Ifm

1
Part I
The International Financial Environment
Multinational Corporation (MNC)
Foreign Exchange Markets
Product Markets Subsidiaries International
Financial
Markets
Dividend
Remittance
& Financing
Exporting
& Importing
Investing
& Financing
CHAPTER 1
Multinational Financial Management:
An Overview
3
Chapter Objectives
To identify the main goal of the MNC and conflicts with that goal;
To describe the key theories that justify international business; and
To explain the common methods used to conduct international business.
Goal of the MNC
The commonly accepted goal of an MNC is to maximize shareholder wealth.
For corporations with shareholders who differ from their managers, a conflict of
goals can exist - the agency problem.
Agency costs are normally larger for MNCs than for purely domestic firms, but
can vary with the management style of the MNC.
Goal of the MNC
Various forms of corporate control can reduce agency problems - stock
compensation, threat of hostile takeover, monitoring by large shareholders.
As MNC managers attempt to maximize their firms value, they may be
confronted with various environmental, regulatory, or ethical constraints.
Theories of International Business
Why are firms motivated to expand their business internationally?
Theory of Comparative Advantage
- Specialization by countries can increase production efficiency.
Imperfect Markets Theory
- The markets for the various resources used in production are imperfect.
Product Cycle Theory
Firm creates
product to
accommodate
local demand.
1
Firm exports
product to
accommodate
foreign demand.
2
Firm
establishes
foreign
subsidiary
to establish
presence in
foreign
country and
possibly to
reduce
costs.
3
Firm differentiates
product from
competitors and/or
expands product
line in foreign
country.
4a
Firms foreign
business declines
as its competitive
advantages are
eliminated.
4b
or
5
International Business Methods
International Trade - a relatively conservative approach involving exporting
and/or importing.
Licensing - provision of technology in exchange for fees or some other
benefits.
Franchising - provision of a specialized sales or service strategy, support
assistance, and possibly an initial investment in the franchise in exchange
for periodic fees.
Joint Ventures - joint ownership and operation by two or more firms.
Acquisitions of Existing Operations
Establishing New Foreign Subsidiaries
Any method of increasing international business that requires a direct
investment in foreign operations normally is referred to as a direct foreign
investment (DFI).
International Opportunities
Cost-benefit Evaluation for
Purely Domestic Firms versus MNCs
Marginal
Return on
Projects
Marginal
Cost of
Capital
Purely
Domestic
Firm
Purely
Domestic
Firm
MNC
MNC
Appropriate
Size for Purely
Domestic Firm
Appropriate
Size for MNC
X Y
Asset Level of Firm
7
Opportunities in Europe
- Single European Act of 1987
- Removal of the Berlin Wall in 1989
- Single currency system in 1999
Opportunities in Latin America
- North American Free Trade Agreement (NAFTA) of 1993
- General Agreement on Tariffs and Trade (GATT) accord
Opportunities in Asia
- Significant growth expected for China
- Asian economic crisis in 1997-1998
Exposure to International Risk
Exposure to Exchange Rate Movements
- exchange rate fluctuations affect cash flows and foreign demand
Exposure to Foreign Economies
- economic conditions affect demand
Exposure to Political Risk
- political actions affect cash flows
8
Overview of an MNCs Cash Flows
Profile A: MNCs focused on International Trade
U.S. Businesses
Foreign Importers
U.S. Customers
Foreign Exporters
U.S.-
based
MNC
$ for products
$ for supplies
$ for exports
$ for imports
9
Profile B: MNCs focused on International Trade and
International Arrangements
U.S. Businesses
Foreign Importers
U.S. Customers
Foreign Exporters
Foreign Firms
U.S.-
based
MNC
$ for products
$ for supplies
$ for exports
$ for imports
$ for service
cost of service
10
Profile C: MNCs focused on International Trade,
International Arrangements, and Direct Foreign Investment
U.S. Businesses
Foreign Importers
U.S. Customers
Foreign Exporters
Foreign Firms
Foreign Subsidiaries
U.S.-
based
MNC
$ for products
$ for supplies
$ for exports
$ for imports
$ for service
cost of service
funds remitted
funds invested
11
Valuation Model for an MNC
Domestic Model (Present value of expected cash flows)
( )
( )
Value =
E CF
$,
=
t
t
t
n
k 1
1
+
where E (CF
$,t
) = expected cash flows to be
received at the end of period t
n = the number of periods into the future in
which cash flows are received
k = the required rate of return by investors
Valuing International Cash Flows
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
where E (CF
j,t
) = expected cash flows denominated
in currency j to be received by the
U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which
currency j can be converted to
dollars at the end of period t
k = the weighted average cost of capital of
the U.S. parent company
13
Impact of New International Opportunities
on an MNCs Value
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
More Exposure to Exchange Rate Risk
New International Opportunities
More Exposure to Political Risk
More Exposure to Foreign Economies
How Chapters Relate to Valuation
Background
on
International
Financial
Markets
(Chapters
2-5)
Exchange Rate
Behavior
(Chapters 6-8)
Long-Term
Investment and
Financing
Decisions
(Chapters 13-18)
Short-Term
Investment and
Financing
Decisions
(Chapters 19-21)
Exchange Rate
Risk Management
(Chapters 9-12)
Risk and
Return of
MNC
Value and
Stock Price
of MNC
15
Chapter Review
Goal of the MNC
- Conflicts against the MNC Goal
- Impact of MNCs Management Style on Agency Costs
- Impact of Corporate Control on Agency Costs
- Constraints Interfering with the MNCs Goal
- Theory of Comparative Advantage
- Imperfect Markets Theory
- Product Cycle Theory
- International Trade Licensing
- Franchising Joint Ventures
- Acquisitions of Existing Operations
- Establishing New Foreign Subsidiaries
- Opportunities in Europe
- Opportunities in Latin America
- Opportunities in Asia
Exposure to International Risk
- Exposure to Exchange Rate Movements
- Exposure to Foreign Economies
- Exposure to Political Risk
- Domestic Model
- Valuing International Cash Flows
- How Chapters Relate to Valuation
CHAPTER 2
International Flow of Funds
2000 South-Western College Publishing
17
Chapter Objectives
To explain the key components of the balance of payments; and
To explain how the international flow of funds is influenced by economic
factors and other factors.
Balance of Payments
The balance of payments is a measurement of all transactions between
domestic and foreign residents over a specified period of time.
The recording of transactions is done by double-entry bookkeeping.
The balance-of-payments statement can be broken down into various
components, the chief ones being the current account and the capital account.
Balance of Payments
The current account represents a summary of the flow of funds between one
specified country and all other countries due to the purchases of goods or
services, or the provision of income on financial assets, over a specified period
of time.
The current account is commonly used to assess the balance of trade, which is
the difference between merchandise exports and merchandise imports.
Balance of Payments
The capital account represents a summary of the flow of funds resulting from
the sale of assets between one specified country and all other countries over a
specified period of time.
Assets include direct foreign investments, portfolio investments, as well as
other capital investments.
International Trade Flows
Distribution of Annual Exports and Imports by the U.S.
Exports
Europe
23%
$153b
Canada
22% $152b
Latin
America
20%
$133b
Japan
10% $66b
Asia
21%
$145b
Eastern Europe
1% $8b
Others
3% $22b
Imports
Europe
20%
$175b
Canada
19% $171b
Latin
America
16%
$142b
Japan
14%
$122b
Asia
27%
$235b
Eastern Europe
1% $8b
Others
3% $25b
19
Since the 1970s, international trade has grown for most countries. The
recent value of U.S. exports and imports is more than eight times the 1975
value.
Since 1976, the value of U.S. imports has exceeded the value of U.S.
exports, causing a balance of trade deficit.
Recent Changes in North American Trade
- A free trade pact between U.S. and Canada was initiated in 1989 and completely phased in
by 1998.
- In 1993, the North American Free Trade Agreement (NAFTA), which removed numerous
trade restrictions among Canada, Mexico, and the U.S., was passed.
Recent Changes in European Trade
- Single European Act of 1987
- Momentum for free enterprise in Eastern Europe
- Single currency system in 1999
Trade Agreements Around the World
- In 1993, a General Agreement on Tariffs and Trade (GATT) accord calling for lower tariffs
was made among 117 countries.
Friction Surrounding Trade Agreements
- Dumping refers to the exporting of products by one country to other
countries at prices below cost.
- Another situation that can break a trade agreement is copyright piracy.
20
Factors Affecting International Trade Flows
Inflation
- A relative increase in a countrys inflation rate will decrease its current account.
National Income
- A relative increase in a countrys income level will decrease its current account.
Government Restrictions
- An increase in the tariffs on imported goods will increase the countrys current account.
- A government can also reduce its countrys imports by enforcing a quota.
Exchange Rates
- If a countrys currency begins to rise in value, its current account balance will decrease.
Note that the factors are interactive, such that their simultaneous influence is
complex.
Correcting a Balance of Trade Deficit
By reconsidering the factors that affect the balance of trade, some common
correction methods can be developed.
However, a weak home currency may not necessarily improve a trade deficit
due to:
- revised pricing policy by foreign competition,
- weakening of some other currencies,
- trade prearrangements (J curve effect), and
- intracompany trade.
J Curve Effect
U
.
S
.

T
r
a
d
e

B
a
l
a
n
c
e

0
Time
J Curve
21
International Capital Flows
Capital flows usually represent direct foreign investment or portfolio
investment.
The DFI positions in the U.S. and outside the U.S. have risen substantially
over time, indicating increasing globalization.
DFI by U.S. firms are mainly targeted at the United Kingdom and Canada,
while much of the DFI in the U.S. comes from the United Kingdom, Japan,
the Netherlands, Germany, and Canada.
Factors Affecting DFI
Changes in Restrictions
- New opportunities may arise from the removal of government barriers.
Privatization
- DFI has also been stimulated by the movement toward free enterprise.
Potential Economic Growth
- Countries that have more potential economic growth are more likely to attract DFI.
Factors Affecting DFI
Tax Rates
- Countries that impose relatively low tax rates on corporate earnings are more likely to attract
DFI.
Exchange Rates
- Firms will typically prefer DFI in countries where the local currency strengthens against their
own.
22
Factors Affecting International Portfolio Investment
Tax Rates on Interest or Dividends
- Investors assess their potential after-tax earnings from investments in foreign securities.
Interest Rates
- Money tends to flow to countries with high interest rates.
Exchange Rates
- If a countrys home currency is expected to strengthen, foreign investors may be attracted.
Agencies that Facilitate International Flows
International Monetary Fund (IMF)
- IMF goals encourage increased internationalization of business.
- Its compensatory financing facility attempts to reduce the impact of export instability on
country economies.
- Financing by the IMF is measured in special drawing rights.
World Bank
- The primary objective of the profit-oriented bank is to make loans to countries in order to
enhance economic development.
- The World Bank may spread its funds by entering into cofinancing agreements.
- A recently established agency offers various forms of political risk insurance.
World Trade Organization
- This was established to provide a forum for multilateral trade negotiations and to settle trade disputes related
to the GATT accord.
- International Financial Corporation (IFC)
- The IFC promotes private enterprise within countries through loans and stock purchases.
International Development Association (IDA)
- The World Bank for less prosperous nations.
Impact of International Trade on an MNCs Value
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Trade Agreements
Inflation in Foreign Countries Exchange Rate Movements
National Income in Foreign Countries
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = the weighted average cost of capital of the U.S. parent
Bank for International Settlements (BIS)
- The BIS facilitates international transactions among countries. It is the central banks central
bank and the lender of last resort.
- Regional Development Agencies
- These agencies, such as the Inter-American Development Bank and the Asian Development
Bank, have regional objectives relating to economic development.
24
Chapter Review
Balance of Payments
- Current Account Capital Account
- Distribution of U.S. Exports and Imports
- U.S. Balance of Trade Trend
- Recent Changes
- Trade Agreements Around the World
- Friction Surrounding Trade Agreements
Chapter Review
- Inflation Government Restrictions
- National Income Exchange Rates
Correcting a Balance of Trade Deficit
- Why a Weak Home Currency is Not a Perfect Solution
International Capital Flows
- Distribution of DFI by U.S. Firms and in the U.S.
- Factors Affecting DFI
- Factors Affecting International Portfolio Investment
Chapter Review
- International Monetary Fund
- World Bank
- World Trade Organization
- International Financial Corporation
- International Development Association
- Bank for International Settlements
- Regional Development Agencies
How International Trade Affects an MNCs Value
CHAPTER 3
International Financial Markets
26
Chapter Objectives
To describe the background and corporate use of the following international
financial markets:
- foreign exchange market,
- Eurocurrency market,
- Eurocredit market,
- Eurobond market, and
- international stock markets.
Motives for Using International Financial Markets
Several barriers deter the complete integration of the markets for real or financial
assets.
Examples include tax differentials, tariffs, quotas, labor immobility, cultural
differences, financial reporting differences, and costs of communication.
Yet, these barriers can also create unique opportunities for specific geographic
markets that will attract foreign creditors and investors.
Motives for Using International Financial Markets
Motives for investing in foreign markets:
- economic conditions
- exchange rate expectations
- international diversification
Motives for providing credit in foreign markets:
- high foreign interest rates
- international diversification
Motives for borrowing in foreign markets:
- low interest rates
27
Foreign Exchange Market
The foreign exchange market allows currencies to be exchanged to facilitate
international trade or financial transactions.
The system for establishing exchange rates has changed over time:
- 1876-1913: gold standard
- WWI & Great Depression: period of instability
- 1944: Bretton Woods Agreement
- 1971: Smithsonian Agreement
- 1973: some official boundaries were eliminated
There is no specific building or location where traders exchange currencies.
Trading also occurs around the clock.
The market for immediate exchange is known as the spot market.
Trading between banks makes up what is often referred to as the interbank
market.
The forward market for currencies enables an MNC to lock in the exchange
rate (called a forward rate) at which it will buy or sell a currency.
Attributes of banks important to customers in need of foreign exchange:
- competitiveness of quote
- special relationship with the bank
- speed of execution
- advice about current market conditions
- forecasting advice
Banks provide foreign exchange transactions for a fee: the bid (buy) quote
for a foreign currency will be less than its ask (sell) quote.
28
The bid/ask spread is normally greater for those currencies that are
less frequently traded.
Exchange rate quotations for widely traded currencies are listed in
many newspapers on a daily basis. Forward rates and cross exchange
rates may be quoted too.
=
ask rate - bid rate
ask rate
bid/ask spread
cross exchange rate :
Quotations that represent the value of a foreign currency in
dollars are referred to as direct quotations, while those that
represent the number of units of a foreign currency per dollar
are referred to as indirect quotations.
value of currency A in $
value of currency B in $
value of 1 unit of
currency A in units =
of currency B
29
Some MNCs involved in international trade use the currency futures and
options markets to hedge their positions.
Futures are similar to forward contracts, except that they are sold on an
exchange while forward contracts are offered by banks.
Currency options are classified as either calls or puts. They can be
purchased on an exchange too.
Eurocurrency Market
U.S. dollar deposits placed in banks in Europe and other continents are
called Eurodollars and are not subject to U.S. regulations.
In the 1960s and 70s, the Eurodollar market, or what is now called the
Eurocurrency market, grew to accommodate increasing international
business.
The market is made up of several large banks called Eurobanks that accept
deposits and provide loans in various currencies.
Eurocurrency Market
Although the market focuses on large-volume transactions, at times no
single bank is willing to lend the needed amount. A syndicate of Eurobanks
may then be composed.
Two regulatory events allow for a more competitive global playing field:
- The Single European Act opens up the European banking industry and calls for similar
regulations.
- The Basel Accord includes standardized guidelines on the classification of capital.
30
Eurocurrency Market
The Eurocurrency market in Asia is sometimes referred to separately as the
Asian dollar market.
The primary function of banks in the Asian dollar market is to channel funds
from depositors to borrowers. Another function is interbank lending and
borrowing.
Eurocredit Market
Loans of one year or longer extended by Eurobanks to MNCs or government
agencies are called Eurocredit loans. These loans are provided in the
Eurocredit market.
Eurocredit loans often have a floating rate, to lessen the risk resulting from a
mismatch in the banks asset and liability maturities.
Syndicated Eurocredit loans are popular among big borrowers too.
Eurobond Market
There are two types of international bonds:
- A foreign bond is issued by a borrower foreign to the country where the bond is placed.
- Eurobonds are sold in countries other than the country represented by the currency
denominating them.
Eurobonds are underwritten by a multi-national syndicate of investment
banks and simultaneously placed in many countries. They are usually issued
in bearer form.
31
Eurobond Market
Eurobonds increased rapidly in volume when in 1984, the withholding tax
was abolished in the U.S. and corporations were allowed to issue bonds
directly to non-U.S. investors.
Interest rates for each currency and credit conditions change constantly,
causing the markets popularity to vary among currencies.
In recent years, governments and corporations from emerging markets have
frequently utilized the Eurobond market.
Why Interest Rates Vary Among Currencies
Interest rates, which can vary substantially for different currencies, are
crucial because they affect the MNCs cost of financing.
The interest rate for a specific currency is determined by the demand for and
supply of funds in that currency.
As the demand and supply schedules change over time for a specific
currency, the equilibrium interest rate for that currency will also change.
32
Why U.S. Dollar Interest Rates Differ from Brazilian Real
Interest Rates (for loanable funds)
The curves are further to the right for the dollar because the
U.S. economy is larger.
The curves are higher for the Brazilian Real because of the
higher inflation in Brazil.
Quantity of $
Interest
Rate
for $
S
D
Quantity of Real
Interest
Rate
for Real
S
D
33
Global Integration of Interest Rates
Many investors shift their savings around currencies to take advantage of
higher interest rates.
Borrowers sometimes also borrow a currency different from what they need
to take advantage of a lower interest rate.
Ultimately, the freedom to transfer funds across countries causes the
demand and supply conditions for funds to be integrated, which in turn
causes interest rates to be integrated.
International Stock Markets
MNCs can obtain funds by issuing stock in international markets, in addition
to the local market.
By having access to various markets, the stocks may be more easily
digested, the image of the MNC may be enhanced, and the shareholder
base may be diversified.
The proportion of individual versus institutional ownership of shares varies
across stock markets. The regulations are different too.
The locations of the MNCs operations may affect the decision about where to place
stock, in view of the cash flows needed to cover dividend payments in the future.
Stock issued in the U.S. by non-U.S. firms or governments are called Yankee stock
offerings.
Non-U.S. firms can also issue American depository receipts (ADRs), which are
certificates representing bundles of stock. The use of ADRs circumvents some
disclosure requirements.
34
Use of International Financial Markets
Foreign cash flow movements of a typical MNC:
Foreign trade. Exports generate foreign cash inflows, while imports require
cash outflows.
Direct foreign investment. Cash outflows to acquire foreign assets generate
future inflows.
Short-term investment or financing in foreign securities, usually in the
Eurocurrency market.
Longer-term financing in the Eurocredit, Eurobond, or international stock
markets.
Impact of Global Financial Markets on an MNCs Value
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Cost of borrowing funds in
global markets
Cost of parents equity in global
markets
Cost of parents
funds borrowed in
global markets
Improved global image from
issuing stock in global markets
E (CF
j,t
) = expected cash
flows in currency j to be
received by the U.S. parent
at the end of period t

