CH8 & 9: International Finance in Multinational Corporations

I. International Monetary System It refers to the global network of governmental and commercial institutions within which currency exchange rates are determined.

I-1. Gold Standard The monetary arrangement that emerged in response to this demand came to be called the Gold Standard. It was an arrangement that evolved naturally rather than a system established by formal agreements among nations.

I-2. Gold Exchange Standard The Bretton Woods agreement adopted a fixed exchange-rate system called the gold exchange standard. Member governments agreed to fix the value of their currencies in terms of gold but were not required to exchange their currencies for gold. The US $ was the exception. It remained convertible into gold at the fixed rate of $35 an ounce.

I-3. Breakdown of the Fixed Exchange- Rate System

I-4. Pegged (fixed rate) System An exchange rate system in which government are willing to both buy and sell currency only at an official exchange rate that is pegged to another currency or currency basket.

I-4. Pegged (fixed rate) System Advantages: If the system can be maintained, residents face less exchange rate risk and trade will flourish. Disadvantages: The absence of exchange rate risk can be an illusion – when exchange rate changes (devaluations or revaluations) come they are huge.

I-5. Limited Flexible System Currencies exhibit limited flexibility with respect to a single currency (such as the US dollar) or to a basket of currencies (such as the ECU).

I-5. Limited Flexible System Advantages: Allow governments to implement broad policy objectives within a relatively flexible exchange rate system; attempts to combine the benefits of a fixed rate system with enough flexibility to make the system manageable. Disadvantages: There is still a chance that the currency will undergo a significant change in value or fall out of exchange rate system.

I-5. More Flexible (floating rate) System Foreign exchange rates are allowed to fluctuate according to market supply and demand without direct interference by monetary or fiscal authorities.

I-5. More Flexible (floating rate) System Advantages: Countries are at least partially insulates from unemployment and inflation in other countries. Disadvantages: Exchange rates change continuously, making it difficult to know how much a future payment or receipt in a foreign currency will be worth in the domestic currency.

II. Functions of the Foreign Exchange Market 1. Transfer of Purchasing Power: Transfer of purchasing power is necessary because international trade and capital transactions normally involve parties living in countries with different national currencies.

II. Functions 2. Provision of Credit: Since the movement of goods between countries takes a time, a means must be devised to finance inventory in transit. The foreign exchange market provides a third source of credit. Specialized instruments, such as bankers’ acceptance and letters of credit, are available to finance trade.

II. Functions 3. Minimizing Foreign Exchange Risk: When time elapses between a transaction and payment, a risk exists that the exchange values of the national currencies may fluctuate. The foreign exchange market provides “hedging” facilities for the transferring the foreign exchange risk to someone else.

III. Types of Foreign Exchange Exposure 1. Operating Exposure: It measures the change in the present value of the firm that results from changes in future operating cash flows caused by an unexpected change in exchange rate.

III. Types of Foreign Exchange Exposure 2. Transaction Exposure: It measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until the exchange rates change.

III. Types of Foreign Exchange Exposure 3. Accounting Exposure It measures potential accounting-derived changes in owners’ equity that result from the need to translate foreign currency financial statements of affiliates into a single reporting currency in order to prepare worldwide consolidated financial statements.

IV. Why do MNEs need to forecast Foreign Exchange Rates? 1. Accounts Payable and Receivable 2. International Price 3. Working Capital Management 4.International Investment Analysis

V. Forecasting Foreign Exchange Rates 1. Price and Exchange Rates 1) Purchasing Power Parity (The law of one price): In the absence of market friction such as transaction costs or other barriers to trade, two identical assets must have the same price wherever they are bought or sold.

If PPP does not hold, then there is an opportunity to simultaneously buy an asset at a low price and sell an identical asset at a high price and lock in an arbitrage profits. In the spot exchange market the law of one price implies that the spot exchange rate between a domestic and a foreign currency is determined by the current price of an asset in the domestic currency relative to the price of that same asset in the foreign currency.

2. Interest Rates and Exchange Rates 1) Interest Rate Parity (IRP): The law of one price requires that the relation between forward and spot exchange rates be determined by the nominal interest rate differential between the two countries. 2) Covered Interest Arbitrage (CIA): It is the profit- seeking activity that forces interest rate parity to hold.

VI. The 5 steps of a Currency Risk Management Program 1. Identify those currencies to which the firm is exposed: 3 exposures. 2. Estimate the firm’s sensitivity to changes in these currency values. 1) Market-based measures of economic exposure 2) An insider’s view of currency risk exposure

3. Decide whether to hedge currency exposures in accordance with the firm’s overall risk management policy. 1) Technical Analysis 2) Fundamental Analysis 3) Passive Approach 4) Active Approach

4. Select an appropriate hedging instrument or hedging strategy. 1) Hedging the currency risk exposures of individual operating units 2) Managing transaction exposure to currency risk 3) Managing operating exposure to currency risk 5. Monitor the firm’s evolving exposures and revisit the above steps as necessary