International Financial Management 7th Edition by Jeff Madura Florida Atlantic University PowerPoint® Presentation by Yee-Tien Fu National Cheng-Chi University Taipei, Taiwan South-Western/Thomson Learning © 2003

Part I The International Financial Environment Multinational Corporation (MNC) Foreign Exchange Markets Dividend Remittance & Financing Exporting & Importing Investing & Financing Product Markets Subsidiaries International Financial Markets

Multinational Financial Management: An Overview 1 Chapter Multinational Financial Management: An Overview South-Western/Thomson Learning © 2003

Chapter Objectives To identify the main goal of the multinational corporation (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. We will focus on MNCs that are based in the United States and that wholly own their foreign subsidiaries.

Conflicts Against the MNC Goal 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. The sheer size of the MNC. The scattering of distant subsidiaries. The culture of foreign managers. Subsidiary value versus overall MNC value.

Impact of Management Control The magnitude of agency costs can vary with the management style of the MNC. A centralized management style reduces agency costs. However, a decentralized style gives more control to those managers who are closer to the subsidiary’s operations and environment.

Impact of Management Control Some MNCs attempt to strike a balance - they allow subsidiary managers to make the key decisions for their respective operations, but the decisions are monitored by the parent’s management.

Impact of Management Control Electronic networks make it easier for the parent to monitor the actions and performance of foreign subsidiaries. For example, corporate intranet or internet email facilitates communication. Financial reports and other documents can be sent electronically too.

Impact of Corporate Control Various forms of corporate control can reduce agency costs. Stock compensation for board members and executives. The threat of a hostile takeover. Monitoring and intervention by large shareholders.

Constraints Interfering with the MNC’s Goal As MNC managers attempt to maximize their firm’s value, they may be confronted with various constraints. Environmental constraints. Regulatory constraints. 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.”

Theories of International Business Why are firms motivated to expand their business internationally? Product Cycle Theory As a firm matures, it may recognize additional opportunities outside its home country.

International Business Methods There are several methods by which firms can conduct international business. International trade is a relatively conservative approach involving exporting and/or importing. The internet facilitates international trade by enabling firms to advertise and manage orders through their websites.

International Business Methods Licensing allows a firm to provide its technology in exchange for fees or some other benefits. Franchising obligates a firm to provide a specialized sales or service strategy, support assistance, and possibly an initial investment in the franchise in exchange for periodic fees.

International Business Methods Firms may also penetrate foreign markets by engaging in a joint venture (joint ownership and operation) with firms that reside in those markets. Acquisitions of existing operations in foreign countries allow firms to quickly gain control over foreign operations as well as a share of the foreign market.

International Business Methods Firms can also penetrate foreign markets by establishing new foreign subsidiaries. In general, any method of conducting business that requires a direct investment in foreign operations is referred to as a direct foreign investment (DFI). The optimal international business method may depend on the characteristics of the MNC.

International Opportunities Investment opportunities - The marginal return on projects for an MNC is above that of a purely domestic firm because of the expanded opportunity set of possible projects from which to select. Financing opportunities - An MNC is also able to obtain capital funding at a lower cost due to its larger opportunity set of funding sources around the world.

International Opportunities Opportunities in Europe The Single European Act of 1987. The removal of the Berlin Wall in 1989. The inception of the euro in 1999. Opportunities in Latin America The North American Free Trade Agreement (NAFTA) of 1993. The General Agreement on Tariffs and Trade (GATT) accord.

International Opportunities Opportunities in Asia The reduction of investment restrictions by many Asian countries during the 1990s. China’s potential for growth. The Asian economic crisis in 1997-1998.

Exposure to International Risk International business usually increases an MNC’s exposure to: exchange rate movements Exchange rate fluctuations affect cash flows and foreign demand. foreign economies Economic conditions affect demand. political risk Political actions affect cash flows.

Managing for Value Like domestic projects, foreign projects involve an investment decision and a financing decision. When managers make multinational finance decisions that maximize the overall present value of future cash flows, they maximize the firm’s value, and hence shareholder wealth.

Valuation Model for an MNC Domestic Model 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

Valuation Model for an MNC Valuing International Cash Flows E (CFj,t ) = expected cash flows denominated in currency j to be received by the U.S. parent at the end of period t E (ERj,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

Valuation Model for an MNC An MNC’s financial decisions include how much business to conduct in each country and how much financing to obtain in each currency. Its financial decisions determine its exposure to the international environment.

Valuation Model for an MNC Impact of New International Opportunities on an MNC’s Value Exchange Rate Risk Political Risk Exposure to Foreign Economies

Chapter Review Goal of the MNC Conflicts Against the MNC Goal Impact of Management Control Impact of Corporate Control Constraints Interfering with the MNC’s Goal Theories of International Business Theory of Comparative Advantage Imperfect Markets Theory Product Cycle Theory

Chapter Review International Business Methods International Trade Licensing Franchising Joint Ventures Acquisitions of Existing Operations Establishing New Foreign Subsidiaries

Chapter Review International Opportunities Investment Opportunities Financing Opportunities Opportunities in Europe Opportunities in Latin America Opportunities in Asia

Chapter Review Exposure to International Risk Exposure to Exchange Rate Movements Exposure to Foreign Economies Exposure to Political Risk Managing for Value

Chapter Review Valuation Model for an MNC Domestic Model Valuing International Cash Flows Impact of Financial Management and International Conditions on Value

International Flow of Funds 2 Chapter International Flow of Funds South-Western/Thomson Learning © 2003

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. Each transaction is recorded as both a credit and a debit, i.e. double-entry bookkeeping. The transactions are presented in three groups – a current account, a capital account, and a financial account.

Balance of Payments The current account summarizes the flow of funds between one specified country and all other countries due to the purchases of goods or services, the provision of income on financial assets, or unilateral current transfers (e.g. government grants and pensions, private remittances). A current account deficit suggests a greater outflow of funds from the specified country for its current transactions.

Balance of Payments The current account is commonly used to assess the balance of trade, which is simply the difference between merchandise exports and merchandise imports.

Balance of Payments The new capital account (as defined in the 1993 System of National Accounts and the fifth edition of IMF’s Balance of Payments Manual) is adopted by the U.S. in 1999. It includes unilateral current transfers that are really shifts in assets, not current income. E.g. debt forgiveness, transfers by immigrants, the sale or purchase of rights to natural resources or patents.

Balance of Payments The financial account (which was called the capital account previously) summarizes the flow of funds resulting from the sale of assets between one specified country and all other countries. Assets include official reserves, other government assets, direct foreign investments, investments in securities, etc.

International Trade Flows Different countries rely on trade to different extents. The trade volume of European countries is typically between 30 – 40% of their respective GDP, while the trade volume of U.S. and Japan is typically between 10 – 20% of their respective GDP. Nevertheless, the volume of trade has grown over time for most countries.

International Trade Flows In 1975, the U.S. exported $107.1 billions in goods, and imported $98.2 billions. Since then, international trade has grown, with U.S. exports and imports of goods valued at $773.3 and $1,222.8 billions respectively for the year of 2000. Since 1976, the value of U.S. imports has exceeded the value of U.S. exports, causing a balance of trade deficit.

International Trade Flows Recent Changes in North American Trade In 1998, a 1989 free trade pact between U.S. and Canada was fully phased in. Passed in 1993, the North American Free Trade Agreement (NAFTA) removes numerous trade restrictions among Canada, Mexico, and the U.S. In 2001, trade negotiations were initiated for a free trade area of the Americas. 34 countries are involved.