E (ER
j,t
) = expected
exchange rate at which
currency j can be
converted to dollars at the
end of period t

k = the weighted average
cost of capital of the U.S.
parent
35
Chapter Review
Motives for Using the International Financial Markets
- Motives for Investing in Foreign Markets
- Motives for Providing Credit in Foreign Markets
- Motives for Borrowing in Foreign Markets
- Foreign Exchange Market
- Foreign Exchange Transactions
- Forward Markets
- Attributes of Banks that Provide Foreign Exchange
- Bid/Ask Spread of Banks
- Direct versus Indirect Quotations
- Cross Exchange Rates
- Currency Futures and Options Markets
Eurocurrency Market
- Development of the Eurocurrency Market
- Composition of the Eurocurrency Market
- Syndicated Eurocurrency Loans
- Standardizing Bank Regulations within the Eurocurrency Market
- Asian Dollar Market
Eurocredit Market
Eurobond Market
- Development of the Eurobond Market
Why Interest Rates Vary Among Currencies
Global Integration of Interest Rates
Use of International Financial Markets
How Financial Markets Affect an MNCs Value
CHAPTER 4
Exchange Rate Determination
37
Chapter Objectives
To explain how exchange rate movements are measured;
To explain how the equilibrium exchange rate is determined; and
To examine the factors that affect the equilibrium exchange rate.
Measuring Exchange Rate Movements
An exchange rate measures the value of one currency in units of another
currency.
A decline in a currencys value is referred to as depreciation, while an
increase is referred to as appreciation.
% A in foreign currency value = (S - S
t-1
) / S
t-1

A positive % A represents appreciation of the foreign currency, while a
negative % A represents depreciation.
38
Exchange Rate Equilibrium
An exchange rate represents the price of a currency, which is
determined by the demand for that currency relative to supply.
Value of
Quantity of
equilibrium
exchange
rate
S
D
Factors that Influence Exchange Rates
Relative Inflation Rates
A relative increase in U.S. inflation will increase the U.S. demand for
British goods, and hence the U.S. demand for British pounds.
In addition, the British desire for U.S. goods, and hence the supply of
pounds, will drop.
Value of
Quantity of
S
D
D
2
S
2
r
2
r
40
Relative Interest Rates
A relative rise in U.S. interest rates will decrease the U.S. demand for
British pounds.
In addition, the supply of pounds by British corporations will increase.
Value of
Quantity of
S
D
D
2
S
2
r
r
2
41
Real Interest Rates
A relatively high interest rate may reflect expectations of relatively high
inflation, which may discourage foreign investment.
Real interest rates adjusts nominal interest rates for inflation:
real nominal
interest = interest inflation
rate rate rate
This relationship is sometimes called the Fisher effect.
42
Value of
Quantity of
S
D
D
2
r
r
2
Relative Income Levels
A relative increase in the U.S. income level will increase the U.S. demand
for British goods, and hence the demand for British pound.
The supply of pounds does not change.
43
Government Controls
- Governments can influence the equilibrium exchange rate in many ways, including :
the imposition of foreign exchange barriers,
the imposition of foreign trade barriers,
intervening in the foreign exchange market, and
affecting macro variables such as inflation, interest rates, and income levels.
Expectations
- Foreign exchange markets react to any news that may have a future effect.
- Institutional investors often take currency positions based on anticipated interest rate
movements in various countries too.
- Because of speculative transactions, foreign exchange rates can be very volatile.
Trade-Related
Factors
1. Inflation
Differential
2. Income
Differential
3. Govt Trade
Restrictions
Financial
Factors
1. Interest Rate
Differential
2. Capital Flow
Restrictions
U.S. demand for foreign
goods, i.e. demand for
foreign currency

Foreign demand for U.S.
goods, i.e. supply of
foreign currency
U.S. demand for foreign
securities, i.e. demand
for foreign currency

Foreign demand for U.S.
securities, i.e. supply of
foreign currency
Exchange
rate
between
foreign
currency
and the
dollar
45
Interaction of Factors
Trade-related factors and financial factors sometimes interact. For
example, an increase in income levels sometimes causes expectations of
higher interest rates.
Over a particular period, different factors may place opposing pressures
on the value of a foreign currency. The sensitivity of the exchange rate to
these factors is dependent on the volume of international transactions
between the two countries.
46
How Factors Have Influenced Exchange Rates
Because the dollars value changes by different magnitudes relative to each foreign
currency, analysts measure the dollars strength with an index.
60
100
140
180
1972 1977 1982 1987 1992 1997
D
o
l
l
a
r
s

I
n
d
e
x

Year
high U.S.
inflation
high U.S. interest rates, a
somewhat depressed U.S.
economy, and low inflation
large balance of
trade deficit
high U.S.
interest rates
Persian Gulf War
47
Speculating on Anticipated Exchange Rates
Chicago Bank expects the exchange rate of the New
Zealand dollar to appreciate from its present level of
$0.50 to $0.52 in 30 days.
1. Borrows
$20 million
2. Holds
NZ$40 million
Exchange at
$0.50/NZ$
Lends at 6.48%
for 30 days
3. Receives
NZ$40,216,000
Exchange at
$0.52/NZ$
4. Holds
$20,912,320
Borrows at 7.20%
for 30 days
Returns $20,120,000
Profit of $792,320
48
Chicago Bank expects the exchange rate of the New
Zealand dollar to depreciate from its present level of
$0.50 to $0.48 in 30 days.
1. Borrows
NZ$40 million
2. Holds
$20 million
Exchange at
$0.50/NZ$
Lends at 6.72%
for 30 days
3. Receives
$20,112,000
Exchange at
$0.48/NZ$
4. Holds
NZ$41,900,000
Borrows at 6.96%
for 30 days
Returns NZ$40,232,000
Profit of NZ$1,668,000
or $800,640
49
Impact of Factors that Influence
Exchange Rates on an MNCs Value
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Inflation rates
Interest rates
Income levels
Government controls
Expectations
E (CF
j,t
E (ER
j,t
50
Chapter Review
Measuring Exchange Rate Movements
Exchange Rate Equilibrium
- Demand for a Currency
- Supply of a Currency for Sale
Chapter Review
- Relative Inflation Rates
- Relative Interest Rates
- Relative Income Levels
- Government Controls
- Expectations
- Interaction of Factors
- How Factors Have Influenced Exchange Rates
How Exchange Rate Determination Affects an MNCs Value
CHAPTER 5
Currency Derivatives
52
Chapter Objectives
To explain how forward contracts are used to hedge based on anticipated exchange
rate movements;
To explain how currency futures contracts are used to speculate or hedge based on
anticipated exchange rate movements; and
To explain how currency options contracts are used to speculate or hedge based on
anticipated exchange rate movements.
Forward Market
A forward contract is an agreement between a corporation and a commercial
bank to exchange a specified amount of a currency at a specified exchange
rate (called the forward rate) on a specified date in the future.
When MNCs anticipate future need or future receipt of a foreign currency,
they can set up forward contracts to lock in the exchange rate.
Forward contracts are not normally used by consumers or small firms.
Forward Market
If the forward rate exceeds the existing spot rate, it contains a premium. If it is less
than the existing spot rate, it contains a discount.
Suppose spot rate = $1.681, and
90-day forward rate = $1.677.
forward
=
$1.677 - $1.681
x
360
=

0.95%

discount $1.681 90
The premium (or discount) reflects the difference between the home interest rate and
the foreign interest rate, so as to prevent arbitrage.
53
Forward Market
Non-deliverable forward contracts (NDFs) are forward contracts whereby the
currencies are not actually exchanged. Instead, a net payment is made by
one party to the other based on the contracted rate and the market
exchange rate on the day of settlement.
While the NDF does not involve delivery, it can effectively hedge future
foreign currency cash flows that are anticipated by the MNC.
Currency Futures Market
Currency futures contracts are contracts specifying a standard volume of a
particular currency to be exchanged on a specific settlement date, typically
the third Wednesdays in March, June, September, and December.
The contracts can be traded by firms or individuals on the trading floor of an
exchange, on automated trading systems, or over the counter.
Currency futures differ from forward contracts in many ways:
- Size of contract Marketplace
- Delivery date Regulation
- Participants Liquidation
- Security deposit Transaction costs
- Clearing operation
Normally, the price of a currency future is similar to the forward rate for a
given currency and settlement date, but different from the spot rate.
54
Holders of futures contracts can close out their position by selling an
identical futures contract. Similarly, sellers of futures contracts can close out
their position by purchasing a currency futures contract with a similar
settlement date.
The gain or loss to the firm is dependent on the difference between the
purchase price and the sale price.
Most currency futures contracts are closed out before their settlement date.
The contracts are guaranteed by the exchange clearinghouse, and margin
requirements are imposed to cover fluctuations in value.
Corporations that have open positions in foreign currencies can use futures
contracts to offset such positions.
Speculators also use them to capitalize on their expectation of a currencys
future movement.
Brokers who fulfill orders to buy or sell futures contracts earn a transaction
fee in the form of a bid/ask spread.
Currency Options Market
A currency option is another contract that can be bought or sold by
speculators and firms.
The standard options that are traded on an exchange through brokers are
guaranteed.
In contrast, the options that are tailored to the specific needs of the firm are
offered by commercial banks and brokerage firms in an over-the-counter
market. There are no credit guarantees for these options.
Currency options are classified as either calls or puts.
55
Currency Call Options
A currency call option grants the right to buy a specific currency at a specific
price (called the exercise or strike price) within a specific period of time.
A call option is in the money when the present exchange rate exceeds the
strike price, at the money when the rates are equal, and out of the money
otherwise.
Option owners will at most lose the premiums they paid for their options.
Premiums of call options vary due to:
- the level of existing spot price relative to strike price,
- the length of time before the expiration date, and
- the potential variability of the currency.
Corporations can use currency call options to cover their foreign currency
positions.
Unlike a futures or forward contract, if the anticipated need does not arise,
the firm can choose to let the options contract expire. The firm can also sell
or exercise the option.
Individuals may also speculate in the currency options market based on their
expectations of the future movements in a particular currency.
When brokerage fees are ignored, the currency call buyers gain will be the
sellers loss if both parties begin and close out their positions at the same
time.
The purchaser of a call option will break even when the spot rate at which
the currency is sold is equal to the strike price plus the option premium.
56
Currency Put Options
A currency put option grants the right to sell a specific currency at a specific
price (the strike price) within a specific period of time.
A put option is in the money when the present exchange rate is less than the
strike price, at the money when the rates are equal, and out of the money
otherwise.
Since option owners are not obligated to exercise their options, they will at
most lose the premiums they paid.
Premiums of put options vary due to:
- the level of existing spot price relative to strike price,
- the length of time before the expiration date, and
- the potential variability of the currency.
Corporations can use currency put options to cover their foreign currency
positions.
Individuals may also speculate with currency put options based on their
expectations of the future movements in a particular currency.
For volatile currencies, one possible speculative strategy is to purchase a
straddle, which represents both a put option and a call option at the same
exercise price.
By purchasing both options, the speculator may gain if the currency moves
substantially in either direction, or if it moves in one direction followed by the
other.
57
Contingency Graphs for Call Options
$1.46 $1.50 $1.54
- $.02
- $.04
- $.06
+$.06
+$.04
+$.02
N
e
t

