# International Finance: Revision Lecture Lectures 10 & 11 Dr Michael Dowling.

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International Finance: Revision Lecture Lectures 10 & 11 Dr Michael Dowling

Disclaimers These revision notes don’t necessarily cover everything that will be on the exam Please don’t assume that essay and computation parts will be linked in exam questions

Exam Structure Total of 6 questions on examHave two hours to answer 4 questions 1 pure essay question, 5 mixture essay and computation

Part 1 Introduction to International Finance Currencies Financing Exchange Rates Foreign Exchange Market Financing of Operations International Cost of Capital

1. Introduction to International Finance Essay Question Discuss four broad different types of multinational enterprises and their different international financial management perspectives and needs Raw materials seekers Market seekers Cost minimizers Knowledge seekers Political safety seekers

2. Currencies (1) Essay Questions Ricardo’s theory of comparative advantage illustrates some of the advantages of international trade. Briefly describe the model Discuss the advantages and disadvantages of the following exchange rate systems using historical or current examples to illustrate the analysis. Gold Standard Flexible exchange rates with Independent Float Flexible exchange rates with Managed Float Briefly discuss some of the benefits and problems associated with a currency monetary union, with particular application to the euro The on-going Eurozone crisis could be said to illustrate some of the practical problems with currency monetary unions. Briefly discuss some of the problems with implementing effective currency monetary unions, using examples from the current Eurozone crisis.

2. Currencies (2) Calculation Questions Spot rates: direct / indirect quotes Cross exchange rates Triangular arbitrage

Cross-rate transactions… Bank Quotations American TermsEuropean Terms BidAskBidAsk British Pounds 1.90721.90770.52420.5243 Euros 1.31081.31120.76270.7629 All rates are in terms of USD. A bank customer wants to sell €1,500,000 for sterling, how much will they receive?

Solution 1. Sell \$ (i.e. buy € from customer) at \$1.3108 = \$1,966,200 2. Buy \$ (i.e. sell £ to customer) at €0.5242 = £1,030,682 3. Effective exchange rate = £1,030,682/€1,500,000 = £0.6871/€1

A Triangular Arbitrage Opportunity

Solution (1)

Solution (2) StepSelltoRateReceive 1 \$5,000,000BAR£2,649,428 2 CAG€3,839,021 3 CL\$5,033,461 Profit = \$33,461

3. Financing (1) Essay Questions Discuss the advantages and disadvantages for a multinational firm of having a centralised cash depositary International financing offers a company lower cost of capital and greater access to capital. Discuss Cost of capital is known to differ across countries. Discuss some of the evidence on this, and present some possible reasons for these differences. What approaches can a firm adopt to lower their cost of capital if their domestic cost of capital is reducing their investment opportunity set?

3. Financing (2) Calculation Questions Netting Calculating WACC

Netting… ReceiptsUSCanadaGermanyUK US -104020 Canada 30-2510 Germany 2045-50 UK 60 40- - No netting - Bilateral netting - Multilateral netting (assume 1% transaction cost) Precautionary cash with / without centralised cash

Calculating WACC…  Risk-free rate  Beta / market return  Debt – yield vs interest rate  Tax rate

Part 2 Risk management Foreign exchange Economic exposure Country risk

4. Foreign Exchange Risk Management (1) Essay Questions Discuss the use of forwards and options to hedge transaction exposure, including the benefits and drawbacks of using each method Should firms hedge their foreign currency exposures?

4. Foreign Exchange Risk Management (2) Calculation Questions The use of forwards, options and money market hedges in forex risk management

Hedging when we have to pay money in a foreign currency US-based Boeing agree to buy a Rolls Royce jet engine for £5 million payable in one year US interest rate6.00% per annum UK interest rate6.50% per annum Spot exchange rate\$1.80/£ Forward exchange rate\$1.75/£ (1 year maturity) To calculate: -Forward market hedge -Money market hedge -Option market hedge (assume \$1.80/£ call options cost \$0.018 per pound)

Forward Market Hedge  Boeing buys its foreign currency payables forward to eliminate its exchange risk exposure  Boeing buys forward its £5m payable in exchange for a given amount of dollars  On maturity date of contract, Boeing will pay the £5m due to BA for a cost of \$8.75m (\$1.75 x 5 million)  Forward ensures that a certain amount of dollars will have to be paid

Money Market Hedge  Hedging by lending and borrowing in the domestic and foreign money markets  Firm lends in foreign currency to hedge its foreign currency payables, thus matching its assets and liabilities in the same currency  If the implied interest rate in the forward contract is the same as the actual interest rates in the two countries, then there will be no difference in amount received under money market and forward hedging

Step-by-step money market hedging Step 1 Buy sterling now with US dollars to match the present value of foreign currency payable = £4,694,836 (£5,000,000/1.065)x(\$1.80/£) = \$8,450,705 Step 2 Invest £4,694,836 at UK interest rate of 6.5%. Step 3 Pay £5m to Rolls Royce from the UK savings which is now worth £5m Cost Future value cost of hedge is US dollar amount x US interest rate i.e. \$8,957,747 (= \$8,450,705*1.06) Forward hedge preferred as cheaper

Options Market Hedge  Forward and money market hedges completely eliminate exchange exposure; however this then removes the opportunity to benefit from favourable exchange rate movements  It also commits us to the exchange, which might not always be appropriate  Options provide more flexibility in our hedging, as well as allowing us to benefit from favourable forex movements

Applying this to Boeing

Another example Princess Cruise Company (PCC) purchased a ship from Mitsubishi for 500 million yen payable in one year. The current spot rate is Y124/\$ and the one-year forward rate is 110/\$. The annual interest rate is 5 percent in Japan and 8 percent in the United States. PCC can also buy a one-year call option on yen at the strike price of \$0.0081 per yen for a premium of 0.014 cents per yen.

5. Economic Exposure Risk Management (1) Essay Questions Discuss some possible approaches to managing operating risk in the multinational enterprise. Give examples to illustrate the analysis What approaches can a firm adopt to optimally manage their economic exposure from international trade?

5. Economic Exposure Risk Management (2) Calculation Questions Calculate operating exposure and how to minimise using forward hedging

A British venture capitalist… … holding a major stake in a social media start- up in Silicon Valley. As a British resident he is concerned with the pound value of the US equity investment. Assume that if US economy booms in the future the equity stake will be worth \$1m and the exchange rate will be \$1.40/£. If US experiences a recession the stake will be worth \$0.5m and exchange rate will be \$1.60/£. Probability of boom is 70 percent and recession is 0.30 percent

OutcomeProbabilityP*SSP 1 0.7\$1,000,000\$1.40£714,286 2 0.3\$500,000\$1.60£312,500

Computation of beta SP = (0.7 x £714,286) + (0.3 x £312,500) = £593,750 S = (0.7 / 1.4) + (0.3 / 1.6) = £0.688/\$ Var (S)= [0.7 x (0.714 – 0.688) 2 ]+ [0.3 x (0.625 – 0.688) 2 ]= 0.00166 Cov (SP) = [0.7 x (714286-593750)(0.714- 0.688)] +[0.3 x (312500- 593750)(0.625-0.688)] = 7535 β = 7535/0.00166 = \$4,539,156

Hedging this exposure

6. Country Risk Management Essay Questions What are the important factors to consider in evaluating the political risk associated with making a foreign direct investment in a foreign country? What operational and financial measures can a multinational corporation take to minimize the political risk associated with FDI? Why do firms invest overseas? Discuss and evaluate some of the motivators and factors in the decision to invest outside of the firm’s home country. Illustrate your answer with relevant modern examples.

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