International Trade Flows Recent Changes in European Trade The Single European Act of 1987 was implemented to remove explicit and implicit trade barriers among European countries. Consumers in Eastern Europe now have more freedom to purchase imported goods. The single currency system implemented in 1999 eliminated the need to convert currencies among participating countries.

International Trade Flows 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. Other trade agreements include: Association of Southeast Asian Nations European Community Central American Common Market North American Free Trade Agreement

International Trade Flows Friction Surrounding Trade Agreements Trade agreements are sometimes broken when one country is harmed by another country’s actions. 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.

Factors Affecting International Trade Flows Inflation A relative increase in a country’s inflation rate will decrease its current account, as imports increase and exports decrease. National Income A relative increase in a country’s income level will decrease its current account, as imports increase.

Factors Affecting International Trade Flows Government Restrictions A government may reduce its country’s imports by imposing tariffs on imported goods, or by enforcing a quota. Note that other countries may retaliate by imposing their own trade restrictions. Sometimes though, trade restrictions may be imposed on certain products for health and safety reasons.

Factors Affecting International Trade Flows Exchange Rates If a country’s currency begins to rise in value, its current account balance will decrease as imports increase and exports decrease. Note that the factors are interactive, such that their simultaneous influence on the balance of trade is a complex one.

Correcting A Balance of Trade Deficit By reconsidering the factors that affect the balance of trade, some common correction methods can be developed. For example, a floating exchange rate system may correct a trade imbalance automatically since the trade imbalance will affect the demand and supply of the currencies involved.

Correcting A Balance of Trade Deficit However, a weak home currency may not necessarily improve a trade deficit. Foreign companies may lower their prices to maintain their competitiveness. Some other currencies may weaken too. Many trade transactions are prearranged and cannot be adjusted immediately. This is known as the J-curve effect. The impact of exchange rate movements on intracompany trade is limited.

International Capital Flows Capital flows usually represent portfolio investment or direct foreign investment. The DFI positions inside and outside the U.S. have risen substantially over time, indicating increasing globalization. In particular, both DFI positions increased during periods of strong economic growth.

Factors Affecting DFI Changes in Restrictions New opportunities may arise from the removal of government barriers. Privatization DFI has also been stimulated by the selling of government operations. Potential Economic Growth Countries with higher 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 to invest their funds in a country when that country’s currency is expected to strengthen.

Factors Affecting International Portfolio Investment Tax Rates on Interest or Dividends Investors will normally prefer countries where the tax rates are relatively low. Interest Rates Money tends to flow to countries with high interest rates. Exchange Rates Foreign investors may be attracted if the local currency is expected to strengthen.

Agencies that Facilitate International Flows International Monetary Fund (IMF) The IM F is an organization of 183 member countries. Established in 1946, it aims to promote international monetary cooperation and exchange stability; to foster economic growth and high levels of employment; and to provide temporary financial assistance to help ease imbalances of payments.

Agencies that Facilitate International Flows International Monetary Fund (IMF) Its operations involve surveillance, and financial and technical assistance. In particular, its compensatory financing facility attempts to reduce the impact of export instability on country economies. The IM F uses a quota system, and its unit of account is the SDR (special drawing right).

Agencies that Facilitate International Flows International Monetary Fund (IMF) The weights assigned to the currencies in the SDR basket are as follows: Currency 2001 Revision 1996 Revision U.S. dollar 45 39 Euro 29 Deutsche mark 21 French franc 11 Japanese yen 15 18 Pound sterling 11 11

Agencies that Facilitate International Flows World Bank Group Established in 1944, the Group assists development with the primary focus of helping the poorest people and the poorest countries. It has 183 member countries, and is composed of five organizations - IBRD, IDA, IFC, MIGA and ICSID.

Agencies that Facilitate International Flows IBRD: International Bank for Reconstruction and Development Better known as the World Bank, the IBRD provides loans and development assistance to middle-income countries and creditworthy poorer countries. In particular, its structural adjustment loans are intended to enhance a country’s long-term economic growth.

Agencies that Facilitate International Flows IBRD: International Bank for Reconstruction and Development The IBRD is not a profit-maximizing organization. Nevertheless, it has earned a net income every year since 1948. It may spread its funds by entering into cofinancing agreements with official aid agencies, export credit agencies, as well as commercial banks.

Agencies that Facilitate International Flows IDA: International Development Association IDA was set up in 1960 as an agency that lends to the very poor developing nations on highly concessional terms. IDA lends only to those countries that lack the financial ability to borrow from IBRD. IBRD and IDA are run on the same lines, sharing the same staff, headquarters and project evaluation standards.

Agencies that Facilitate International Flows IFC: International Finance Corporation The IFC was set up in 1956 to promote sustainable private sector investment in developing countries, by financing private sector projects; helping to mobilize financing in the international financial markets; and providing advice and technical assistance to businesses and governments.

Agencies that Facilitate International Flows M IGA: Multilateral Investment Guarantee Agency The MIGA was created in 1988 to promote FDI in emerging economies, by offering political risk insurance to investors and lenders; and helping developing countries attract and retain private investment.

Agencies that Facilitate International Flows ICSID: International Centre for Settlement of Investment Disputes The ICSID was created in 1966 to facilitate the settlement of investment disputes between governments and foreign investors, thereby helping to promote increased flows of international investment.

Agencies that Facilitate International Flows World Trade Organization (WTO) Created in 1995, the WTO is the successor to the General Agreement on Tariffs and Trade (GATT). It deals with the global rules of trade between nations to ensure that trade flows smoothly, predictably and freely. At the heart of the WTO's multilateral trading system are its trade agreements.

Agencies that Facilitate International Flows World Trade Organization (WTO) Its functions include: administering WTO trade agreements; serving as a forum for trade negotiations; handling trade disputes; monitoring national trading policies; providing technical assistance and training for developing countries; and cooperating with other international groups.

Agencies that Facilitate International Flows Bank for International Settlements (BIS) Set up in 1930, the BIS is an international organization that fosters cooperation among central banks and other agencies in pursuit of monetary and financial stability. It is the “central banks’ central bank” and “lender of last resort.”

Agencies that Facilitate International Flows Bank for International Settlements (BIS) The BIS functions as: a forum for international monetary and financial cooperation; a bank for central banks; a center for monetary and economic research; and an agent or trustee in connection with international financial operations.

Agencies that Facilitate International Flows Regional Development Agencies Agencies with more regional objectives relating to economic development include the Inter-American Development Bank; the Asian Development Bank; the African Development Bank; and the European Bank for Reconstruction and Development.

Impact of International Trade on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Exchange Rate Movements Inflation in Foreign Countries National Income in Foreign Countries Trade Agreements

Chapter Review Balance of Payments Current, Capital, and Financial Accounts International Trade Flows Recent Changes in North American and European Trade Trade Agreements Around the World

Chapter Review Factors Affecting International Trade Flows Inflation National Income Government Restrictions Exchange Rates Interaction of Factors

Chapter Review Correcting a Balance of Trade Deficit Why a Weak Home Currency is Not A Perfect Solution International Capital Flows Factors Affecting DFI Factors Affecting International Portfolio Investment

Chapter Review Agencies that Facilitate International Flows International Monetary Fund (IMF) World Bank Group World Trade Organization (WTO) Bank for International Settlements (BIS) Regional Development Agencies How International Trade Affects an MNC’s Value

International Financial Markets 3 Chapter International Financial Markets South-Western/Thomson Learning © 2003

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 The markets for real or financial assets are prevented from complete integration by barriers such as tax differentials, tariffs, quotas, labor immobility, communication costs, cultural differences, and financial reporting differences. Yet, these barriers can also create unique opportunities for specific geographic markets that will attract foreign investors.