p
r
o
f
i
t

p
e
r

u
n
i
t

Future spot rate
For purchasers of
British pound call options
exercise price = $1.50
premium = $0.02
$1.46 $1.50 $1.54
- $.02
- $.04
- $.06
+$.06
+$.04
+$.02
N
e
t

p
r
o
f
i
t

p
e
r

u
n
i
t

Future spot rate
For sellers of
British pound call options
premium = $0.02
58
Contingency Graphs for Put Options
$1.46 $1.50 $1.54
- $.02
- $.04
- $.06
+$.06
+$.04
+$.02
N
e
t

p
r
o
f
i
t

p
e
r

u
n
i
t

Future spot rate
For purchasers of
British pound put options
premium = $0.03
$1.46 $1.50 $1.54
- $.02
- $.04
- $.06
+$.06
+$.04
+$.02
N
e
t

p
r
o
f
i
t

p
e
r

u
n
i
t

Future spot rate
For sellers of
British pound put options
premium = $0.03
59
Conditional Currency Options
Some options are structured with the premium conditioned on
the actual movement in the currencys value over the period of
concern.
For example, suppose a conditional put option on British pounds
has an exercise price of $1.70, and a so-called trigger of $1.74.
The premium will have to be paid only if the pounds value
exceeds the trigger value.
The payment of the premium is avoided conditionally at the cost
of a higher premium.
60
Option Type Exercise Price Trigger Premium
basic put $1.70 - $0.02
conditional put $1.70 $1.74 $0.04
$1.66
$1.68
$1.70
$1.72
$1.74
$1.76
$1.78
$1.80
$1.66 $1.70 $1.74 $1.78 $1.82
Spot Rate
E
f
f
e
c
t
i
v
e

E
x
c
h
a
n
g
e

R
a
t
e

Basic Put
Conditional Put
61
European Currency Options
European-style currency options are similar to American-style options except
that they can only be exercised on the expiration date.
For firms that purchase options to hedge future foreign currency cash flows,
this loss in terms of flexibility is probably not an issue. Hence, if their
premiums are lower, European-style currency options may be preferred.
Efficiency of
Currency Futures and Options
If foreign exchange markets are efficient, speculation in the currency futures
and/or currency options markets should not consistently generate
abnormally large profits.
A speculative strategy requires the speculator to incur risk. On the other
hand, corporations use the futures and options markets to reduce their
exposure to fluctuating exchange rates.
62
Impact of Currency Derivatives
on an MNCs Value
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Currency futures
Currency options
E (CF
j,t
E (ER
j,t
63
Chapter Review
Forward Market
- How MNCs Use Forward Contracts
- Premium or Discount on the Forward Rate
- Non-Deliverable Forward Contracts
- Comparison of Currency Futures and Forward Contracts
- Pricing Currency Futures
- Closing Out a Futures Position
- Credit Risk of Currency Futures Contracts
- Corporate Use of Currency Futures
- Speculation with Currency Futures
- Transaction Costs of Currency Futures
Currency Options Market
- Factors Affecting Call Option Premiums
- Hedging with Currency Call Options
- Speculating with Currency Call Options
- Break-Even Point from Speculation
- Factors Affecting Put Option Premiums
- Hedging with Currency Put Options
- Speculating with Currency Put Options
- Speculating with Combined Put and Call Options
Contingency Graphs for Options
European Currency Options
Efficiency of Currency Futures and Options
How the Use of Currency Futures and Options Affects an MNCs Value
Part II Exchange Rate Behavior
Existing spot
exchange rates
at other locations
Existing cross
exchange rates
of currencies
Existing inflation
rate differential
Future exchange
rate movements
Existing spot
exchange rate
Existing forward
exchange rate
Existing interest
rate differential
locational
arbitrage
triangular
arbitrage
purchasing power parity
international
Fisher effect
covered interest arbitrage
covered interest arbitrage
Fisher
effect
CHAPTER 6
Government Influence on Exchange Rates
66
Chapter Objectives
To describe the exchange rate systems used by various governments;
To explain how governments can use direct intervention to influence exchange rates;
To explain how governments can use indirect intervention to influence exchange
rates; and
To explain how government intervention in the foreign exchange market can affect
economic conditions.
Exchange Rate Systems
Exchange rate systems can be classified according to the degree to which
exchange rates are controlled by the government.
Exchange rate systems normally fall into one of the following categories:
- fixed
- freely floating
- managed float
- pegged
Fixed Exchange Rate Systems
In a fixed exchange rate system, exchange rates are either held constant or
allowed to fluctuate only within very narrow boundaries.
Examples: Bretton Woods era (1944-1971)
Smithsonian Agreement (1971)
Pros: Work becomes easier for the MNCs. Cons: The government may alter
the value of
a specific currency.
In fact, the dollar was devalued more than once after the United States
experienced balance of trade deficits.
67
Freely Floating
In a freely floating exchange rate system, exchange rates are determined by
market forces without intervention by governments.
Pros:
World stability is enhanced as problems
experienced by one country may not easily spread to other countries.
No intervention policies are needed and
governments are not restricted by exchange rate boundaries when setting new policies.
Less capital flow restrictions are needed, thus
enhancing the efficiency of the financial market.
Freely Floating
Cons:
The MNCs will need to devote substantial
resources to managing exposure to exchange rate fluctuations.
The country that initially experienced economic
problems (such as high inflation, increasing unemployment rate) may have its problems
compounded.
Managed Float
A managed float or dirty float exchange rate system resembles the freely
floating system in that rates are allowed to fluctuate freely on a daily basis.
Yet, it is like the fixed system in that governments may intervene to prevent
the rates from moving too much in one direction.
It has been pointed out that a government can manipulate exchange rates
such that its own country benefits at the expense of others.
Examples: Korea (1997), Russia (1997)
68
Pegged Exchange Rate Systems
In a pegged exchange rate system, the home currencys value is pegged to
a foreign currency or to some unit of account, and moves in line with that
currency or unit against other currencies.
Examples:
- Malaysia and Thailand before the Asian crisis
- The European Economic Communitys snake arrangement (1972-1979)
- The European Monetary Systems exchange rate mechanism (ERM) (1979-1999)
The ERM experienced severe problems in the fall of 1992, as economic
conditions and goals varied among European countries.
Speculators make it even more difficult for a currency board to defend its
position against pressures exerted by economic conditions.
Note that the local interest rates must be aligned with the interest rates of
the currency to which the local currency is tied.
How will a country (called PEG) whose currency is pegged to the U.S. dollar
be affected when the currency of another country (called FLOAT) fluctuates
against the dollar?
When FLOATs currency depreciates against the dollar (and hence against
PEGs currency), FLOAT exports more to and imports less from both the
U.S. and PEG. The volume of trade between the U.S. and PEG decreases
too.
The reverse happens when FLOATs currency appreciates against the dollar.
69
The Euro
On January 1, 1999, the euro was introduced. By 2002, the national currencies of the
participating countries will be withdrawn from the financial system and replaced with the
euro.
The Frankfurt-based European Central Bank is responsible for setting a common monetary
policy. It aims to control inflation and to stabilize the value of the euro.
As currency movements among the European countries will be eliminated, more long-term
business arrangements between firms of European countries will be encouraged.
The Euro
Non-European firms can also compare European products and European firms
more easily, as their values are denominated in the same currency.
Cross-border investing may increase due to the elimination of exchange rate risk.
However, non-European investors may not achieve as much diversification as in
the past.
Government Intervention
Each country has a government agency (called the central bank) that may intervene in the
foreign exchange markets to control the value of the countrys currency.
In the United States, the Federal Reserve System (Fed) is the central bank.
Central banks manage exchange rates
- to smooth exchange rate movements,
- to establish implicit exchange rate boundaries, and/or
- to respond to temporary disturbances.
Direct intervention refers to the exchange of currencies that the central bank
holds as reserves for other currencies in the foreign exchange market.
Example: To strengthen the dollar, the Fed will exchange foreign currencies for
dollars.
Direct intervention is usually most effective when there is a coordinated effort
among central banks.
70
Effects of Direct Central Bank Intervention
in the Foreign Exchange Market
V
a
l
u
e

o
f

Quantity of
V
2
V
1
S
D
2
D
1
V
a
l
u
e

o
f

Quantity of
V
1
V
2
S
2
D
S
1
71
When the change in money supply is not adjusted for, the intervention is said to
be nonsterilized. A sterilized intervention occurs when Treasury securities are
bought or sold simultaneously to maintain the money supply.
Some speculators attempt to determine when the central bank is intervening, and
the extent of the intervention, in order to capitalize on the anticipated results.
The central bank can also intervene indirectly by influencing the factors that
determine a currencys value, such as interest rates.
Note that high interest rates adversely affects local borrowers, and may weaken
the economy.
Some governments also use foreign exchange controls (such as restrictions on
the exchange of the currency) as a form of indirect intervention.
Exchange Rate Target Zones
Many economists have criticized the present system because of the wide swings in the
exchange rates of major currencies.
It has been suggested that target zones be used, whereby an initial exchange rate will be
established with specific boundaries.
The ideal target zone should allow rates to adjust to economic factors without causing wide
swings in international trade and fear in financial markets. However, the actual result may
be a system no different from what exists today.
Intervention as a Policy Tool
The exchange rate is a tool, like tax laws and money supply, with which the
government can use to achieve its desired economic objectives.
A weak home currency can stimulate foreign demand for products (and hence
local jobs), but may lead to higher inflation.
A strong currency is a possible cure for high inflation, but may cause higher
unemployment.
72
Impact of Government Actions on Exchange Rates
Government Intervention in
Government Monetary
and Fiscal Policies
Relative National
Income Levels
Relative National
Income Levels
Relative National
Income Levels
Relative National
Income Levels
Relative National
Income Levels
Relative National
Income Levels
Tax Laws,
etc.
Quotas,
Tariffs, etc.
Government
Purchases & Sales
of Currencies
73
Impact of Central Bank Intervention
on an MNCs Value
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Direct intervention
Indirect intervention
E (CF
j,t
E (ER
j,t
74
Chapter Review
- Fixed Exchange Rate System
- Freely Floating Exchange Rate System
- Managed Float Exchange Rate System
- Pegged Exchange Rate System
Europes Exchange Rate Mechanism
Currency Boards
Impact of Exchange Rates on Countries with Pegged Currencies
Chapter Review
A Single European Currency
- Impact on European Monetary Policy
- Impact on Business Within Europe
- Impact on the Valuation of Businesses in Europe
- Impact on Financial Flows
- Impact on Exchange Rate Risk
- Reasons for Government Intervention
- Direct Intervention
- Indirect Intervention
Chapter Review
Exchange Rate Target Zones
Intervention as a Policy Tool
- Influence of a Weak Home Currency on the Economy
- Influence of a Strong Home Currency on the Economy
How Central Bank Intervention Can Affect an MNCs Value
CHAPTER 7
International Arbitrage
and Interest Rate Parity
76
Chapter Objectives
To explain the conditions that will result in various forms of international
arbitrage, along with the realignments that will occur in response to the
various forms of international arbitrage; and
To explain the concept of interest rate parity, and how it prevents arbitrage
opportunities.
Arbitrage can be defined as capitalizing on a discrepancy in quoted prices. Often, the
funds invested are not tied up and no risk is involved.
Locational arbitrage is possible when the bid price of one bank is higher than the ask
price of another bank for the same currency.
e.g. Bank A Bank B
dollars -> pounds pounds -> dollars
$1.61 / $1.62 /
In response to the imbalance in demand and supply resulting from such arbitrage
activity, the prices will adjust very quickly.
Triangular arbitrage is possible when a quoted cross exchange rate differs
from that calculated using the appropriate spot rates.
e.g. Bank A Bank B Bank C
$
-
>
-
> Canadian$ Canadian$
-
> $
$1.60 / 0.50 / C$ $0.81 / C$
Note: Calculated cross rate = 0.50625 / C$
In response to the imbalance in demand and supply resulting from such
arbitrage activity, the prices will adjust very quickly.
77
Covered interest arbitrage tends to force a relationship between the interest
rates of two countries and their forward exchange rate.
e.g. Borrow $ at 3%, or use existing funds
which are earning interest at 2%.
Convert $ to at $1.60/ and engage in a
90-day forward contract to sell at $1.60/.
Lend at 4%.
In response to the imbalance in demand and supply resulting from such
arbitrage activity, the rates will adjust very quickly.
Locational arbitrage ensures that quoted exchange rates are similar across
banks in different locations.
Triangular arbitrage ensures that cross exchange rates are set properly.
Covered interest arbitrage ensures that forward exchange rates are set
properly.
Any discrepancy will trigger arbitrage, which will then eliminate the
discrepancy. Arbitrage thus makes the foreign exchange market more
orderly.
Interest Rate Parity
When market forces cause interest rates and exchange rates to be such that
covered interest arbitrage is no longer feasible, the equilibrium state
achieved is referred to as interest rate parity (IRP).
When IRP exists, the rate of return achieved from covered interest arbitrage
should equal the rate available in the home country. By simplifying
and rearranging terms:
forward
=
(1 + home interest rate) _
1

premium (1 + foreign interest rate)
78
If the 6-month Mexican peso interest rate = 6% ,
6-month U.S. dollar interest rate = 5% ,
then from the U.S. investors perspective,
forward
=
(1 + .05) _
1 =
_

