the project. Multinational capital budgeting typically uses a similar process.

Subsidiary versus parent perspective

capital budgeting may generate different result and a different conclusion

depending on whether it is conducted from the perspective of an MNC’s
subsidiary or from the perspective of MNC;s parent. The subsidiary perspective
does not consider possible exchange rate and tan effect on cash flow transferred
by the subsidiary to the parent. When a parent is deciding whether to implement
an international project it should be determine whether the project is feasible
from its own perspective.

Tan differential
If the earning due to the project will someday be remitted to the parent, the
MNC needs to be consider how the parent’s Govt. taxes these earning if the
parent’s Govt. impose a high tax rate on the remitted funds the project may be
feasible from the subsidiary point of view. Under such a scenario the parent
should not consider implementing the project even through it appears feasible
from the subsidiary perspective.

Restricted Remittances

Consider a potential project to be implemented in a country where Govt.

restriction require that a percentage of the subsidiary earning remain in the
country. Since the parent may be never have access to these funds, the project is
not attractive to the parent. Yet the project may be attractive to the subsidiary,
one possible solution is to let the subsidiary obtain partial financing for the
project within the host country. In this case the portion of funds not allowed to
be sent to the parent can be uses to lover the financing cost over time.

Exassive remittance

A parent changes it subsidiary very high administrative fees because

management is centralized at the headquarters. To the subsidiary the fees
respect an expense to the parent the fees respect revenue that may subsidiary
exceed the actual cost of managing the subsidiary neglecting the parent
perspective will distort the true value of a foreign project.

Exchange rate movement

The amount received by the parent is therefore influenced by the existing

exchange rate if the subsidiary project is assessed from the subsidiary

Perspective the cash flows forecasted for the subsidiary do not have it be
converted to the parent currency.

Impact for multinational capital budgeting

Regard lean(inclined) of the long term project to be considered an MNC will

normally require forecast of the economic and financial characteristic related to
the project.

The characteristic are:

 (i) Initial investment the parent initial investment in a project may constitute
the major source of funds to support a particular project. Working capital
to support the project overtime is also included.

(ii) Consumer demand

(iii) Price future inflation on rates must be forecasted

(iv) Variable cost hourly labor cost to cost of materials.

(v) Fixed cost sensitive to any change in host country’s inflation rate.

(vi) Project life time some project have indefinite lifetime. Political events
may force the firm to liquidate the project earliest that planned.

(vii) Salvage (liquidation) value host government could take over the project
without adequately compersateeing the MNC

(ix) Tax's laws after tax cash flow are necessary for an adequate capital
budgeting analysis, international tax effects must be determined on any
proposed foreign projects.

(x) Exchange rates most budgeting technique are used to cover short term
position it is possible to hedge over longer periods (with long term forward
contract or currency swap).

(xi) Required rate of return cash flow can be discounted at project required rate
of return.

Factors to consider in multinational capital budgeting

(i) Exchange rate fluctuation

(ii) Inflation

(iii) Financing arrangement

(iv) Blocked funds

(v) Uncertain salvage value

(vi) Impact of project on preventing cash flow

(vii) Host Govt. incentives

 (viii) Exchange rate will typically change overtime. The difficultly in
accurately forecasting exchange rate is well known.

(ix) inflation - capital budgeting analysis implicitly consider inflation, since

variable cost permute and product prices generally have been rising over
time. In some countries inflation can be quite volatile from year to year
and can therefore strongly influence a project net cash flows.

(x) Financing arrangement

(xi) Many foreign projects are partially financed by foreign subsidiary. If the
parent provides the endive investment no foreign financing is required
can sequent the subsidiary makes no interest payment and therefore
remits larger cash flow to the parent. Given the larger payment to the
parent, the cash flow ultimately received by the parent are more
susceptible to exchange rate movements. Some foreign projects are
completely financed with retained earning of existing foreign subsidiary.

(xii) A subsidiary’s investment in a project as an the opportunity cost is

viewed since the funds could be remitted to the parent rather that invested
in the foreign project.

(xiii) Blocked funds

(xiv) The host country may block fund that the subsidiary attempts to send to
the parent, some countries require that earning shuerated by the
subsidiary be reinvested locally for at least there year before they can be
remitted such restriction can affect the accept/reject decision on a project.

(xv) Uncertain salvage value

(xvi) The salvage value of an MNC’s project topically has a significant impact
on the project’s NPV.

(xvii) if the actual salvage value is expected to equal or exceed the break
even salvage value (called SVn) can be determine by setting NPV equal
to zero.

(xviii) Impact of project on prevailing cash flows

(xix) In reality in the new project there may be often be an impact. Some
foreign projects may have favorable impact on prevailing cash flows.
 (xx) If a manufacture of competer components establishes foreign subsidiary

(xxi) To manufacture competer the subsidiary might order the component from
the parent. In the case the sale volume of the parent would increase

(xxii)

(xxiii)

Host Govt. incentives

A low rate host Govt. loan a reduced tax rate offered to the subsidiary will
enhance periodic cash flows. If the Govt. subsidiary the initial establishment of
the subsidiary the MNC’s initial investment will be reduced.

Adjusting project assessment for risk

3 methods used to adjust evaluate for risk:

(i) Risk adjusted discount rate

(ii) Sensitively analysis

(iii) Simulations

Risk adjusted discount rate– the greater the uncertainly about a project
forecasted cash flows the larger should be the discount rate applied to cash
flows. This risk adjusted discount rate tends to reduce the worth of a project by
a degree that reflects the risk the project exhibits.

The risk adjusted discount rate is a commonly used technique perhaps because
of the case with which it can be arbitrarily adjusted.

Sensitively analysis - Sensitively analysis can be more useful than simple point
estimates because it meassesses the project learned on various instances that
may occur.

Simulations - Simulations can be used for a varity of tasks including the

generation of a probability distribution for NPV based on a range of possible
values for one or more input variables.

Simulations generates a distribution of NPV’s for the project the major

advantage of Simulation techniqye does not put all of its empasis on any
aneparticuler NPV forecast but instead provides a distribution of the possible
outcomes that may occur.

Impavt of multinational capital budgeting on an MNC’s value

multinational capital budgeting decision affects the value the MNC. Because
multinational capital budgeting decision determine the types of operation of the
MNC’s they also affect the level of the MNC’s risk when the MNC’s parent
financially supports the foreign projects it cost of capital is affected, which
influence its requoirsd rate of return on its business and its vaulue.