Motives for Using International Financial Markets Investors invest in foreign markets: to take advantage of favorable economic conditions; when they expect foreign currencies to appreciate against their own; and to reap the benefits of international diversification.

Motives for Using International Financial Markets Creditors provide credit in foreign markets: to capitalize on higher foreign interest rates; when they expect foreign currencies to appreciate against their own; and to reap the benefits of international diversification.

Motives for Using International Financial Markets Borrowers borrow in foreign markets: to capitalize on lower foreign interest rates; and when they expect foreign currencies to depreciate against their own.

Foreign Exchange Market The foreign exchange market allows currencies to be exchanged in order to facilitate international trade or financial transactions. The system for establishing exchange rates has evolved over time. From 1876 to 1913, each currency was convertible into gold at a specified rate, as dictated by the gold standard.

Foreign Exchange Market This was followed by a period of instability, as World War I began and the Great Depression followed. The 1944 Bretton Woods Agreement called for fixed currency exchange rates. By 1971, the U.S. dollar appeared to be overvalued. The Smithsonian Agreement devalued the U.S. dollar and widened the boundaries for exchange rate fluctuations from ±1% to ±2%.

Foreign Exchange Market Even then, governments still had difficulties maintaining exchange rates within the stated boundaries. In 1973, the official boundaries for the more widely traded currencies were eliminated and the floating exchange rate system came into effect.

Foreign Exchange Transactions 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. The forward market enables an MNC to lock in the exchange rate at which it will buy or sell a certain quantity of currency on a specified future date.

Foreign Exchange Transactions Hundreds of banks facilitate foreign exchange transactions, though the top 20 handle about 50% of the transactions. At any point in time, arbitrage ensures that exchange rates are similar across banks. Trading between banks occurs in the interbank market. Within this market, foreign exchange brokerage firms sometimes act as middlemen.

Foreign Exchange Transactions The following attributes of banks are important to foreign exchange customers: competitiveness of quote special relationship between the bank and its customer speed of execution advice about current market conditions forecasting advice

Foreign Exchange Transactions Banks provide foreign exchange services for a fee: the bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) quote. This is the bid/ask spread. bid/ask % spread = ask rate – bid rate ask rate Example: Suppose bid price for £ = $1.52, ask price = $1.60. bid/ask % spread = (1.60–1.52)/1.60 = 5%

Foreign Exchange Transactions The bid/ask spread is normally larger for those currencies that are less frequently traded. The spread is also larger for “retail” transactions than for “wholesale” transactions between banks or large corporations.

Interpreting Foreign Exchange Quotations Exchange rate quotations for widely traded currencies are frequently listed in the news media on a daily basis. Forward rates may be quoted too. The quotations normally reflect the ask prices for large transactions.

Interpreting Foreign Exchange Quotations Direct quotations represent the value of a foreign currency in dollars, while indirect quotations represent the number of units of a foreign currency per dollar. Note that exchange rate quotations sometimes include IMF’s special drawing rights (SDRs). The same currency may also be used by more than one country.

Interpreting Foreign Exchange Quotations A cross exchange rate reflects the amount of one foreign currency per unit of another foreign currency. Value of 1 unit of currency A in units of currency B = value of currency A in $ value of currency B in $

Currency Futures and Options Market A currency futures contract specifies a standard volume of a particular currency to be exchanged on a specific settlement date. Unlike forward contracts however, futures contracts are sold on exchanges. Currency options contracts give the right to buy or sell a specific currency at a specific price within a specific period of time. They are sold on exchanges too.

$ Eurocurrency Market U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars. In the 1960s and 70s, the Eurodollar market, or what is now referred to as the Eurocurrency market, grew to accommodate increasing international business and to bypass stricter U.S. regulations on banks in the U.S.

$ Eurocurrency Market The Eurocurrency market is made up of several large banks called Eurobanks that accept deposits and provide loans in various currencies. For example, the Eurocurrency market has historically recycled the oil revenues (petrodollars) from oil-exporting (OPEC) countries to other countries.

$ Eurocurrency Market Although the Eurocurrency market focuses on large-volume transactions, there are times when no single bank is willing to lend the needed amount. A syndicate of Eurobanks may then be composed to underwrite the loans. Front-end management and commitment fees are usually charged for such syndicated Eurocurrency loans.

$ Eurocurrency Market The recent standardization of regulations around the world has promoted the globalization of the banking industry. In particular, the Single European Act has opened up the European banking industry. The 1988 Basel Accord signed by G-10 central banks outlined common capital standards, such as the structure of risk weights, for their banking industries.

$ 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 Loans of one year or longer are extended by Eurobanks to MNCs or government agencies in the Eurocredit market. These loans are known as Eurocredit loans. Floating rates are commonly used, since the banks’ asset and liability maturities may not match - Eurobanks accept short-term deposits but sometimes provide longer term loans.

Eurobond Market BONDS There are two types of international bonds. Bonds denominated in the currency of the country where they are placed but issued by borrowers foreign to the country are called foreign bonds or parallel bonds. Bonds that are sold in countries other than the country represented by the currency denominating them are called Eurobonds.

BONDS Eurobond Market The emergence of the Eurobond market is partially due to the 1963 Interest Equalization Tax imposed in the U.S. The tax discouraged U.S. investors from investing in foreign securities, so non-U.S. borrowers looked elsewhere for funds. Then in 1984, U.S. corporations were allowed to issue bearer bonds directly to non-U.S. investors, and the withholding tax on bond purchases was abolished.

BONDS Eurobond Market Eurobonds are underwritten by a multi-national syndicate of investment banks and simultaneously placed in many countries through second-stage, and in many cases, third-stage, underwriters. Eurobonds are usually issued in bearer form, pay annual coupons, may be convertible, may have variable rates, and typically have few protective covenants.

BONDS Eurobond Market Interest rates for each currency and credit conditions in the Eurobond market change constantly, causing the popularity of the market to vary among currencies. About 70% of the Eurobonds are denominated in the U.S. dollar. In the secondary market, the market makers are often the same underwriters who sell the primary issues.

Comparing Interest Rates Among Currencies Interest rates vary substantially for different countries, ranging from about 1% in Japan to about 60% in Russia. Interest rates are crucial because they affect the MNC’s cost of financing. The interest rate for a specific currency is determined by the demand for and supply of funds in that currency.

Comparing Interest Rates Among Currencies As the demand and supply schedules change over time for a specific currency, the equilibrium interest rate for that currency will also change. Note that the freedom to transfer funds across countries causes the demand and supply conditions for funds to be somewhat integrated, such that interest rate movements become integrated too.

International Stock Markets In addition to issuing stock locally, MNCs can also obtain funds by issuing stock in international markets. This will enhance the firm’s image and name recognition, and diversify the shareholder base. The stocks may also be more easily digested. Note that market competition should increase the efficiency of new issues.

International Stock Markets Stock issued in the U.S. by non-U.S. firms or governments are called Yankee stock offerings. Many of such recent stock offerings resulted from privatization programs in Latin America and Europe. Non-U.S. firms may also issue American depository receipts (ADRs), which are certificates representing bundles of stock. ADRs are less strictly regulated.

International Stock Markets The locations of the MNC’s operations can influence the decision about where to place stock, in view of the cash flows needed to cover dividend payments. Market characteristics are important too. Stock markets may differ in size, trading activity level, regulatory requirements, taxation rate, and proportion of individual versus institutional share ownership.