.9434%

premium (1 + .06) (not annualized)
If the pesos spot rate is $.10/peso,
then the 6-month forward rate
= spot rate
x
(1 + premium)
= .10
x
(1
_
.009434) = $.09906/peso
The relationship between the forward rate and the interest rate differential
can be simplified and approximated as follows:
forward
=
forward rate - spot rate
premium spot rate

home _ foreign
interest rate interest rate
This approximated form provides a reasonable estimate when the interest
rate differential is small.
79
Graphic Analysis of Interest Rate Parity
Interest Rate Differential (%)
home interest rate - foreign interest rate
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1 3 - 1 - 3
IRP line
80
Graphic Analysis of Interest Rate Parity
Home Interest Rate - Foreign Interest Rate (%)
Forward
Premium (%)
Forward
Discount (%)
- 2
- 4
2
4
1 3 - 3
- 1
IRP line
Zone of potential
covered interest
arbitrage by
foreign investors
Zone of potential
covered interest
arbitrage by
local investors
Zone where
covered
interest
arbitrage is
not feasible
81
IRP generally holds. Where it does not hold, covered interest
arbitrage may still not be worthwhile due to transaction costs,
currency restrictions, differential tax laws, political risk, etc.
When IRP exists, it does not mean that both local and foreign
investors will earn the same returns.
What it means is that investors cannot use covered interest
arbitrage to achieve higher returns than those achievable in
their respective home countries.
82
Correlation Between Spot and Forward Rates
Because of
interest rate
parity, a forward
rate will normally
move in tandem
with the spot rate.
This correlation
depends on
interest rate
movements.
t
0
t
2
t
1
I
n
t
e
r
e
s
t

R
a
t
e
s

i
A
i
U.S.
time
t
0
t
2
t
1
S
p
o
t

a
n
d

F
o
r
w
a
r
d

R
a
t
e
s

Spot
A
Forward
A.
time
83
Impact of Arbitrage on an MNCs Value
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Forces of Arbitrage
E (CF
j,t
E (ER
j,t
84
Chapter Review
- Locational Arbitrage
- Triangular Arbitrage
- Covered Interest Arbitrage
- Comparison of Arbitrage Effects
Chapter Review
- Derivation of Interest Rate Parity
- Numerical Example
- Graphic Analysis of Interest Rate Parity
- Interpretation of Interest Rate Parity
- Considerations When Assessing Interest Rate Parity
Correlation Between Spot and Forward Rates
Impact of Arbitrage on an MNCs Value
CHAPTER 8
Relationships between Inflation,
Interest Rates, and Exchange Rates
86
Chapter Objectives
To explain the purchasing power parity (PPP) theory and its implications for
exchange rate changes;
To explain the international Fisher effect (IFE) theory and its implications for
exchange rate changes; and
To compare the PPP theory, IFE theory, and theory of interest rate parity
(IRP).
Purchasing Power Parity
When a countrys inflation rate rises relatively, decreased exports and
increased imports depress the countrys currency. The theory of purchasing
power parity (PPP) focuses on this inflation - exchange rate relationship.
The absolute form is the law of one price. It suggests that similar products
in different countries should be equally priced when measured in the same
currency.
The relative form of PPP accounts for market imperfections like
transportation costs, tariffs, and quotas.
When inflation occurs and PPP holds, the exchange rate will adjust to
maintain the parity:
P
f
(1 + I
f
) (1 + e
f
) = P
h
(1 + I
h
)
where P
h
= price index of goods in the home country
P
f
= price index of goods in the foreign country
I
h
= inflation rate in the home country
I
f
= inflation rate in the foreign country
e
f
= % change in the foreign currencys value
Since P
h
= P
f
, solving for e
f
gives:

e
f

=
(1 + I
h
) _
1

(1 + I
f
)
87
The relationship can be simplified as follows:
e
f
I
h

_
I
f

This formula is appropriate only when the inflation differential is small.
Suppose that the inflation rate in U.S. is 9%, while U.K.s rate is 5%. Then
PPP suggests that the should appreciate by about 4%.
U.S. will import more, while U.K. will import less, until the has risen by
about 4%. At this point, U.K. goods will cost 5+4=9% more to U.S.
consumers, while U.S. goods will cost 9-4=5% more to U.K. consumers.
88
Graphic Analysis of Purchasing Power Parity
Inflation Rate Differential (%)
home inflation rate - foreign inflation rate
%A in the
foreign
currencys
spot rate
- 2
- 4
2
4
1 3 - 1 - 3
PPP line
89
Graphic Analysis of Purchasing Power Parity
Inflation Rate Differential (%)
home inflation rate - foreign inflation rate
%A in the
foreign
currencys
spot rate
- 2
- 4
2
4
1 3 - 1 - 3
PPP line
Increased
purchasing
power of
foreign
goods
Decreased
purchasing
power of
foreign
goods
90
If the actual inflation differential and exchange rate % change for two or more
countries deviate significantly from the PPP line over time, then PPP does not hold.
A statistical test can be developed by applying regression analysis to the historical
exchange rates and inflation differentials:
e
f
= a
0
+ a
1
{ (1+I
h
)/(1+I
f
) - 1 } +
The appropriate t-tests are then applied to a
0
and a
1
, whose hypothesized values are 0
and 1 respectively.
PPP may not occur consistently due to:
- the existence of other influential factors like differentials in income levels and risk, as well as government
controls; and
- the lack of substitutes for traded goods.
A limitation in testing PPP is that the results may vary according to the base period
used.
PPP can also be tested by assessing a real exchange rate over time. If this rate
reverts to some mean level over time, this would suggest that it is constant in the long
run.
International Fisher Effect
According to the Fisher effect, nominal risk-free interest rates contain a real
rate of return and an anticipated inflation.
If the same real return is required across countries, differentials in interest
rates may be due to differentials in expected inflation.
According to PPP, exchange rate movements are caused by inflation rate
differentials.
The international Fisher effect (IFE) theory suggests that currencies with
higher interest rates will depreciate because the higher rates reflect higher
expected inflation.
91
According to the IFE, the expected effective return on a foreign
investment should equal the effective return on a domestic
investment:
(1 + i
f
) (1 + e
f
)
_
1 = i
h

where i
h
= interest rate in the home country
i
f
= interest rate in the foreign country
e
f
= % change in the foreign currencys value
Solving for e
f
:
e
f

=
(1 + i
h
) _
1

(1 + i
f

)
The simplified form, e
f
i
h

_
i
f
, provides reasonable
estimates when the interest rate differential is small.
92
Japan
U.S.
Canada
Japan
U.S.
Canada
Japan
U.S.
Canada
Investors
Residing
in
Attempt
to
Invest in
i
h
Return
in Home
Currency
Real
Return
Earned
i
f
e
f
I
h
Japan

U.S.

Canada
5
5
5
8
8
8
13
13
13
5
8
13
5
8
13
5
8
13
0
- 3
- 8
3
0
- 5
8
5
0
5
5
5
8
8
8
13
13
13
3
3
3
6
6
6
11
11
11
2
2
2
2
2
2
2
2
2
% % % % % %
93
Graphic Analysis of the International Fisher Effect
Interest Rate Differential (%)
home interest rate - foreign interest rate
- 2
- 4
2
4
1 3 - 1 - 3
IFE line
Higher
returns from
investing in
foreign
deposits
Lower
returns from
investing in
foreign
deposits
%A in the
foreign
currencys
spot rate
94
While the IFE theory may hold during some time frames, there is evidence
that it does not consistently hold.
A statistical test can be developed by applying regression analysis to the
historical exchange rates and nominal interest rate differentials:
e
f
= a
0
+ a
1
{ (1+i
h
)/(1+i
f
) - 1 } +
The appropriate t-tests are then applied to a
0
and a
1
, whose hypothesized
values are 0 and 1 respectively.
Since the IFE is based on PPP, it will not hold when PPP does not hold.
According to the IFE, the high interest rates in southeast Asian countries before the
Asian crisis should not attract foreign investment because of exchange rate
expectations.
However, since narrow bands were being maintained by some central banks, some
foreign investors were motivated.
Unfortunately for these investors, the efforts made to stabilize the currencies were
overwhelmed by market forces.
95
Comparison of IRP, PPP, and IFE Theories
Forward Rate
Discount or Premium
Exchange Rate
Expectations
Inflation Rate
Differential
Interest Rate
Differential
(IRP)
Fisher
Effect
International
Fisher Effect (IFE)
Purchasing
Power Parity
(PPP)
96
Impact of Inflation on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Effect of Inflation
97
Chapter Review
Purchasing Power Parity (PPP)
- Derivation of PPP
- Rationale Behind PPP Theory
- Graphic Analysis of PPP
- Testing the PPP Theory
- Why PPP Does Not Occur
- Limitation in Tests of PPP
- PPP in the Long Run
Chapter Review
International Fisher Effect (IFE)
- Derivation of the IFE
- Graphic Analysis of the IFE
- Tests of the IFE
- Why the IFE does Not Occur
- Application of the IFE to the Asian Crisis
Comparison of IRP, PPP, and IFE Theories
Impact of Foreign Inflation on the Value of the MNC
Part III
Exchange Rate Risk Management
Information on existing
and anticipated
economic conditions of
various countries and
on historical exchange
rate movements
Information on existing
and anticipated
cash flows in
each currency
at each subsidiary
Measuring
exposure to
exchange rate
fluctuations
Forecasting
exchange
rates
Managing
exposure to
exchange rate
fluctuations
CHAPTER 9
Forecasting Exchange Rates
10
0
Chapter Objectives
To explain how firms can benefit from forecasting exchange rates;
To describe the common techniques used for forecasting; and
To explain how forecasting performance can be evaluated.
Why Firms Forecast Exchange Rates
MNCs need exchange rate forecasts for their:
- hedging decisions,
- short-term financing decisions,
- short-term investment decisions,
- capital budgeting decisions,
- long-term financing decisions, and
- earnings assessment.
Forecasting Techniques
Technical forecasting involves the use of historical data to predict future values.
It includes statistical analysis and time series models, and is similar to the
technical forecasting of stock prices.
Speculators may find technical forecasting models useful for predicting day-to-
day movements. For MNCs however, their use may be limited, since they
typically focus on the near future, and rarely provide point or range estimates.
Fundamental forecasting is based on the fundamental relationships between
economic variables and exchange rates.
A forecast may arise simply from a subjective assessment, or it can be based on
quantitative measurements.
For example, in a regression model, the coefficients are estimated using
historical data. Forecasts can then be made using the appropriate variable
values. If the values are uncertain, sensitivity analysis can be applied.
10
1
Known relationships like the PPP can also be used. However, problems may
arise because:
the timing of the impact of inflation fluctuations
on trade behavior is not known for sure,
the relative prices may be measured
inaccurately,
trade barriers may disrupt the trade patterns
that should emerge according to PPP,
other factors that affect exchange rates exist.
In general, fundamental forecasting is limited by :
the uncertain timing of the impact of factors,
the need for forecasts for factors with
instantaneous impact,
the possibility that other relevant factors may be
omitted from the model,
changes in the sensitivity of currency
movements to each factor over time.
Market-based forecasting involves developing forecasts from market indicators.
Usually, either the spot rate or the forward rate is used, since they should reflect the
market expectation of the future rates.
For long-term forecasting, the quoted interest rates on risk-free instruments can be used
to determine what the forward rates should be under conditions of interest rate parity.
Note that the use of forward rates has been criticized because they are driven by another
market force - the interest rate differential.
10
2
Mixed forecasting refers to the use of a combination of forecasting
techniques.
The actual forecast is a weighted average of the various forecasts
developed.
Forecasting Services
The corporate need to forecast currency values has prompted some
consulting firms and banks to offer forecasting services.
Advice on international cash management, assessment of exposure to
exchange rate risk and hedging may be provided too.
One way to determine whether a forecasting service is valuable is to
compare the accuracy of its forecasts with the accuracy of publicly available
and free forecasts.
Evaluation of Forecast Performance
An MNC that forecasts exchange rates should monitor its performance over time to
determine whether its forecasting procedure is satisfactory. The MNC will also want to
compare its various forecasting methods.
One such measure is the absolute forecast error as a percentage of the realized
value:
| forecasted value - realized value |
realized value
MNCs may have more confidence in their forecasts when they know the mean error
for their past forecasts.
10
3
Note that the degree of forecast accuracy may vary for different
currencies. For example, the value of a less volatile currency is
likely to be forecasted more accurately.
If the errors are consistently positive or negative over time, then
there is a bias in the forecasting procedure.
The following regression model can test for bias: actual_rate = a
0

+ a
1
T] forecast +
If a bias is found, the estimated a
0
and a
1
values can be used to
correct the systematic error.
10
4
Graphic Evaluation of Forecast Performance
Perfect
forecast
line
x z
x
z
R
e
a
l
i
z
e
d

V
a
l
u
e

Predicted Value
Region of
downward
bias
Region of
upward bias
10
5
Forecasting Under Market Efficiency
If the foreign exchange market is weak-form efficient, then the current
exchange rates already reflect historical information. So, technical analysis
would not be useful.
If the market is semistrong-form efficient, then all the relevant public
information is already reflected in the current exchange rates.
If the market is strong-form efficient, then all the relevant public and private
information is already reflected in the current exchange rates.
Forecasting Exchange Rate Volatility
MNCs also forecast exchange rate volatility. This enables them to develop best-case
and worst-case scenarios along with their point estimate forecasts.
Several methods are possible:
Use the volatility of historical exchange rate
movements as a forecast.
Use a time series of the volatility patterns in
previous periods.
Derive the exchange rates implied standard
deviation from the currency option pricing model.
Application of Exchange Rate Forecasting to the Asian Crisis
Before the crisis, the spot rate served as a reasonable predictor, while the
use of fundamental factors was not as suitable, because of intervention by
the central banks.
But even after the crisis began, it is unlikely that the degree of depreciations
could have been accurately predicted by the usual models.
The two key factors leading to the sharp decline in the Asian currency values
are:
- the large amount of foreign investment, and
- the fear of a massive selloff of the currencies.
10
6
Impact of Forecasted Exchange Rates
on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Technical forecasting
Fundamental forecasting
Market-based forecasting
Mixed forecasting
10
7
Chapter Review
Why Firms Forecast Exchange Rates
Technical Forecasting
Fundamental Forecasting
Market-Based Forecasting
Mixed Forecasting
Forecasting Services
Forecast Accuracy Over Time
Forecast Accuracy Among Currencies
Forecast Bias
Graphic Evaluation of Forecast Performance
Forecasting Under Market Efficiency
Forecasting Exchange Rate Volatility
Application of Exchange Rate Forecasting to the Asian Crisis
How Exchange Rate Forecasting Affects an MNCs Value
CHAPTER 10
Measuring Exposure to
Exchange Rate Fluctuations
10
9
Chapter Objectives
To discuss the relevance of an MNCs exposure to exchange rate risk;
To explain how transaction exposure can be measured;
To explain how economic exposure can be measured; and
To explain how translation exposure can be measured.
Is Exchange Rate Risk Relevant?
Purchasing Power Parity Argument:
Exchange rate movements will be matched by price movements.
PPP does not necessarily hold.
The Investor Hedge Argument:
MNC shareholders can hedge against exchange rate fluctuations on their own.
The investors may not have complete information on corporate exposure. They may not have the capabilities
to correctly insulate themselves too.
Currency Diversification Argument:
An MNC that is well diversified should not be affected by exchange rate movements because
of offsetting effects.
This is a naive presumption.
Stakeholder Diversification Argument:
Well diversified stakeholders will be somewhat insulated against losses experienced by an
MNC due to exchange rate risk.
MNCs may be affected in the same way because of exchange rate risk.
Types of Exposure
Exposure to exchange rate fluctuations comes in three forms:
- Transaction exposure
- Economic exposure
- Translation exposure
11
0
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.
Two steps are involved in measuring transaction exposure:
1 determine the projected net amount of inflows or outflows in each foreign currency, and
2 determine the overall risk of exposure to those currencies.
To determine the overall risk, assess the standard deviations and
correlations of the currencies, taking into account the size of the MNCs
position in each currency in terms of a standard currency.
The standard deviation statistic on historical data measures currency
variability. Note that the variability may change over time.
Correlation coefficients indicate the degree to which two currencies move in
relation to each other. They may change over time too.
A related method, the value-at-risk (VAR) method, incorporates currency
volatility and correlations to determine the potential maximum one-day loss.
Historical data is used to determine the potential one-day decline in a
particular currency. This decline is then applied to the net cash flows in that
currency.
Economic Exposure
Economic exposure refers to the degree to which a firms present value of
future cash flows can be influenced by exchange rate fluctuations.
Cash flows that do not require conversion of currencies do not reflect
transaction exposure. Yet, these cash flows may also be influenced
significantly by exchange rate movements.
11
1
Economic Exposure
Transactions that
Influence the
Firms Local
Currency Inflows
Impact of Local
Currency
Appreciation on
Transactions
Impact of Local
Currency
Depreciation on
Transactions
Local sales (relative
to foreign competition
in local markets)
Firms exports
denominated in local
currency
Firms exports
denominated in
foreign currency
Interest received from
foreign investments

Decrease

Decrease

Decrease

Decrease

Increase

Increase

Increase

Increase
11
2
Economic Exposure
Transactions that
Influence the
Firms Local
Currency Outflows
Impact of Local
Currency
Appreciation on
Transactions
Impact of Local
Currency
Depreciation on
Transactions
Firms imported
supplies denominated
in local currency
Firms imported
supplies denominated
in foreign currency
Interest owed on
foreign funds
borrowed

No Change

Decrease

Decrease

No Change

Increase

Increase
11
3
Economic Exposure
Even purely domestic firms can be affected by economic exposure if there is
foreign competition within the local markets. However, their degree of
exposure is likely to be much less than for MNCs.
One method of measuring economic exposure is by reviewing how the
earnings forecast in the income statement changes in response to
alternative exchange rate scenarios.
Economic Exposure
Another method of assessing a firms economic exposure is by applying regression
analysis to historical cash flow and exchange rate data as follows:
% D in the inflation - % D in the
adjusted cash flows exchange
measured in the = a
0
+ a
1
x rate of the +
firms home currency currency
over period t over period t
The model can be varied by including more currencies, using an index of currencies,
focusing on selected cash flows only, or using the stock price.
Translation Exposure
The exposure of the MNCs consolidated financial statements to exchange
rate fluctuations is known as translation exposure.
Translation exposure may not be relevant because translating financial
statements for consolidated reporting purposes does not affect an MNCs
cash flows.
In reality however, translation exposure may affect the stock price of a firm
through its impact on consolidated earnings.
11
4
Note that the current translation of earnings may be a useful base to derive
the expected future cash flows when earnings are remitted by the foreign
subsidiaries to the parent.
Translation exposure is dependent on:
- the degree of foreign involvement by foreign subsidiaries,
- the locations of foreign subsidiaries, and
- the accounting methods used.
According to estimates, the total translated earnings of U.S.-based MNCs
were reduced by $20 billion in the third quarter of 1998 alone simply
because of the depreciation of Asian currencies against the dollar.
In general, translation exposure is more closely monitored when the foreign
earnings of the subsidiaries are more likely to be remitted to the parent,
because this signals a business operation that is subject to economic
exposure.
11
5
Impact of Exchange Rate Exposure
on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Transaction exposure
Economic exposure
11
6
Chapter Review
- Purchasing Power Parity Argument
- The Investor Hedge Argument
- Currency Diversification Argument
- Stakeholder Diversification Argument
Types of Exposure
- Transaction Exposure
- Economic Exposure
- Translation Exposure
Chapter Review
- Transaction Exposure to Net Cash Flows
- Transaction Exposure Based on Currency Variability & Currency Correlations
- Transaction Exposure Based on Value-at-Risk
Economic Exposure
- Economic Exposure to Local Currency Appreciation & Depreciation
- Economic Exposure of Domestic Firms & MNCs
- Measuring Economic Exposure
Sensitivity of Earnings to Exchange Rates
Sensitivity of Cash Flows to Exchange Rates
Chapter Review
- Does Translation Exposure Matter
- Determinants of Translation Exposure
The Degree of Foreign Involvement by Foreign Subsidiaries
The Locations of Foreign Subsidiaries
The Accounting Methods Used
Impact of Exchange Rate Exposure on an MNCs Value
CHAPTER 11
Managing Transaction Exposure
11
8
Chapter Objectives
To identify the commonly used techniques for hedging transaction exposure;
To explain how each technique can be used to hedge future payables and
receivables;
To compare the advantages and disadvantages among hedging techniques; and
To suggest other methods of reducing exchange rate risk when hedging techniques
are not available.
Transaction exposure exists when the future cash transactions of a firm are affected
by exchange rate fluctuations.
However, on the average, hedging may not reduce the MNCs costs.
If transaction exposure exists, the MNC should
1 identify the degree of transaction exposure,
2 decide whether to hedge and how much to hedge based on its degree of risk aversion and exchange rate
forecasts, and
3 choose among the various hedging techniques available if it decides to hedge.
MNCs that adopt a centralized approach to hedging must identify the net
transaction exposure in each currency for all its subsidiaries.
Note that sometimes, a firm can reduce its transaction exposure by pricing
its exports in the same currency that will be needed to pay for imports.
Techniques to Eliminate Transaction Exposure
A futures hedge involves the use of currency futures to hedge transaction
exposure.
Recall that futures contracts represent a standardized number of units for
each currency.
A futures hedge is not always beneficial, but some firms may be more
comfortable locking in their exchange rates than remaining exposed to
exchange rate fluctuations.
11
9
A forward hedge involves the use of forward contracts by large corporations to
hedge transaction exposure.
Based on the firms degree of risk aversion, the decision about whether to
hedge can be made by comparing the known result of hedging to the possible
results of remaining unhedged.
For payables :
real nominal cost nominal cost
cost of = of payables of payables
hedging with hedging without hedging
For receivables :
nominal nominal
real home currency home currency
cost of = revenues revenues
hedging received received
without hedging with hedging
If the real cost is negative, then hedging is more favorable than not hedging.
To estimate the real cost, the probability distribution of the exchange rates is
needed:
expected probability real cost
real cost = E that exchange x of hedging
of hedging
i
rate is i when rate is i
The overall probability that hedging will be more costly can also be computed.
Note that to avoid distortion, the real cost of hedging for each currency should
be expressed as a percentage of their respective hedged amounts if they are to
be compared.
12
0
A money market hedge involves taking one or more money market position to
cover a future payables or receivables position.
Often, two positions are required:
- For payables, (1) borrow the home currency representing future payables, and (2) invest in the
foreign currency.
- For receivables, (1) borrow the foreign currency representing future receivables, and (2) invest in
the home currency.
If interest rate parity (IRP) exists, and transaction costs do not exist, the money
market hedge will yield the same results as the forward hedge.
This is so because the forward premium on the forward rate reflects the interest
rate differential between the two currencies.
A currency option hedge involves the use of currency call or put options to hedge
transaction exposure.
Recall that the option owner can choose not to exercise the contract.
Hence, the firm will be insulated from adverse exchange rate movements, but
may benefit from favorable movements.
However, the firm must assess whether the advantages are worth the premium
paid for the option.
Most MNCs determine which hedging technique is optimal on a case-by-case
basis.
Note that when using a futures, forward, or money market hedge, the firm can
determine its future cash flows with certainty. However, this is not the case when
using a currency option hedge or when remaining unhedged.
A further complication for many firms is that the amount of foreign currency to be
received at the end of the period being analyzed is uncertain.
12
1
Hedging Long-Term Transaction Exposure
Over the long run, the continual hedging of repeated transactions that are expected in the near
future has limited effectiveness.
Hence, MNCs that are certain of their future cash flows may attempt long-term hedging.
The commonly used techniques are long-term forward contracts, currency swaps, and parallel
loans.
Long-term forward contracts, or long forwards, with maturities of ten years or more, can be set up
for very creditworthy customers.
Currency swaps can take many forms. In one form, two parties, with the aid of brokers, agree to
exchange specified amounts of currencies on specified dates in the future.
A parallel loan, or back-to-back loan, involves an exchange of currencies between two parties,
with a promise to re-exchange the currencies at a specified exchange rate on a future date.
Alternative Hedging Techniques
Sometimes, a firm may not be able to eliminate its transaction exposure completely because it
cannot accurately predict its cash flows, or because the costs of hedging are too high.
To reduce exposure under such conditions, the firm can consider leading and lagging, cross-
hedging, or currency diversification.
The act of leading and lagging refers to an adjustment in the timing of payment request or
disbursement to reflect expectations about future currency movements.
When a currency cannot be hedged, cross-hedging may be practiced. With cross-hedging, a
currency that is highly correlated with the currency of concern is hedged instead. The stronger
the positive correlation, the more effective the strategy will be.
With currency diversification, the firm diversifies its business among numerous countries whose
currencies are not highly correlated.
12
2
Impact of Hedging Transaction Exposure
on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Hedging decisions on
transaction exposure
12
3
Chapter Review
- Selective Hedging of Transaction Exposure
- Identifying the Net Transaction Exposure
- Adjusting the Invoice Policy to Manage Exposure
- Futures Hedge
- Forward Hedge
- Money Market Hedge
- Currency Option Hedge
- Calculating the Real Cost of Hedging
- Determining the Optimal Hedge
Limitation of Repeated Short-Term Hedging
- Long-Term Forward Contract
- Currency Swap
- Parallel Loan
- Leading and Lagging
- Cross-Hedging
- Currency Diversification
How Transaction Exposure Management Affects an MNCs Value
CHAPTER 12
Managing Economic Exposure
and Translation Exposure
12
5
Chapter Objectives
To explain how an MNCs economic exposure can be hedged; and
To explain how an MNCs translation exposure can be hedged.
Economic Exposure
Economic exposure refers to the impact exchange rate fluctuations can have on
a firms future cash flows. Recall that cash flows can be affected in ways not
directly associated with foreign transactions.
The management of economic exposure tends to result in a long-term solution.
Its importance can be seen from the bankruptcy of Laker Airways, and from the
impact the 1997/8 Asian crisis had on firms.
Economic Exposure
A firm can assess its economic exposure by determining the sensitivity of its
expenses and revenues to various possible exchange rate scenarios.
The firm can then reduce its exposure by restructuring its operations.
Economic Exposure
For example, a firm may attempt to balance its exchange-rate-sensitive
revenues and expenses by :
1. increasing or reducing sales in new or existing
foreign markets,
2. increasing or reducing its dependency on
foreign suppliers,
3. establishing or eliminating production facilities
in foreign markets, and/or
4. increasing or reducing its level of debt
denominated in foreign currencies.
12
6
Economic Exposure
Note that computer spreadsheets can be very helpful in assessing alternative
scenarios.
MNCs must be very confident about the long-term potential benefits before they
proceed to restructure their operations, because of the high costs of reversal.
Translation exposure results when an MNC translates each subsidiarys financial
data to its home currency for consolidated financial reporting.
Some firms are concerned about translation exposure because of its potential
impact on reported consolidated earnings, and may attempt to avoid it by
matching its foreign liabilities with its foreign assets.
To hedge translation exposure, forward contracts can be used.
For example, a U.S.-based MNC that is concerned about the translated value of
its British earnings may enter a one-year forward contract to sell pounds.
If the pound depreciates during the fiscal year, the gain generated from the
forward contract position may offset the translation loss.
Hedging translation exposure is limited by:
- inaccurate earnings forecasts,
- inadequate forward contracts for some currencies,
- accounting distortions, and
- increased transaction exposure.
Perhaps, the best way for MNCs to deal with translation exposure is to clarify
how their consolidated earnings have been affected by exchange rate
movements.
12
7
Impact of Hedging Economic Exposure
on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Hedging decisions on
economic exposure
12
8
Chapter Review
Managing Economic Exposure
Importance of Managing Economic Exposure
Assessing Economic Exposure
Reducing Economic Exposure by Restructuring
Expediting the Analysis with Computer Spreadsheets
Issues Involved in the Restructuring Decision
Managing Translation Exposure
Use of Forward Contracts to Hedge Translation Exposure
Limitations of Hedging Translation Exposure
Alternative Solution to Hedging Translation Exposure
How Economic Exposure Management Affects an MNCs Value
Part IV
Long-Term Asset and Liability Management
Existing
Host Country
Tax Laws
Exchange
Rate
Projections
Country Risk
Analysis
Risk Unique to
Multinational
Project
MNCs Cost
of Capital
International
Interest Rates
on Long-Term
Funds
MNCs Access
to Foreign
Financing
Potential
Revision in
Host Country
Tax Laws or
Other
Provisions
Estimated
Cash Flows of
Multinational
Project
Required
Return on
Multinational
Project
Multinational
Capital
Budgeting
Decisions
CHAPTER 13
Direct Foreign Investment
13
1
Chapter Objectives
To describe common motives for initiating direct foreign investment; and
To illustrate the benefits of international diversification.
Motives for Direct Foreign Investment
There are several ways in which DFI can boost revenues or reduce costs :
1. Attract new sources of demand, especially
when growth is limited in the home country.
2. Enter markets in which superior profits are
possible.
3. Fully benefit from economies of scale,
especially for firms that utilize much
machinery.
4. Use foreign factors of production.
5. Use foreign raw materials.
6. Use foreign technology.
7. Exploit monopolistic advantages, especially
for firms that possess resources or skills
not available to competing firms.
8. React to exchange rate movements. DFI can
be considered when the foreign currency
appears to be undervalued. DFI can also
help reduce economic exposure.
9. React to trade restrictions.
10. Diversify internationally.