International Stock Markets Electronic communications networks (ECNs) have been created to match orders between buyers and sellers in recent years. As ECNs become more popular over time, they may ultimately be merged with one another or with other exchanges to create a single global stock exchange.

Comparison of International Financial Markets The foreign cash flow movements of a typical MNC can be classified into four corporate functions, all of which generally require the use of the foreign exchange markets. Foreign trade. Exports generate foreign cash inflows while imports require cash outflows.

Comparison of International Financial Markets Direct foreign investment (DFI). 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 MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Cost of parent’s funds borrowed in global markets Cost of borrowing funds in global markets Improved global image from issuing stock in global markets Cost of parent’s equity in global markets

Chapter Review Motives for Using International Financial Markets Motives for Investing in Foreign Markets Motives for Providing Credit in Foreign Markets Motives for Borrowing in Foreign Markets

Chapter Review Foreign Exchange Market History of Foreign Exchange Foreign Exchange Transactions Interpreting Foreign Exchange Quotations Currency Futures and Options Markets

Chapter Review 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

Chapter Review Eurobond Market Development of the Eurobond Market Underwriting Process Features Comparing Interest Rates Among Currencies Global Integration of Interest Rates

Chapter Review International Stock Markets Issuance of Foreign Stock in the U.S. Issuance of Stock in Foreign Markets Comparison of International Financial Markets How Financial Markets Affect An MNC’s Value

Exchange Rate Determination 4 Chapter Exchange Rate Determination South-Western/Thomson Learning © 2003

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. When a currency declines in value, it is said to depreciate. When it increases in value, it is said to appreciate. On the days when some currencies appreciate while others depreciate against the dollar, the dollar is said to be “mixed in trading.”

Measuring Exchange Rate Movements The percentage change (% D) in the value of a foreign currency is computed as St – St-1 St-1 where St denotes the spot rate at time t. A positive % D represents appreciation of the foreign currency, while a negative % D represents depreciation.

Exchange Rate Equilibrium An exchange rate represents the price of a currency, which is determined by the demand for that currency relative to the supply for that currency.

Factors that Influence Exchange Rates Relative Inflation Rates U.S. inflation   U.S. demand for British goods, and hence £.  British desire for U.S. goods, and hence the supply of £.

Factors that Influence Exchange Rates Relative Interest Rates U.S. interest rates   U.S. demand for British bank deposits, and hence £.  British desire for U.S. bank deposits, and hence the supply of £.

Factors that Influence Exchange Rates Relative Interest Rates A relatively high interest rate may actually reflect expectations of relatively high inflation, which discourages foreign investment. It is thus useful to consider real interest rates, which adjust the nominal interest rates for inflation.

Factors that Influence Exchange Rates Relative Interest Rates real nominal interest  interest – inflation rate rate rate This relationship is sometimes called the Fisher effect.

Factors that Influence Exchange Rates Relative Income Levels U.S. income level   U.S. demand for British goods, and hence £. No expected change for the supply of £.

Factors that Influence Exchange Rates Government Controls Governments may influence the equilibrium exchange rate by: imposing foreign exchange barriers, imposing foreign trade barriers, intervening in the foreign exchange market, and affecting macro variables such as inflation, interest rates, and income levels.

Factors that Influence Exchange Rates 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. Because of speculative transactions, foreign exchange rates can be very volatile.

Factors that Influence Exchange Rates Expectations Signal Impact on $ Poor U.S. economic indicators Weakened Fed chairman suggests Fed is Strengthened unlikely to cut U.S. interest rates A possible decline in German Strengthened interest rates Central banks expected to Weakened intervene to boost the euro

Factors that Influence Exchange Rates Interaction of Factors Trade-related factors and financial factors sometimes interact. Exchange rate movements may be simultaneously affected by these factors. For example, an increase in the level of income sometimes causes expectations of higher interest rates.

Factors that Influence Exchange Rates Interaction of Factors 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.

Factors that Influence Exchange Rates How Factors Have Influenced Exchange Rates Because the dollar’s value changes by different magnitudes relative to each foreign currency, analysts often measure the dollar’s strength with an index. The weight assigned to each currency is determined by its relative importance in international trade and/or finance.

Impact of Exchange Rates on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Inflation Rates, Interest Rates, Income Levels, Government Controls, Expectations

Chapter Review Measuring Exchange Rate Movements Exchange Rate Equilibrium Demand for a Currency Supply of a Currency for Sale Equilibrium

Chapter Review Factors that Influence Exchange Rates Relative Inflation Rates Relative Interest Rates Relative Income Levels Government Controls Expectations Interaction of Factors How Factors Have Influenced Exchange Rates

Chapter Review How Exchange Rates Affect an MNC’s Value

5 Chapter Currency Derivatives South-Western/Thomson Learning © 2003

Chapter Objectives To explain how forward contracts are used for hedging based on anticipated exchange rate movements; and To explain how currency futures contracts and currency options contracts are used for hedging or speculation based on anticipated exchange rate movements.

Forward Market The forward market facilitates the trading of forward contracts on currencies. 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.

Forward Market 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 often valued at $1 million or more, and are not normally used by consumers or small firms.

Forward Market As with the case of spot rates, there is a bid/ask spread on forward rates. Forward rates may also contain a premium or discount. If the forward rate exceeds the existing spot rate, it contains a premium. If the forward rate is less than the existing spot rate, it contains a discount.

= forward rate – spot rate  360 Forward Market annualized forward premium/discount = forward rate – spot rate  360 spot rate n where n is the number of days to maturity Example: Suppose £ spot rate = $1.681, 90-day £ forward rate = $1.677. $1.677 – $1.681 x 360 = – 0.95% $1.681 90 So, forward discount = 0.95%

Forward Market The forward premium/discount reflects the difference between the home interest rate and the foreign interest rate, so as to prevent arbitrage.

Forward Market A non-deliverable forward contract (NDF) is a forward contract whereby there is no actual exchange of currencies. Instead, a net payment is made by one party to the other based on the contracted rate and the market rate on the day of settlement. Although NDFs do not involve actual delivery, they can effectively hedge expected foreign currency cash flows.

Currency Futures Market Currency futures contracts specify 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. They are used by MNCs to hedge their currency positions, and by speculators who hope to capitalize on their expectations of exchange rate movements.

Currency Futures Market The contracts can be traded by firms or individuals through brokers on the trading floor of an exchange (e.g. Chicago Mercantile Exchange), on automated trading systems (e.g. GLOBEX), or over-the-counter. Participants in the currency futures market need to establish and maintain a margin when they take a position.

Currency Futures Market Forward Markets Futures Markets Contract size Customized. Standardized. Delivery date Customized. Standardized. Participants Banks, brokers, Banks, brokers, MNCs. Public MNCs. Qualified speculation not public speculation encouraged. encouraged. Security Compensating Small security deposit bank balances or deposit required. credit lines needed.

Currency Futures Market Forward Markets Futures Markets Clearing Handled by Handled by operation individual banks exchange & brokers. clearinghouse. Daily settlements to market prices. Marketplace Worldwide Central exchange telephone floor with global network. communications.

Currency Futures Market Forward Markets Futures Markets Regulation Self-regulating. Commodity Futures Trading Commission, National Futures Association. Liquidation Mostly settled by Mostly settled by actual delivery. offset. Transaction Bank’s bid/ask Negotiated Costs spread. brokerage fees.

Currency Futures Market Normally, the price of a currency futures contract is similar to the forward rate for a given currency and settlement date, but differs from the spot rate when the interest rates on the two currencies differ. These relationships are enforced by the potential arbitrage activities that would occur otherwise.