13
2
The optimal method for a firm to penetrate a foreign market is partially
dependent on the characteristics of the market.
Before investing in a foreign country, the potential benefits must be weighed
against the costs and risks.
As conditions change over time, the potential benefits from pursuing DFI in
various countries change too.
Benefits of
International Diversification
overall
=

E

p
i

x
expected return
expected return i on business unit i
overall variance = E p
i
2
o
i
2
+ E E p
i
p
j
Cov
ij

i i j,j i
where p
i
= % of funds invested in business unit i
o
i
2

= variance of the return on business unit i
Cov
ij
= covariance between the returns on
business unit i and business unit j
13
3
When a firm invests in foreign projects, the overall return will be more
stable because of the lower correlations between the returns of projects
implemented in different economies.
Benefits of International Diversification
Domestic
Project Portfolio
Global
Project Portfolio
A
v
e
r
a
g
e

V
a
r
i
a
n
c
e

o
f

R
e
t
u
r
n
s

Number of Projects
13
4
An MNC with projects positioned around the world is concerned
about the risk and return characteristics of the projects.
Frontier
of efficient
project portfolios
E
x
p
e
c
t
e
d

R
e
t
u
r
n

Risk
13
5
The actual location of the frontier of efficient project portfolios depends
on the business in which the firm is involved.
E
x
p
e
c
t
e
d

R
e
t
u
r
n

Risk
Efficient frontier of
project portfolios for
a single-product MNC
Efficient frontier of
project portfolios for
a multi-product MNC
13
6
Decisions Subsequent to DFI
Some periodic decisions are necessary:
Should further expansion take place?
Should the earnings be remitted to the parent, or used by the subsidiary?
Host Government View of DFI
DFI may provide needed employment or technology. However, locally
owned companies may lose business due to the new competition.
The ability of a host government to attract DFI is dependent on the countrys
markets and resources, as well as government regulations and incentives.
13
7
Impact of Direct Foreign Investment
Decisions on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
DFI decisions on type
of business and location
13
8
Chapter Review
Diversification Benefits of Multiple Projects
Risk-Return Analysis of International Projects
Decisions Subsequent to DFI
Host Government View of DFI
Impact of the DFI Decision on an MNCs Value
CHAPTER 14
Multinational Capital Budgeting
14
0
Chapter Objectives
To compare the capital budgeting analysis of an MNCs subsidiary with that
of its parent;
To demonstrate how multinational capital budgeting can be applied to
determine whether an international project should be implemented; and
To explain how the risk of international projects can be assessed.
Subsidiary versus Parent Perspective
Should a parent or its subsidiary conduct the capital budgeting for a multinational
project?
The results may vary with the perspective because the net after-tax cash inflows to
the parent can differ substantially from those to the subsidiary.
The difference in cash inflows is due to :
1. tax differentials
2. restricted remittances
3. excessive remittances
4. exchange rate movements
14
1
Remitting Subsidiary Earnings to the Parent
After-Tax Cash Flows Remitted by Subsidiary
Cash Flows Generated by Subsidiary
After-Tax Cash Flows to Subsidiary
Cash Flows Remitted by Subsidiary
Withholding Tax Paid
to Host Government
Retained Earnings
by Subsidiary
Corporate Taxes Paid
to Host Government
Conversion of Funds
to Parents Currency
Parent
Cash Flows to Parent
14
2
Input for Multinational Capital Budgeting
The following forecasts are normally required:
1. initial investment 2. consumer demand
3. price 4. variable cost
5. fixed cost 6. project lifetime
7. salvage (liquidation) value 8. fund-transfer restrictions
9. tax laws 10. exchange rates 11. required rate of return
Capital budgeting is necessary for all long-term projects that deserve consideration.
One method of performing the analysis is to calculate the net present value of the
project:
net n cash flow salvage
present =
_
initial + E in period t + value
value outlay
t =1
(1+ k )
t
(1+ k )
n

k = required rate of return on the project
n = lifetime of the project (number of periods)
If the net present value is positive, the project may be accepted.
Factors to Consider in Multinational Capital Budgeting
A variety of factors may affect the capital budgeting analysis :
1. Exchange rate fluctuations - Different
scenarios should be considered together with their probability of occurrence.
2. Inflation - Inflation can be quite volatile
from year to year in some countries.
3. Financing arrangement - Many foreign
projects are partially financed by foreign subsidiaries.
14
3
4. Blocked funds - Some countries may
require that the earnings be reinvested locally for a certain period of
time before they can be remitted to the parent.
5. Uncertain salvage value - The salvage
value typically has a significant impact on the projects net present
value.
6. Impact of project on prevailing cash flows.
7. Host government incentives.
14
4
Adjusting Project Assessment for Risk
If an MNC is unsure of the cash flows of a proposed project, it needs to adjust its
assessment for this risk.
One method is to use a risk-adjusted discount rate. The greater the uncertainty,
the larger the discount rate that is applied.
Many computer software packages are also available to perform sensitivity
analysis and simulation.
Impact of Multinational Capital Budgeting Decisions on an MNCs Value
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Multinational capital
budgeting decisions E (CF
j,t
) = expected cash
flows in currency j to be
received by the U.S.
parent at the end of period
t
E (ER
j,t
) = expected
currency j can be
converted to dollars at the
end of period t
k = the weighted average
cost of capital of the U.S.
parent
14
5
Chapter Review
Subsidiary versus Parent Perspective
- Tax Differentials
- Restricted Remittances
- Excessive Remittances
- Exchange Rate Movements
Input for Multinational Capital Budgeting
Chapter Review
- Exchange Rate Fluctuations
- Inflation
- Financing Arrangement
- Blocked Funds
- Uncertain Salvage Value
- Impact of Project on Prevailing Cash Flows
- Host Government Incentives
Chapter Review
Adjusting Project Assessment for Risk
- Risk-Adjusted Discount Rate
- Sensitivity Analysis
- Simulation
Impact of Multinational Capital Budgeting on an MNCs Value
CHAPTER 15
Multinational Restructuring
14
7
Chapter Objectives
To provide a background on how MNCs use international acquisitions as a form of
multinational restructuring;
To explain how MNCs conduct valuations of foreign target firms;
To explain why valuations of a target firm vary among MNCs that plan to restructure
by acquiring a target; and
To identify other types of multinational restructuring.
Multinational Restructuring
Decisions by an MNC to build a new subsidiary, to acquire a company, to
sell an existing subsidiary, to downsize some of its operations, or to shift
some production from one subsidiary to another, represent different forms of
multinational restructuring.
MNCs continuously assess possible forms of multinational restructuring to
capitalize on changing economic, political and industrial conditions across
countries.
International Acquisitions
Through an international acquisition, a firm can immediately expand its
international business, since the structure is already in place, and customer
relationships have already been established.
However, it usually costs more to acquire a company than to establish a new
subsidiary. It is also necessary to integrate the parent management style
with that of the acquired company.
14
8
Trends in International Acquisitions
0
200
400
600
800
1000
1200
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
N
u
m
b
e
r

o
f

A
c
q
u
i
s
i
t
i
o
n
s

Foreign Acquisitions
of U.S. Firms
0
20
40
60
80
100
1988 1989 1990 1991 1992 1993 1994 1995 1996 1997
V
a
l
u
e

o
f

A
c
q
u
i
s
i
t
i
o
n
s

(
i
n

b
i
l
l
i
o
n
s

o
f

$
)

U.S. Acquisitions
of Foreign Firms
Foreign Acquisitions
of U.S. Firms
U.S. Acquisitions of Foreign Firms
14
9
All countries have one or more agencies that monitor mergers and
acquisitions. MNCs need to be aware of the barriers that may be imposed by
them.
Examples of such barriers include laws against hostile takeovers, restricted
foreign majority ownership, red tape, and special requirements.
The cost of overcoming the barriers should be taken into consideration when
acquiring a foreign company.
One method of valuing a foreign target is to calculate its net present value :
net n cash flow salvage
present =
_
initial + E in period t + value
value outlay
t =1
(1+ k )
t
(1+ k )
n

k = required rate of return on the acquisition
n = lifetime of the acquired company
Note that the relevant exchange rates, taxes and blocked-funds restrictions should be
taken into account.
If the net present value is positive, the foreign company may be acquired.
During the Asian crisis, some MNCs capitalized on the low property values,
weakened currencies, and the need for funds by many firms, to invest in
Asia. These MNCs must not ignore the adverse effects of the crisis too.
In Europe, the adoption of the euro as the local currency by several
countries simplifies the analysis for an MNC that is comparing possible
target firms in these participating countries.
15
0
Factors that Affect the Expected Cash Flows of the Foreign Target
Target-Specific Factors
1. Targets previous cash flows 2. Managerial talent of the target
Factors that Affect the Expected Cash Flows of the Foreign Target
Country-Specific Factors 1. Targets local economic conditions
2. Targets local political conditions 3. Targets industrial conditions
4. Targets currency conditions 5. Targets local stock market conditions
6. Taxes applicable to the target
The Valuation Process
The MNC first conducts an initial screening of the prospective targets to
identify those that deserve a closer assessment.
The MNC then values each of the targets that passed the screening process
by calculating their net present values, for example.
Only those targets with positive net present values will be further considered.
If the MNC decides not to bid for a target at this time, it will need to redo its
analysis the next time it reconsiders acquiring the target.
Why Valuations of a Target May Vary Among MNCs
The targets expected future cash flows varies.
- Different MNCs will manage the targets operations differently.
- Each MNC may have a different plan for fitting the target within the structure of the MNC.
- Acquirers based in certain countries may be subjected to less taxes on remitted earnings.
The effect of exchange rates varies.
- Different MNCs have different schedules for the target to remit funds to the parent.
15
1
Why Valuations of a Target May Vary Among MNCs
The required rate of return varies.
- Different MNCs may have different plans for the target, with different levels of risk.
- The local risk-free interest rate may be different for MNCs based in different countries.
- MNCs in some countries have more flexibility in their ability to use financial leverage.
Other Types of Multinational Restructuring
An MNC may engage in a partial international acquisition of a firm, by
purchasing a portion of the existing stock of a foreign firm.
The valuation of the firm will vary depending on whether the MNC plans to
acquire enough shares to control the firm.
Many MNCs also acquire businesses that are being sold by governments all
over the world.
It is usually difficult to measure the value of these privatized businesses
because of the many uncertainties surrounding the transition.
MNCs commonly engage in international alliances, such as joint ventures
and licensing agreements, with foreign firms.
The initial outlay is typically smaller, but the cash flows to be received will be
smaller too.
An MNC should also conduct periodic assessments to determine whether to
retain its foreign investments or to divest them.
The MNC should compare the present value of the cash flows if the project is
continued to the proceeds that would be received if the project is divested.
15
2
Impact of Multinational Restructuring
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Multinational restructuring decisions
15
3
Chapter Review
Background on Multinational Restructuring
- Trends in International Acquisitions
- Barriers to International Acquisitions
- Model for Valuing a Foreign Target
- Assessing Potential Acquisitions in Asia and Europe
Factors that Affect the Expected Cash Flows
- Target-Specific Factors
- Country-Specific Factors
The Valuation Process
- International Screening Process
- Estimating the Targets Value
Why a Targets Value May Vary Among MNCs
- Expected Cash Flows From the Target
- Exchange Rate Effects on Remitted Funds
- Required Return of the Acquirer
- International Partial Acquisitions
- International Acquisitions of Privatized Businesses
- International Alliances
- International Divestments
Impact of Multinational Restructuring on an MNCs Value
CHAPTER 16
Country Risk Analysis
15
5
Chapter Objectives
To identify the common factors used by MNCs to measure a countrys political risk;
To identify the common factors used by MNCs to measure a countrys financial risk;
To explain the techniques used to measure country risk; and
To explain how the assessment of country risk is used by MNCs when making financial
decisions.
Why Country Risk Analysis Is Important
Country risk represents the potentially adverse impact of a countrys
environment on the MNCs cash flows.
Country risk can be used :
- to monitor countries where the MNC is presently doing business;
- as a screening device to avoid conducting business in countries with excessive risk; and
- to improve the analysis used in making long-term investment or financing decisions.
Political Risk Factors
Attitude of Consumers in the Host Country
- Some consumers may be very loyal to local products.
Attitude of Host Government
- The host government may impose special requirements, restrictions, or additional taxes, subsidize
local firms, or fail to enforce copyright laws.
- Blockage of Fund Transfers
- Funds may not be optimally used.
Currency Inconvertibility
- The MNC parent may need to exchange earnings for goods.
War
- Internal and external battles, or even the threat of war, can have a devastating effect.
Bureaucracy
- Bureaucracy can complicate business.
Corruption
- Corruption can increase the cost of conducting business or reduce revenue.
15
6
Financial Risk Factors
One financial factor is the current and potential state of the countrys economy.
- A recession can severely reduce demand.
- Financial distress can also encourage the government to restrict the MNCs operations.
A countrys economy is dependent on other financial factors, such as interest
rates, exchange rates, and inflation.
Government purchasing power indicators, such as the budget deficit, are also
important if the government is a customer of the MNC.
Types of Country Risk Assessment
A macro-assessment of country risk is an overall risk assessment of a country
without consideration of the MNCs business.
A micro-assessment of country risk is the risk assessment of a country as
related to the MNCs type of business.
The overall assessment of country risk thus consists of :
1. Macro-political risk 3. Micro-political risk
2. Macro-financial risk 4. Micro-financial risk
Risk assessors often differ in opinion due to subjectivities in :
- identifying the relevant political and financial factors,
- determining the relative importance of each factor, and
- predicting the values of the factors.
Techniques to Assess Country Risk
A checklist approach involves measuring all the identified factors and assigning
weights to them.
The Delphi technique involves collecting independent opinions on country risk.
Quantitative analysis tools like discriminant analysis and regression analysis can
be used when financial and political variables have been measured for a period
of time.
15
7
Comparing Risk Ratings Among Countries: The Foreign Investment Risk Matrix (FIRM)
Unclear
Zone
Acceptable
Zone
Unacceptable
Zone
Financial Risk Rating
P
o
l
i
t
i
c
a
l

R
i
s
k

R
a
t
i
n
g

Good Poor
S
t
a
b
l
e

U
n
s
t
a
b
l
e

Inspection visits involve traveling to a country and meeting with government
officials, firm executives, and/or consumers.
In some cases, it may be most appropriate to use a combination of two or
more techniques.
15
8
Quantifying Country Risk
1. Assign values and weights to the political risk factors.
2. Multiply the factor values with their respective weights, and sum up to give the political risk
rating.
3. Derive the financial risk rating similarly.
4. Assign weights to the political and financial ratings according to their perceived importance.
5. Multiply the ratings with their respective weights, and sum up to give the overall country
risk rating.

Incorporating Country Risk in Capital Budgeting
Adjustment of the Discount Rate
- The higher the perceived risk, the higher the discount rate applied to the projects cash flows.
Adjustment of the Estimated Cash Flows
- By analyzing each possible impact, the MNC can determine the probability distribution of the net
present values for the project.
Applications of Country Risk Analysis
While the overall risk rating of a country can be useful, it cannot always detect
upcoming crises.
The Persian Gulf crisis is an example of how a countrys risk can change over
time.
Through the 1997/8 Asian crisis, MNCs realized that they had underestimated
the potential financial problems that could occur in the high-growth Asian
countries.
Reducing Exposure to Host Government Takeovers
Use a Short-Term Horizon
- This technique concentrates on recovering cash flow quickly.
Rely on Unique Supplies or Technology
- In this way, the host government will not be able to take over and operate the subsidiary successfully.
Hire Local Labor
- The local employees can apply pressure on their government.
15
9
Impact of Country Risk on an MNCs Value
E (CF
j,t
) = expected
cash flows in currency
j to be received by the
U.S. parent at the end
of period t

E (ER
j,t
) = expected
currency j can be
converted to dollars at
the end of period t

k = the weighted
average cost of capital
of the U.S. parent
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Exposure of foreign projects
to country risk
Borrow Local Funds
- The local banks can apply pressure on their government.
Purchase Insurance
- Many home countries of MNCs have investment guarantee programs that insure to some
extent the risks of expropriation, wars, or currency blockage.
- Similar programs may be offered by the host country or an international agency too.
16
0
Chapter Review
Why Country Risk Analysis Is Important
Financial Risk Factors
- Macro-Assessment of Country Risk
- Micro-Assessment of Country Risk
- Checklist Approach
- Delphi Technique
- Quantitative Analysis
- Inspection Visits
- Combination of Techniques
Comparing Risk Ratings Among Countries
Quantifying Country Risk
Incorporating Country Risk in Capital Budgeting
- Adjustment of the Discount Rate
- Adjustment of the Estimated Cash Flows
Applications of Country Risk Analysis
Impact of Country Risk on an MNCs Value
CHAPTER 17
Multinational Cost of Capital
and Capital Structure
16
2
Chapter Objectives
To explain how corporate and country characteristics influence an MNCs
cost of capital;
To explain why there are differences in the costs of capital among countries;
and
To explain how corporate and country characteristics are considered by an
MNC when it establishes its capital structure.
Cost of Capital
A firms capital consists of equity (retained earnings and funds obtained by
issuing stock) and debt (borrowed funds).
The cost of equity reflects an opportunity cost, while the cost of debt is
reflected in interest expenses.
Firms attempt to use a capital structure that will minimize their cost of
capital.
The lower a firms cost of capital, the lower is its required rate of return on a
given proposed project.
Cost of Capital
A firms weighted average cost of capital can be measured as :
(
debt
)

k
d
(

1

_

t

)

+

(
equity
)

k
e

debt+equity debt+equity
where k
d
is the before-tax cost of its debt
t is the corporate tax rate
k
e
is the cost of financing with equity
16
3
The interest payments on debt are tax deductible. However, when
interest expense increases, the probability of bankruptcy will
increase too.
Cost of Capital
C
o
s
t

o
f

C
a
p
i
t
a
l

Debt Ratio
16
4
Cost of Capital for MNCs versus Domestic Firms
Because of their size, MNCs are often given preferential treatment by
creditors. Their per unit flotation costs is usually smaller too.
MNCs are also normally able to obtain funds through international capital
markets.
MNCs may have more stable cash inflows due to international
diversification.
However, MNCs are exposed to exchange rate risk.
MNCs are also exposed to country risk.
The capital asset pricing model (CAPM) defines the required return on a
stock as :
R
f
+ | ( market return - R
f
)
where R
f
= risk-free rate of return
| = beta of stock
A stocks beta represents the sensitivity of the stocks returns to market
returns.
The lower a projects beta, the lower the systematic risk, and the lower the
required rate of return, if the unsystematic risk is considered irrelevant.
Costs of Capital Across Countries
The cost of debt is primarily determined by :
- the risk-free interest rate for the borrowed currency, and
- the risk premium required by creditors.
The risk-free rate may vary across countries.
- This is due to different tax laws, demographics, monetary policies, and economic conditions.
The risk premium may vary across countries.
- This is due to different economic conditions, relationships between corporations and creditors, government
intervention, and degrees of financial leverage.
16
5
Comparative Costs of Debt Across Countries
There is some positive correlation among the costs of debt
for different countries.
1
2
3
4
5
6
7
8
9
1996 1997 1998
C
o
s
t
s

o
f

D
e
b
t

U.S.
U.K.
Canada
U.S.
Australia
Germany
Japan
16
6
The cost of equity is determined by :
- the risk-free interest rate that could have been earned by the shareholders,
- the premium that reflects the firms risk, and
- the investment opportunities in the country.
Since the costs may vary across countries,
- MNCs based in some countries may have a competitive advantage over others,
- MNCs may be able to adjust their sources of funds to capitalize on the differences, and
- MNCs in different countries may have different optimal debt-equity ratios.
Using the Cost of Capital for Assessing Foreign Projects
Foreign projects may have risk levels different from that of the MNC, such that the MNCs
weighted average cost of capital may not be the appropriate required rate of return.
To account for this risk differential in the capital budgeting process,
- the probability distribution of net present values can be computed, or
- the MNCs weighted average cost of capital may be adjusted accordingly.
The MNCs Capital Structure Decision
Corporate characteristics may influence the MNCs capital structure :
- MNCs with more stable cash flows can handle more debt.
- Lower credit risk means more access to credit.
- More profitable MNCs may be able to finance most of their investment with retained earnings.
- If the parent backs the subsidiarys debt, the subsidiary may be able to borrow more.
- Local shareholders may monitor a subsidiary, though not from the parents perspective.
Host country characteristics may influence the MNCs capital structure too:
- MNCs in countries where investors have less investment opportunities may be able to raise equity
at a relatively low cost.
- Interest rates may vary across countries.
- A currencys strength may change over time.
- Different countries have different risks.
- Different countries have different tax laws.
16
7
MNCs may prefer to use a more debt-intensive capital structure when they
exhibit characteristics such as stable cash flows, low credit risk, and limited
access to retained earnings.
MNCs may prefer that their subsidiaries use a more debt-intensive capital
structure when their subsidiaries are subject to low local interest rates,
potentially weak local currencies, a high degree of country risk, and high
taxes.
Interaction Between Subsidiary and Parent Financing Decisions
Increased debt financing by the subsidiary
Larger amount of internal funds available
to the parent
Reduced need for debt financing by the
parent
Reduced debt financing by the subsidiary
Smaller amount of internal funds available
to the parent
Increased need for debt financing by the
parent
Using a Target Capital Structure on a Local versus Global Basis
An MNC may deviate from its local targets, and yet still achieve its global
target capital structure when the capital structures of all its subsidiaries are
consolidated.
This may be done to offset abnormal degrees of financial leverage in certain
subsidiaries as necessitated by local conditions.
However, this strategy is rational only if it is acceptable by the MNCs
creditors and investors.
16
8
Impact of Multinational Capital Structure
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Parents capital structure decisions
16
9
Chapter Review
Cost of Capital
Size of Firm
Access to International Capital Markets
International Diversification
Exposure to Exchange Rate Risk
Exposure to Country Risk
Capital Asset Pricing Model
17
0
Chapter Review
- Country Differences in the Cost of Debt
Differences in the Risk-Free Rate
Differences in the Risk Premium
- Country Differences in the Cost of Equity
Using the Cost of Capital for Assessing Foreign Projects
- Influence of Corporate Characteristics
Stability of MNCs Cash Flows
MNCs Credit Risk
MNCs Access to Retained Earnings
MNCs Guarantees on Debt
MNCs Agency Problems
- Influence of Country Characteristics
Stock Restrictions in Host Countries
Interest Rates in Host Countries
Strength of Host Country Currencies
Country Risk in Host Countries
Tax Laws in Host Countries
Interaction Between Subsidiary and Parent Financing Decisions
- Impact of Increased Debt Financing by the Subsidiary
- Impact of Reduced Debt Financing by the Subsidiary
Using a Target Capital Structure on a Local versus Global Basis
Impact of Capital Structure Decisions on an MNCs Value
CHAPTER 18
Long-Term Financing
17
2
Long-Term Financing Decision
0
10
20
30
40
Annualized Bond Yields
(10-year maturity, as of June 1998)
Chapter Objectives
To explain why MNCs consider long-term financing in foreign currencies;
To explain how to assess the feasibility of long-term financing in foreign
currencies; and
To explain how the assessment of long-term financing in foreign currencies
is adjusted for bonds with floating interest rates.
To make the long-term financing decision, the MNC must
1 determine the amount of funds needed,
2 forecast the price (interest rate) at which the bond may be issued,
3 forecast the periodic exchange rates for the borrowed currency over the life of the bond, and
3 account for the uncertainty of the actual financing costs that will be incurred.
17
3
Comparing Bond Denomination Alternatives
One approach to assessing a currency is to forecast its exchange rate for each
point in time that a payment is needed, in order to determine the home currency
required.
Alternatively, exchange rate probabilities can be developed to compute the
expected cost of financing.
The probability distributions of exchange rates can also be fed into a simulation
program to generate a probability distribution of financing costs.
Financing with Floating-Rate Eurobonds
Eurobonds are often issued with a floating coupon rate. For example, the rate
may be tied to the London Interbank Offer Rate (LIBOR).
If the coupon rate is floating, projections are required for both exchange rates
and interest rates.
Exchange Rate Risk of Foreign Bonds
Some foreign currencies exhibit more risk than others.
The exchange rate risk from financing with bonds in foreign currencies can be
hedged with
1 offsetting cash inflows in that currency,
2 forward contracts, or
3 currency swaps.
Long-Term Financing in Multiple Currencies
Sometimes, the appropriate selection for a borrower may be a portfolio of
bonds denominated in various diversified currencies.
To avoid the higher transactions costs associated with issuing various types of
bonds, the MNC may develop a currency cocktail bond.
A popular currency cocktail is the Special Drawing Right (SDR), which is a
weighted composite of various major currencies.
17
4
Investors in Fixed
Rate Bonds Issued
by Quality Company
Investors in Variable
Rate Bonds Issued
by Risky Company
Quality Company
Choice of 9% fixed or
LIBOR+.5% variable
Risky Company
Choice of 10.5% fixed or
LIBOR+1% variable
Fixed Rate
Payments
at 9%
Variable Rate
Payments at
LIBOR+1%
Illustration of An Interest Rate Swap
Using Swaps to Hedge Financing Costs
Interest rate swaps can be used to hedge interest rate risk. They enable a
firm to exchange fixed rate payments for variable rate payments, or vice
versa.
Financial intermediaries are usually involved in swap agreements. They
match up participants and also assume the default risk involved for a fee.
17
5
Illustration of An Interest Rate Swap
Investors in Fixed
Rate Bonds Issued
by Quality Company
Investors in Variable
Rate Bonds Issued
by Risky Company
Quality Company
Choice of 9% fixed or
LIBOR+.5% variable
Risky Company
Choice of 10.5% fixed or
LIBOR+1% variable
Variable Rate
Payments at
LIBOR+.5%
Fixed Rate
Payments at
9.5%
Fixed Rate
Payments
at 9%
Variable Rate
Payments at
LIBOR+1%
Currency swaps can be used to hedge exchange rate risk. They enable
firms to exchange currencies at periodic intervals.
An alternative method is the parallel (or back-to-back) loan, which
represents simultaneous loans provided by two parties with an agreement
to repay the loans at a specified point in the future.
17
6
Illustration of A Currency Swap
Marks Received From
Ongoing Operations
Investors in Mark-
denominated Bonds
Issued by Beck
Investors in Dollar-
denominated Bonds
Issued by Miller
Miller Company
[known within the dollar-
denominated market]
Mark
Payments
Beck Company
[known within the mark-
denominated market]
Dollars Received From
Ongoing Operations
Dollar
Payments
Dollar
Payments
Mark
Payments
Mark
Payments
Dollar
Payments
17
7
Subsidiary of
U.K.- based MNC
that is located
in the U.S.
Illustration of A Parallel Loan
Provision
of Loans
Subsidiary of
U.S.- based MNC
that is located
in the U.K.
British Parent
U.S. Parent
Repayment
of Loans in
the Currency
that was
Borrowed
1
2
Foreign Debt Maturity Decisions
An MNC must decide on the maturity for any potential debt. To do
this, the MNC may want to assess the yield curve for the currency the
bond is to be denominated in.
Since the slopes of yield curves can vary among countries, the
choice of financing with long-term debt versus short-term or
medium-term debt may vary among countries too.
17
8