Currency Futures Market Currency futures contracts have no credit risk since they are guaranteed by the exchange clearinghouse. To minimize its risk in such a guarantee, the exchange imposes margin requirements to cover fluctuations in the value of the contracts.

Currency Futures Market Speculators often sell currency futures when they expect the underlying currency to depreciate, and vice versa.

Currency Futures Market Currency futures may be purchased by MNCs to hedge foreign currency payables, or sold to hedge receivables.

Currency Futures Market Holders of futures contracts can close out their positions by selling similar futures contracts. Sellers may also close out their positions by purchasing similar contracts.

Currency Futures Market Most currency futures contracts are closed out before their settlement dates. Brokers who fulfill orders to buy or sell futures contracts earn a transaction or brokerage fee in the form of the bid/ask spread.

Currency Options Market A currency option is another type of contract that can be purchased or sold by speculators and firms. The standard options that are traded on an exchange through brokers are guaranteed, but require margin maintenance. U.S. option exchanges (e.g. Chicago Board Options Exchange) are regulated by the Securities and Exchange Commission.

Currency Options Market In addition to the exchanges, there is an over-the-counter market where commercial banks and brokerage firms offer customized currency options. There are no credit guarantees for these OTC options, so some form of collateral may be required. Currency options are classified as either calls or puts.

Currency Call Options A currency call option grants the holder 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 if spot rate > strike price, at the money if spot rate = strike price, out of the money if spot rate < strike price.

Currency Call Options Option owners can sell or exercise their options. They can also choose to let their options expire. At most, they will lose the premiums they paid for their options. Call option premiums will be higher when: (spot price – strike price) is larger; the time to expiration date is longer; and the variability of the currency is greater.

Currency Call Options Firms with open positions in foreign currencies may use currency call options to cover those positions. They may purchase currency call options to hedge future payables; to hedge potential expenses when bidding on projects; and to hedge potential costs when attempting to acquire other firms.

Currency Call Options Speculators who expect a foreign currency to appreciate can purchase call options on that currency. Profit = selling price – buying (strike) price – option premium They may also sell (write) call options on a currency that they expect to depreciate. Profit = option premium – buying price + selling (strike) price

Currency Call Options The purchaser of a call option will break even when selling price = buying (strike) price + option premium The seller (writer) of a call option will break even when buying price = selling (strike) price

Currency Put Options A currency put option grants the holder 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 if spot rate < strike price, at the money if spot rate = strike price, out of the money if spot rate > strike price.

Currency Put Options Put option premiums will be higher when: (strike price – spot rate) is larger; the time to expiration date is longer; and the variability of the currency is greater. Corporations with open foreign currency positions may use currency put options to cover their positions. For example, firms may purchase put options to hedge future receivables.

Currency Put Options Speculators who expect a foreign currency to depreciate can purchase put options on that currency. Profit = selling (strike) price – buying price – option premium They may also sell (write) put options on a currency that they expect to appreciate. Profit = option premium + selling price – buying (strike) price

Currency Put Options One possible speculative strategy for volatile currencies is to purchase both a put option and a call option at the same exercise price. This is called a straddle. 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.

Conditional Currency Options A currency option may be structured such that the premium is conditioned on the actual currency movement over the period of concern. Suppose a conditional put option on £ has an exercise price of $1.70, and a trigger of $1.74. The premium will have to be paid only if the £’s value exceeds the trigger value.

Conditional Currency Options Similarly, a conditional call option on £ may specify an exercise price of $1.70, and a trigger of $1.67. The premium will have to be paid only if the £’s value falls below the trigger value. In both cases, the payment of the premium is avoided conditionally at the cost of a higher premium.

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 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 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.

Impact of Currency Derivatives on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Currency Futures Currency Options

Chapter Review Forward Market How MNCs Use Forward Contracts Non-Deliverable Forward Contracts

Chapter Review Currency Futures Market Contract Specifications Comparison of Currency Futures and Forward Contracts Pricing Currency Futures Credit Risk of Currency Futures Contracts Speculation with Currency Futures How Firms Use Currency Futures Closing Out A Futures Position Transaction Costs of Currency Futures

Chapter Review Currency Options Market Currency Call Options Factors Affecting Currency Call Option Premiums How Firms Use Currency Call Options Speculating with Currency Call Options

Chapter Review Currency Put Options Factors Affecting Currency Put Option Premiums Hedging with Currency Put Options Speculating with Currency Put Options

Chapter Review Conditional Currency Options European Currency Options Efficiency of Currency Futures and Options How the Use of Currency Futures and Options Affects an MNC’s Value

Part II Exchange Rate Behavior Existing spot exchange rates at other locations locational arbitrage Existing spot exchange rate Existing cross exchange rates of currencies triangular arbitrage covered interest arbitrage Existing forward exchange rate Existing inflation rate differential Fisher effect covered interest arbitrage purchasing power parity Existing interest rate differential Future exchange rate movements international Fisher effect

Government Influence On Exchange Rates 6 Chapter Government Influence On Exchange Rates South-Western/Thomson Learning © 2003

Chapter Objectives To describe the exchange rate systems used by various governments; To explain how governments can use direct and 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 the 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 System In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow bands. The Bretton Woods era (1944-1971) fixed each currency’s value in terms of gold. The 1971 Smithsonian Agreement which followed merely adjusted the exchange rates and expanded the fluctuation boundaries. The system was still fixed.

Fixed Exchange Rate System Pros: Work becomes easier for the MNCs. Cons: Governments may revalue their currencies. In fact, the dollar was devalued more than once after the U.S. experienced balance of trade deficits. Cons: Each country may become more vulnerable to the economic conditions in other countries.

Freely Floating Exchange Rate System In a freely floating exchange rate system, exchange rates are determined solely by market forces. Pros: Each country may become more insulated against the economic problems in other countries. Pros: Central bank interventions that may affect the economy unfavorably are no longer needed.

Freely Floating Exchange Rate System Pros: Governments are not restricted by exchange rate boundaries when setting new policies. Pros: Less capital flow restrictions are needed, thus enhancing the efficiency of the financial market.

Freely Floating Exchange Rate System Cons: MNCs may need to devote substantial resources to managing their exposure to exchange rate fluctuations. Cons: The country that initially experienced economic problems (such as high inflation, increasing unemployment rate) may have its problems compounded.

Managed Float Exchange Rate System In a managed (or “dirty”) float exchange rate system, exchange rates are allowed to move freely on a daily basis and no official boundaries exist. However, governments may intervene to prevent the rates from moving too much in a certain direction. Cons: A government may manipulate its exchange rates such that its own country benefits at the expense of others.

Pegged Exchange Rate System In a pegged exchange rate system, the home currency’s 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. The European Economic Community’s snake arrangement (1972-1979) pegged the currencies of member countries within established limits of each other.

Pegged Exchange Rate System The European Monetary System which followed in 1979 held the exchange rates of member countries together within specified limits and also pegged them to a European Currency Unit (ECU) through the exchange rate mechanism (ERM). The ERM experienced severe problems in 1992, as economic conditions and goals varied among member countries.

Pegged Exchange Rate System In 1994, Mexico’s central bank pegged the peso to the U.S. dollar, but allowed a band within which the peso’s value could fluctuate against the dollar. By the end of the year, there was substantial downward pressure on the peso, and the central bank allowed the peso to float freely. The Mexican peso crisis had just began ...

Currency Boards A currency board is a system for maintaining the value of the local currency with respect to some other specified currency. For example, Hong Kong has tied the value of the Hong Kong dollar to the U.S. dollar (HK$7.8 = $1) since 1983, while Argentina has tied the value of its peso to the U.S. dollar (1 peso = $1) since 1991.

Currency Boards For a currency board to be successful, it must have credibility in its promise to maintain the exchange rate. It has to intervene to defend its position against the pressures exerted by economic conditions, as well as by speculators who are betting that the board will not be able to support the specified exchange rate.

Exposure of a Pegged Currency to Interest Rate Movements A country that uses a currency board does not have complete control over its local interest rates, as the rates must be aligned with the interest rates of the currency to which the local currency is tied. Note that the two interest rates may not be exactly the same because of different risks.

Exposure of a Pegged Currency to Exchange Rate Movements A currency that is pegged to another currency will have to move in tandem with that currency against all other currencies. So, the value of a pegged currency does not necessarily reflect the demand and supply conditions in the foreign exchange market, and may result in uneven trade or capital flows.

Dollarization Dollarization refers to the replacement of a local currency with U.S. dollars. Dollarization goes beyond a currency board, as the country no longer has a local currency. For example, Ecuador implemented dollarization in 2000.

A Single European Currency € In 1991, the Maastricht treaty called for a single European currency. On Jan 1, 1999, the euro was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. Greece joined the system in 2001. By 2002, the national currencies of the 12 participating countries will be withdrawn and completely replaced with the euro.

A Single European Currency € Within the euro-zone, cross-border trade and capital flows will occur without the need to convert to another currency. European monetary policy is also consolidated because of the single money supply. The Frankfurt-based European Central Bank (ECB) is responsible for setting the common monetary policy.

A Single European Currency € The ECB aims to control inflation in the participating countries and to stabilize the euro within reasonable boundaries. The common monetary policy may eventually lead to more political harmony. Note that each participating country may have to rely on its own fiscal policy (tax and government expenditure decisions) to help solve local economic problems.

A Single European Currency € As currency movements among the European countries will be eliminated, there should be an increase in all types of business arrangements, more comparable product pricing, and more trade flows. It will also be easier to compare and conduct valuations of firms across the participating European countries.

A Single European Currency € Stock and bond prices will also be more comparable and there should be more cross-border investing. However, non-European investors may not achieve as much diversification as in the past. Exchange rate risk and foreign exchange transaction costs within the euro-zone will be eliminated, while interest rates will have to be similar.

A Single European Currency € Since its introduction in 1999, the euro has declined against many currencies. This weakness was partially attributed to capital outflows from Europe, which was in turn partially attributed to a lack of confidence in the euro. Some countries had ignored restraint in favor of resolving domestic problems, resulting in a lack of solidarity.

Government Intervention Each country has a government agency (called the central bank) that may intervene in the foreign exchange market to control the value of the country’s currency. In the United States, the Federal Reserve System (Fed) is the central bank.

Government Intervention Central banks manage exchange rates to smooth exchange rate movements, to establish implicit exchange rate boundaries, and/or to respond to temporary disturbances. Often, intervention is overwhelmed by market forces. However, currency movements may be even more volatile in the absence of intervention.

Government Intervention Direct intervention refers to the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market. Direct intervention is usually most effective when there is a coordinated effort among central banks.

Government Intervention When a central bank intervenes in the foreign exchange market without adjusting for the change in money supply, it is said to engaged in nonsterilized intervention. In a sterilized intervention, Treasury securities are purchased or sold at the same time to maintain the money supply.

Government Intervention 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 of the intervention effort.

Government Intervention Central banks can also engage in indirect intervention by influencing the factors that determine the value of a currency. For example, the Fed may attempt to increase interest rates (and hence boost the dollar’s value) by reducing the U.S. money supply. Note that high interest rates adversely affects local borrowers.

Government Intervention Governments may also use foreign exchange controls (such as restrictions on currency exchange) as a form of indirect intervention.

Exchange Rate Target Zones Many economists have criticized the present exchange rate system because of the wide swings in the exchange rates of major currencies. Some have suggested that target zones be used, whereby an initial exchange rate will be established with specific boundaries (that are wider than the bands used in fixed exchange rate systems).

Exchange Rate Target Zones The ideal target zone should allow rates to adjust to economic factors without causing wide swings in international trade and fear in the financial markets. However, the actual result may be a system no different from what exists today.

Intervention as a Policy Tool Like tax laws and money supply, the exchange rate is a tool which a government can use to achieve its desired economic objectives. A weak home currency can stimulate foreign demand for products, and hence local jobs. However, it may also lead to higher inflation.

Intervention as a Policy Tool A strong currency may cure high inflation, since the intensified foreign competition should cause domestic producers to refrain from increasing prices. However, it may also lead to higher unemployment.

Impact of Central Bank Intervention on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Direct Intervention Indirect Intervention

Chapter Review Exchange Rate Systems Fixed Exchange Rate System Freely Floating Exchange Rate System Managed Float Exchange Rate System Pegged Exchange Rate System Currency Boards Exposure of a Pegged Currency to Interest Rate and Exchange Rate Movements Dollarization

Chapter Review A Single European Currency Membership Euro Transactions 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 Status Report on the Euro

Chapter Review Government Intervention Reasons for Government Intervention Direct Intervention Indirect Intervention Exchange Rate Target Zones

Chapter Review 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 MNC’s Value

International Arbitrage And Interest Rate Parity 7 Chapter International Arbitrage And Interest Rate Parity South-Western/Thomson Learning © 2003

Chapter Objectives To explain the conditions that will result in various forms of international arbitrage, along with the realignments that will occur in response; and To explain the concept of interest rate parity, and how it prevents arbitrage opportunities.

International Arbitrage Arbitrage can be loosely defined as capitalizing on a discrepancy in quoted prices. Often, the funds invested are not tied up and no risk is involved. In response to the imbalance in demand and supply resulting from arbitrage activity, prices will realign very quickly, such that no further risk-free profits can be made.

International Arbitrage Locational arbitrage is possible when a bank’s buying price (bid price) is higher than another bank’s selling price (ask price) for the same currency. Example: Bank C Bid Ask Bank D Bid Ask NZ$ $.635 $.640 NZ$ $.645 $.650 Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$.

International Arbitrage Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rates. Example: Bid Ask British pound (£) $1.60 $1.61 Malaysian ringgit (MYR) $.200 $.202 £ MYR8.1 MYR8.2 Buy £ @ $1.61, convert @ MYR8.1/£, then sell MYR @ $.200. Profit = $.01/£. (8.1.2=1.62)

International Arbitrage When the exchange rates of the currencies are not in equilibrium, triangular arbitrage will force them back into equilibrium.

International Arbitrage Covered interest arbitrage is the process of capitalizing on the interest rate differential between two countries, while covering for exchange rate risk. Covered interest arbitrage tends to force a relationship between forward rate premiums and interest rate differentials.

International Arbitrage Example: £ spot rate = 90-day forward rate = $1.60 U.S. 90-day interest rate = 2% U.K. 90-day interest rate = 2% 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%.

International Arbitrage 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.

International Arbitrage Any discrepancy will trigger arbitrage, which will then eliminate the discrepancy. Arbitrage thus makes the foreign exchange market more orderly.

Interest Rate Parity (IRP) Market forces cause the forward rate to differ from the spot rate by an amount that is sufficient to offset the interest rate differential between the two currencies. Then, covered interest arbitrage is no longer feasible, and the equilibrium state achieved is referred to as interest rate parity (IRP).

Derivation of IRP When IRP exists, the rate of return achieved from covered interest arbitrage should equal the rate of return available in the home country. End-value of a $1 investment in covered interest arbitrage = (1/S)  (1+iF)  F = (1/S)  (1+iF)  [S  (1+p)] = (1+iF)  (1+p) where p is the forward premium.