17
9
Yield Curves
as of June 1998
A
n
n
u
a
l
i
z
e
d

Y
i
e
l
d

Term to Maturity
18
0
Yield Curves
as of June 1998
A
n
n
u
a
l
i
z
e
d

Y
i
e
l
d

Term to Maturity
18
1
Impact of Long-Term Financing Decisions
on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Parents long-term financing decision
18
2
Chapter Review
Comparing Bond Denomination Alternatives
- Use of Exchange Rate Probabilities
- Use of Simulation
Financing with Floating-Rate Eurobonds
Exchange Rate Risk of Foreign Bonds
- Hedging Exchange Rate Risk
Long-Term Financing in Multiple Currencies
- Currency Cocktail Bonds
- Interest Rate Swaps
- Currency Swaps
Foreign Debt Maturity Decisions
Impact of Long-Term Financing Decisions on an MNCs Value
Part V
Short-Term Asset and Liability Management
Subsidiaries
of MNC with
Excess Funds
Subsidiaries
of MNC with
Deficient Funds
International
Commercial
Paper Market
Eurobanks in
Eurocurrency
Market
MNC
Parent
Deposits Purchase
Securities
Provision
of Loans
Provision
of Loans
Deposits
Purchase
Securities
Borrow
Funds
Borrow
Funds
Borrow
Funds
Borrow
Funds
Borrow Funds Borrow Funds
CHAPTER 19
Financing International Trade
18
5
Chapter Objectives
To describe the methods of payment for international trade;
To explain common trade finance methods; and
To describe the major agencies that facilitate international trade with export
insurance and/or loan programs.
Payment Methods for International Trade
In any international trade transaction, credit is provided by either
- the supplier (exporter),
- the buyer (importer),
- one or more financial institutions, or
- any combination of the above.
The form of credit whereby the supplier funds the entire trade cycle is known
as supplier credit.
Method 1 : Prepayments
Time of payment : Before shipment
Goods available to buyers : After payment
Risk to exporter : None
Risk to importer : Relies completely on
exporter to ship goods as
ordered
18
6
Method 2 : Letters of credit (L/C)
These are issued by a bank on behalf of the importer promising to pay the exporter upon presentation
of the shipping documents.
Time of payment : When shipment is made
Risk to exporter : Very little or none
Risk to importer : Relies on exporter to ship
goods as described in documents
Method 3a : Sight Drafts (bills of exchange) or
Documents against payments
These are unconditional promises drawn by the exporter instructing the buyer to pay
the face amount of the drafts.
Time of payment : On presentation of draft
Risk to exporter : If draft is unpaid, must
dispose of goods
goods as described
Method 3b : Time Drafts (bills of exchange) or
Documents against acceptance
Most transactions handled on a draft basis are processed through banking channels.
Time of payment : On maturity of draft
Goods available to buyers : Before payment
Risk to exporter : Relies on buyer to pay drafts
goods as described in documents
18
7
Method 4 : Consignments
The exporter ships the goods to the importer while still retaining actual title to the
merchandise.
Time of payment : At time of sale by buyer
Risk to exporter : Allows importer to sell
inventory before paying exporter
Risk to importer : None
Method 5 : Open accounts
The exporter ships the merchandise and expects the buyer to remit payment according
to the agreed-upon terms.
Time of payment : As agreed upon
Risk to exporter : Relies completely on buyer to
pay account as agreed upon
Risk to importer : None
Trade Finance Methods
Banks play a critical role in financing trade :
Accounts Receivable Financing
- The banks loan to the exporter is secured by an assignment of the account receivable.
Factoring, especially cross-border factoring
- The exporting firm sells the accounts receivable to a third party known as a factor.
- The factor then assumes all administrative responsibilities involved in collecting from the
buyer and the associated credit exposure.
18
8
Documentary Credit Procedure
Importers
Bank
Importer Exporter
Correspondent
Bank
1. Sale Contract
2.
Request
for Credit
3. Send Credit
4.
Deliver
Letter of
Credit
5. Deliver Goods
6.
Present
Documents
7. Present Documents
8.
Documents
& Claim for
Payment
9. Payment
Letters of Credit (L/C)
- The bank undertakes to make payments on behalf of the buyer to the exporter upon presentation of the
required documents, which typically include a draft (sight or time), a commercial invoice, and a bill of lading.
- Sometimes, the exporter may request that a local bank confirm the L/C.
- Letters of credit are usually irrevocable.
- Variations include the standby L/C, the transferable L/C, and an assignment of proceeds under the L/C.
18
9
Life Cycle of a Typical Bankers Acceptance
Importers
Bank
1. Purchase Order
2. Apply
for L/C
10. Sign
Promissory
Note to Pay
14. Pay
Face Value
of B/A
7. Shipping Documents &
Time Draft
5. Ship Goods
6.
Shipping
Documents
& Time
Draft
11.
Shipping
Documents
Exporters
Bank
Importer Exporter
4. L/C
Notification
9. Pay
Discounted
Value of
B/A
3. L/C
8. Pay Discounted Value of B/A
Money Market
Investor
12. B/A
16. Pay Face Value of B/A
13. Pay Discounted Value of B/A
15. Present B/A at Maturity
1 - 7 : Prior to B/A
8 -13 : When B/A
is created
14-16 : When B/A
matures
Bankers Acceptance (B/A)
- This is a time draft, drawn on and accepted by a bank. The accepting bank is obliged to pay
the holder of the draft at maturity.
- The exporter does not need to worry about the credit risk of the importer. In addition, there is
little exposure to political risk or to exchange controls imposed by governments.
- A B/A allows an exporter to receive funds immediately, while yet allowing an importer to delay
its payment until a future date.
19
0
Working Capital Financing
- This bank loan finances the working capital cycle that begins with the purchase of inventory
and continues until the eventual conversion to cash.
- Medium-Term Capital Goods Financing (Forfaiting)
- The importer issues a promissory note to pay for its imported capital goods. The exporter then
sells the note to a forfaiting bank, which then assumes total responsibility for the note.
Countertrade
- This denotes all types of foreign trade transactions in which the sale of goods to one country
is linked to the purchase or exchange of goods from that same country.
- Examples of countertrade include barter, compensation, and counterpurchase.
- The primary participants are governments and multinationals, with assistance provided by
specialists.
Agencies that Motivate International Trade
Due to the inherent risks of international trade, insurance against the various
forms of risk is desirable.
The Export-Import Bank is an agency of the U.S. government that aims to
finance and facilitate the export of U.S. goods and services and maintain the
competitiveness of U.S. companies in overseas markets.
The Eximbank offers guarantees, loans, bank insurance, and export credit
insurance.
The Private Export Funding Corporation (PEFCO) is owned by a U.S.
consortium of commercial banks and industrial firms.
- It provides medium- and long-term financing for foreign buyers.
The Overseas Private Investment Corporation (OPIC) is an U.S. federal
agency responsible for insuring direct U.S. investments in foreign countries
against the risks of currency inconvertibility, expropriation, and other political
risks.
19
1
Impact of International Trade Financing
on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Trade financing decisions
19
2
Chapter Review
- Prepayments
- Letters of Credit
- Sight Drafts and Time Drafts
- Consignments
- Open Accounts
- Accounts Receivable Financing
- Factoring
- Letters of Credit
- Bankers Acceptances
- Working Capital Financing
- Medium-Term Capital Goods Financing (Forfaiting)
- Countertrade
- Export-Import Bank of the U.S.
- Private Export Funding Corporation
- Overseas Private Investment Corporation
Impact of International Trade Financing on an MNCs Value
CHAPTER 20
Short-Term Financing
19
4
Chapter Objectives
To explain why MNCs consider foreign financing;
To explain how MNCs determine whether to use foreign financing; and
To illustrate the possible benefits of financing with a portfolio of currencies.
Sources of Short-Term Financing
Euronotes are unsecured debt securities with typical maturities of 1, 3 or 6
months. They are underwritten by commercial banks.
MNCs may also issue Euro-commercial papers to obtain short-term
financing.
MNCs typically utilize direct Eurobank loans to maintain their relationships
with Eurobanks too.
Internal Financing by MNCs
Before an MNCs parent or subsidiary searches for outside funding, it should
determine if any internal funds are available.
Parents of MNCs may also raise funds by increasing their markups on the
supplies that they send to their subsidiaries.
Why MNCs Consider Foreign Financing
An MNC may finance in a foreign currency to offset a net receivables
position in that foreign currency.
The cost of financing may vary with the currency borrowed in the
Eurocurrency market. A Eurocurrency loan may also offer a slightly lower
rate than a loan in the same currency through the home country.
19
5
Determining the Effective Financing Rate
The actual cost of financing is dependent on
1 the interest rate on the loan, and
2 the movement in the borrowed currencys value over the life of the loan.
Effective financing rate = ( 1+ i
f
) ( 1+ e
f
) - 1
where i
f

= interest rate on the loan
e
f
= % A in the currencys spot rate
Criteria Considered for Foreign Financing
There are various criteria an MNC must consider in its financing decision,
including
- interest rate parity,
- the forward rate as a forecast, and
- exchange rate forecasts.
If interest rate parity exists, foreign financing with a simultaneous hedge of
that position in the forward market will result in financing costs similar to
those for domestic financing.
19
6
Implications of IRP for Financing
IRP
holds?
Financing
costs*
Type of
financing
Forward rate accurately
predicts future spot rate
Forward rate over-
estimates future spot rate
Forward rate under-
estimates future spot rate
Forward premium(discount)
exceeds (is less than)
interest rate differential
Forward premium (discount)
is less than (exceeds)
* as compared to the financing costs for domestic financing
Scenario
Yes Covered Similar
Yes Uncovered
Similar
Yes Uncovered Lower
Yes Uncovered Higher
No Covered Higher
No Covered Lower
19
7
If the forward rate is an unbiased predictor of the future spot rate, then the
effective financing rate of a foreign currency will on average be equal to the
domestic financing rate.
Exchange rate forecasts will also assist the firm in its financing decision.
Sometimes, it may be useful to develop a probability distribution, instead of
relying on a single point estimate.
Financing with a Portfolio of Currencies
While foreign financing can result in lower financing costs, the variance in
the costs is higher.
MNCs may be able to achieve lower financing costs without excessive risk
by financing with a portfolio of currencies.
This is so because if the chosen currencies are not highly correlated, they
are not likely to appreciate simultaneously to offset the advantage given by
their low interest rates.
A firm that repeatedly finances in a currency portfolio will normally prefer to
compose a financing package that exhibits a somewhat predictable effective
financing rate.
The portfolio variance can measure how volatile the portfolios effective
financing rate is.
Hence, MNCs can use historical variability to compare various financing
packages.
19
8
Impact of Short-Term Financing Decisions
on an MNCs Value
E (CF
j,t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Expenses incurred from
short-term financing
19
9
Chapter Review
Sources of Short-Term Financing
Internal Financing by MNCs
Why MNCs Consider Foreign Financing
- Foreign Financing to Offset Foreign Receivables
- Foreign Financing to Reduce Costs
Determining the Effective Financing Rate
Chapter Review
- Interest Rate Parity
- The Forward Rate as a Forecast
- Exchange Rate Forecasts
- Portfolio Diversification Effects
- Repeated Financing with a Currency Portfolio
Impact of Short-Term Financing Decisions on an MNCs Value
CHAPTER 21
International Cash Management
20
1
Chapter Objectives
To explain the difference between a subsidiary perspective and a parent
perspective in analyzing cash flows;
To explain the various techniques used to optimize cash flows;
To explain common complications in optimizing cash flows; and
To explain the potential benefits and risks of foreign investments.
Cash Flow Analysis:
Subsidiary Perspective
The management of working capital has a direct influence on the amount
and timing of cash flow :
- inventory management
- accounts receivable management
- cash management
- liquidity management
Centralized Cash Flow Management
While each subsidiary is managing its working capital, there is a need to
monitor and manage the cash flows between the parent and its subsidiaries.
This task of international cash management should be delegated to a
centralized cash management group, and can be segmented into two
functions:
optimizing cash flow movements, and
- investing excess cash.
20
2
Cash Flow of the Overall MNC

Subsidiary
Short-Term
Securities
Long-Term
Projects

Parent
Cash Dividends
Sources
of Debt
Stock-
holders

Subsidiary
Funds for
Supplies
Interest &/or Principal
Loans or Investment
Fees & Earnings
Excess Cash
Fees & Earnings
Excess Cash
Interest &/or Principal
Loans or Investment
Purchase
Sale
Long-Term
Investment
Return on
Investment
Loans
Repayment
New Issues
20
3
Techniques to Optimize Cash Flows
1. Accelerating Cash Inflows
The more quickly the inflows are received, the more quickly they can be
invested or used for other purposes.
Common methods include the establishment of lockboxes around the world
and preauthorized payments.
2. Minimizing Currency Conversion Costs
Netting is the accounting of all transactions over a period to determine one
net payment.
A bilateral netting system involves transactions between two units, such as
between a parent and its subsidiary, or between two subsidiaries.
A multilateral netting system usually involves more complex interchanges
among the parent and several subsidiaries.
3. Managing Blocked Funds
A government may require funds to remain within the country in order to
create jobs and reduce unemployment.
To deal with funds blockage, the MNC may reinvest the excess funds in the
host country, adjust the transfer pricing policy, borrow locally to finance
operations, or find a use for the funds within the host country.
20
4
4. Managing Intersubsidiary Cash Transfers
Proper cash flow management can also be beneficial to a subsidiary in need
of funds.
For example, a subsidiary with excess funds can provide financing by paying
for its supplies earlier than is necessary. This is called leading.
Alternatively, a subsidiary in need of funds can be allowed to lag its
payments. This is called lagging.
Complications in Optimizing Cash Flows
Company-Related Characteristics
- When a subsidiary delays its payments to the other subsidiaries, the other subsidiaries may
be forced to borrow until the payments arrive.
- Government restrictions
- Some governments may prohibit the use of a netting system, or periodically prevent cash
from leaving the country.
Characteristics of Banking Systems
- The abilities of banks to facilitate cash transfers for MNCs may vary among countries.
Investing Excess Cash
Should the excess cash of all subsidiaries remain separated or should they
be pooled together?
Centralized cash management allows for more efficient usage of funds and
possibly higher returns.
However, the pooling and matching of funds may result in excessive
transaction costs, especially when the subsidiaries are transacting in
different currencies.
20
5
How can the MNC determine the effective yield expected from each
alternative?
The effective yield for foreign deposits is
quoted % A in the
( 1 + interest )( 1 + the currency ) 1
rate value
The above relation can be similarly applied to other short-term foreign
investments.
What does interest rate parity (IRP) suggest about short-term investing?
A foreign currency with a high interest rate will normally exhibit a forward
discount that reflects the differential between its interest rate and the
investors home interest rate.
However, even if IRP holds, short-term foreign investing on an uncovered
basis may result in a higher effective yield than domestic investing.
How can the forward rate be used to evaluate the short-term investment
decision?
If IRP exists, the forward rate can be used as a break-even point to assess
the short-term investment decision.
The effective yield is higher if the spot rate at maturity is more than the
forward rate at the time the investment is undertaken, and vice versa.
20
6
Use of the Forward Rate as a Forecast
IRP
holds?
Financing
costs*
Type of
financing
Forward rate accurately
predicts future spot
rate
Forward rate over-
estimates future spot
rate
Forward rate under-
estimates future spot
rate
Forward
premium(discount)
exceeds (is less than)
Forward premium
(discount)
is less than (exceeds)
* as compared to the financing costs for domestic financing
Scenario
Yes Covered Similar
Yes Uncovere
d
Similar
Yes
Uncovered Lower
Yes Uncovered Higher
No Covered Higher
No Covered Lower
Forward rate forecasts
future spot rate with no
bias
Yes Uncovered
Similar on
average
20
7
How can forecasted exchange rates influence the short-term investment
decision?
Given an exchange rate forecast, the effective yield can be forecasted, and
then compared with the yield on a local currency deposit.
By rearranging terms, the exchange rate percentage change that equates
foreign and domestic yields can also be computed.
At times, it may be useful to use a probability distribution instead of a single
prediction.
Is it worthwhile to diversify investments among currencies?
If an MNC is not sure how exchange rates will change over time, it may
prefer to diversify its cash among securities with different currency
denominations.
The degree to which such a portfolio will reduce risk depends on the
correlations among the currencies.
Some banks offer dynamic hedging for firms that invest in short-term
securities denominated in foreign currencies.
Dynamic hedging reflects periodic hedging by the bank : hedges are applied
when the currencies held are expected to depreciate and removed when
they are expected to appreciate.
The overall performance is dependent on the managers ability to forecast
the direction of exchange rate movements.
20
8
Impact of Direct Foreign Investment
E (CF
j,t
by the U.S. parent in period t
E (ER
j,t
( ) ( )
( )
Value =
E CF E ER
, ,
=
j t j t
j
m
t
t
n
k
=1
1
1
Returns on International
Cash Management
20
9
Chapter Review
Cash Flow Analysis: Subsidiary Perspective
Centralized Cash Management
- Accelerating Cash Inflows
- Minimizing Currency Conversion Costs
- Managing Blocked Funds
- Managing Intersubsidiary Cash Transfers
Chapter Review
- Company-Related Characteristics
- Government Restrictions
- Characteristics of Banking Systems
Chapter Review
- Centralized Cash Management
- Determining the Effective Yield
- Implications of Interest Rate Parity
- Use of the Forward Rate as a Forecast
- Use of Exchange Rate Forecasts
- Diversifying Cash Across Currencies
- Using Dynamic Hedging to Hedge Investments
Impact of International Cash Management on an MNCs Value

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