Derivation of IRP End-value of a $1 investment in the home country = 1 + iH Equating the two and rearranging terms: p = (1+iH) – 1 (1+iF) i.e. forward = (1 + home interest rate) – 1 premium (1 + foreign interest rate)

Determining the Forward Premium Example: Suppose 6-month ipeso = 6%, i$ = 5%. From the U.S. investor’s perspective, forward premium = 1.05/1.06 – 1  - .0094 If S = $.10/peso, then 6-month forward rate = S  (1 + p)  .10  (1 _ .0094)  $.09906/peso

Determining the Forward Premium Note that the IRP relationship can be rewritten as follows: F – S = S(1+p) – S = p = (1+iH) – 1 = (iH–iF) S S (1+iF) (1+iF) The approximated form, p  iH–iF, provides a reasonable estimate when the interest rate differential is small.

Test for the Existence of IRP To test whether IRP exists, collect the actual interest rate differentials and forward premiums for various currencies. Pair up data that occur at the same point in time and that involve the same currencies, and plot the points on a graph. IRP holds when covered interest arbitrage is not worthwhile.

Interpretation of IRP 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.

Does IRP Hold? Various empirical studies indicate that IRP generally holds. While there are deviations from IRP, they are often not large enough to make covered interest arbitrage worthwhile. This is due to the characteristics of foreign investments, including transaction costs, political risk, and differential tax laws.

Considerations When Assessing IRP Transaction Costs IRP may not be feasible after taking into consideration transaction costs.

Considerations When Assessing IRP Political Risk A crisis in the foreign country could cause its government to restrict any exchange of the local currency for other currencies. Investors may also perceive a higher default risk on foreign investments. Differential Tax Laws If tax laws vary, after-tax returns should be considered instead of before-tax returns.

Explaining Changes in Forward Premiums During the 1997-98 Asian crisis, the forward rates offered to U.S. firms on some Asian currencies were substantially reduced for two reasons. The spot rates of these currencies declined substantially during the crisis. Their interest rates had increased as their governments attempted to discourage investors from pulling out their funds.

Impact of Arbitrage on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Forces of Arbitrage

Chapter Review International Arbitrage Locational Arbitrage Triangular Arbitrage Covered Interest Arbitrage Comparison of Arbitrage Effects

Chapter Review Interest Rate Parity (IRP) Derivation of IRP Determining the Forward Premium Test for the Existence of IRP Interpretation of IRP Does IRP Hold? Considerations When Assessing IRP

Chapter Review Explaining Changes in Forward Premiums Impact of Arbitrage on an MNC’s Value

Relationships Between Inflation, Interest Rates, and Exchange Rates 8 Chapter Relationships Between Inflation, Interest Rates, and Exchange Rates South-Western/Thomson Learning © 2003

Chapter Objectives To explain the theories of purchasing power parity (PPP) and international Fisher effect (IFE), and their implications for exchange rate changes; and To compare the PPP theory, IFE theory, and theory of interest rate parity (IRP).

Purchasing Power Parity (PPP) When one country’s inflation rate rises relative to that of another country, decreased exports and increased imports depress the country’s currency. The theory of purchasing power parity (PPP) attempts to quantify this inflation - exchange rate relationship.

Interpretations of PPP The absolute form of PPP, or the “law of one price,” 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. It states that the rate of price changes should be similar.

Rationale behind PPP Theory Suppose U.S. inflation > U.K. inflation.  U.S. imports from U.K. and  U.S. exports to U.K., so £ appreciates. This shift in consumption and the appreciation of the £ will continue until in the U.S., priceU.K. goods  priceU.S. goods, & in the U.K., priceU.S. goods  priceU.K. goods.

Derivation of PPP Pf (1 + If ) (1 + ef ) = Ph (1 + Ih ) Assume home country’s price index (Ph) = foreign country’s price index (Pf) When inflation occurs, the exchange rate will adjust to maintain PPP: Pf (1 + If ) (1 + ef ) = Ph (1 + Ih ) where Ih = inflation rate in the home country If = inflation rate in the foreign country ef = % change in the value of the foreign currency

Derivation of PPP ef = (1 + Ih ) – 1 (1 + If ) Since Ph = Pf , solving for ef gives: ef = (1 + Ih ) – 1 (1 + If ) If Ih > If , ef > 0 (foreign currency appreciates) If Ih < If , ef < 0 (foreign currency depreciates) If Ih = 5% & If = 3%, ef = 1.05/1.03 – 1 = 1.94% From the home country perspective, both price indexes rise by 5%.

Simplified PPP Relationship When the inflation differential is small, the PPP relationship can be simplified as ef » Ih _ If Suppose IU.S. = 9%, IU.K. = 5%. Then PPP suggests that e£  4%. Then, 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.

Testing the PPP Theory Conceptual Test Plot the actual inflation differential and exchange rate % change for two or more countries on a graph. If the points deviate significantly from the PPP line over time, then PPP does not hold.

Testing the PPP Theory ef = a0 + a1 { (1+Ih)/(1+If) - 1 } + m Statistical Test Apply regression analysis to the historical exchange rates and inflation differentials: ef = a0 + a1 { (1+Ih)/(1+If) - 1 } + m The appropriate t-tests are then applied to a0 and a1, whose hypothesized values are 0 and 1 respectively.

Testing the PPP Theory Empirical studies indicate that the relationship between inflation differentials and exchange rates is not perfect even in the long run. However, the use of inflation differentials to forecast long-run movements in exchange rates is supported.

Why PPP Does Not Occur PPP may not occur consistently due to: confounding effects, and Exchange rates are also affected by differentials in interest rates, income levels, and risk, as well as government controls. lack of substitutes for traded goods.

PPP in the Long Run PPP can be tested by assessing a “real” exchange rate over time. The real exchange rate is the actual exchange rate adjusted for inflationary effects in the two countries of concern. If this rate reverts to some mean level over time, this would suggest that it is constant in the long run.

International Fisher Effect (IFE) 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, differentials in interest rates may be due to differentials in expected inflation. According to PPP, exchange rate movements are caused by inflation rate differentials.

International Fisher Effect (IFE) The international Fisher effect (IFE) theory suggests that currencies with higher interest rates will depreciate because the higher rates reflect higher expected inflation. Hence, investors hoping to capitalize on a higher foreign interest rate should earn a return no better than what they would have earned domestically.

Derivation of the IFE According to the IFE, E(rf ), the expected effective return on a foreign money market investment, should equal rh , the effective return on a domestic investment. rf = (1 + if ) (1 + ef ) – 1 if = interest rate in the foreign country ef = % change in the foreign currency’s value rh = ih = interest rate in the home country

Derivation of the IFE (1 + if ) Setting rf = rh : (1 + if ) (1 + ef ) – 1 = ih Solving for ef : ef = (1 + ih ) _ 1 (1 + if ) If ih > if , ef > 0 (foreign currency appreciates) If ih < if , ef < 0 (foreign currency depreciates) If ih = 8% & if = 9%, ef = 1.08/1.09 – 1 = - .92% This will make the return on the foreign investment equal to the domestic return.

Derivation of the IFE ef » ih _ if When the interest rate differential is small, the IFE relationship can be simplified as ef » ih _ if If the British rate on 6-month deposits were 2% above the U.S. interest rate, the £ should depreciate by approximately 2% over 6 months. Then U.S. investors would earn about the same return on British deposits as they would on U.S. deposits.

Graphic Analysis of the IFE The point of the IFE theory is that if a firm periodically tries to capitalize on higher foreign interest rates, it will achieve a yield that is sometimes above and sometimes below the domestic yield. On the average, the firm would achieve a yield similar to that by a corporation that makes domestic deposits only.

Tests of the IFE If the actual points of interest rates and exchange rate changes are plotted over time on a graph, we can see whether the points are evenly scattered on both sides of the IFE line. Empirical studies indicate that the IFE theory holds during some time frames. However, there is also evidence that it does not consistently hold.

Tests of the IFE ef = a0 + a1 { (1+ih)/(1+if) – 1 } + m A statistical test can be developed by applying regression analysis to the historical exchange rates and nominal interest rate differentials: ef = a0 + a1 { (1+ih)/(1+if) – 1 } + m The appropriate t-tests are then applied to a0 and a1, whose hypothesized values are 0 and 1 respectively.

Why the IFE Does Not Occur Since the IFE is based on PPP, it will not hold when PPP does not hold. For example, if there are factors other than inflation that affect exchange rates, the rates will not adjust in accordance with the inflation differential.

Application of the IFE to the Asian Crisis 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 some central banks were maintaining their currencies within narrow bands, some foreign investors were motivated.

Application of the IFE to the Asian Crisis Unfortunately for these investors, the efforts made by the central banks to stabilize the currencies were overwhelmed by market forces. In essence, the depreciation in the Southeast Asian currencies wiped out the high level of interest earned.

Impact of Inflation on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Effect of Inflation

Chapter Review Purchasing Power Parity (PPP) Interpretations of PPP Rationale behind PPP Theory Derivation of PPP Using PPP to Estimate Exchange Rate Effects Simplified PPP Relationship

Chapter Review Purchasing Power Parity (PPP) … continued Testing the PPP Theory Why PPP Does Not Occur PPP in the Long Run

Chapter Review International Fisher Effect (IFE) Derivation of the IFE Tests of the IFE Why the IFE does Not Occur Application of the IFE to the Asian Crisis 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

Forecasting Exchange Rates 9 Chapter Forecasting Exchange Rates South-Western/Thomson Learning © 2003

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 The numerous methods available for forecasting exchange rates can be categorized into four general groups: technical, fundamental, market-based,and mixed.

Technical Forecasting Technical forecasting involves the use of historical data to predict future values. It includes statistical analysis and time series models. Speculators may find the models useful for predicting day-to-day movements. However, since they typically focus on the near future and rarely provide point/range estimates, they are of limited use to MNCs.

Fundamental Forecasting Fundamental forecasting is based on the fundamental relationships between economic variables and exchange rates. A forecast may arise simply from a subjective assessment of the factors that affect exchange rates. A forecast may be based on quantitative measurements (with the aid of regression models and sensitivity analysis) too.

Fundamental Forecasting Known relationships like the PPP can be used for the regression models. However, problems may arise. In the case of PPP: the timing of the impact of inflation on trade behavior is not known for sure, prices may be measured inaccurately, trade barriers may disrupt the trade patterns that should emerge, and other influential factors may exist.

Fundamental Forecasting In general, fundamental forecasting is limited by : the uncertain timing of the impact of the factors, the need for forecasts for factors with instantaneous impact, the possibility that other relevant factors may be omitted from the model, and changes in the sensitivity of currency movements to each factor over time.

Market-Based Forecasting Market-based forecasting involves developing forecasts from market indicators. Usually, either the spot rate or the forward rate is used, since speculation should push the rates to the level that reflect the market expectation of the future exchange rate.

Market-Based Forecasting Since forward contracts have low trading volumes and are not widely quoted, the interest rates on risk-free instruments can be used to determine what the forward rates should be according to IRP for long-term forecasting.

Mixed Forecasting 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 investment banks to offer forecasting services. Advice on hedging and international cash management, and assessment of the firm’s exposure to exchange rate risk, may be provided too.

Forecasting Services 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 may also want to compare the various forecasting methods.

Evaluation of Forecast Performance One measure of forecast performance is the absolute forecast error as a percentage of the realized value: | forecasted value – realized value | realized value Over time, MNCs are likely to have more confidence in their forecasts when they know the mean error for their past forecasts.

Evaluation of Forecast Performance The ability to forecast currency values may vary with the currency of concern. In particular, the value of a less volatile currency is likely to be forecasted more accurately.

Forecast Bias If the forecast errors are consistently positive or negative over time, then there is a bias in the forecasting procedure.

Forecast Bias The following regression model can be used to test for forecast bias: realized = a0 + a1 ´ forecast + m If a predictor is found to be biased, the estimated a0 and a1 values can be used to correct the systematic error.

Graphic Evaluation of Forecast Performance If the points appear to be scattered evenly on both sides of the perfect forecast line, then the forecasts are said to be unbiased. Note that a more thorough assessment can be conducted by separating the entire period into subperiods.

Comparison of Forecasting Techniques The different forecasting techniques can be evaluated graphically - by comparing the distances from the perfect forecast line, or statistically - by computing the mean of the absolute forecast errors, and then using a t-test or a nonparametric test to determine whether there is a significant difference in the accuracy of the forecasting techniques.

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.

Forecasting Under Market Efficiency If the market is strong-form efficient, then all the relevant public and private information is already reflected in the current exchange rates. Foreign exchange markets are generally found to be at least semistrong-form efficient.

Forecasting Under Market Efficiency Nevertheless, MNCs may still find forecasting worthwhile, since their goal is not to earn speculative profits but to use exchange rate forecasts to implement policies. In particular, MNCs may need to determine the range of possible exchange rates in order to assess the degree to which their operating performance could be affected.

Exchange Rate Volatility MNCs also forecast exchange rate volatility. This enables them to specify a range (confidence interval) and develop best-case and worst-case scenarios along with their point estimate forecasts. Popular methods for forecasting volatility include: the use of recent exchange rate volatility,

Exchange Rate Volatility the use of a historical time series of volatilities (there may be a pattern in how the exchange rate volatility changes over time), and the derivation of the exchange rate’s 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, because the central banks were maintaining a somewhat stable value for their respective currencies. But even after the crisis began, it is unlikely that the degree of depreciation could have been accurately predicted by the usual models.

Application of Exchange Rate Forecasting to the Asian Crisis The large amount of foreign investment and the fear of a massive selloff of the currencies played key roles in the sharp decline of the Asian currency values. However, these two factors cannot be easily incorporated into a fundamental forecasting model in a manner that will precisely identify the timing and magnitude of currency depreciation.

Impact of Forecasted Exchange Rates on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Technical Forecasting Fundamental Forecasting Market-based Forecasting Mixed Forecasting

Chapter Review Why Firms Forecast Exchange Rates Forecasting Techniques Technical Forecasting Fundamental Forecasting Market-Based Forecasting Mixed Forecasting Forecasting Services Performance of Forecasting Services

Chapter Review Evaluation of Forecast Performance Forecast Accuracy Over Time Forecast Accuracy Among Currencies Search for Forecast Bias Statistical Test of Forecast Bias Graphic Evaluation of Forecast Performance Comparison of Forecasting Techniques

Chapter Review Forecasting Under Market Efficiency Exchange Rate Volatility Application of Exchange Rate Forecasting to the Asian Crisis How Exchange Rate Forecasting Affects an MNC’s Value

Measuring Exposure To Exchange Rate Fluctuations 10 Chapter Measuring Exposure To Exchange Rate Fluctuations South-Western/Thomson Learning © 2003

Chapter Objectives To discuss the relevance of an MNC’s 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.

Is Exchange Rate Risk Relevant? 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 their individual exposure too.

Is Exchange Rate Risk Relevant? 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.

Is Exchange Rate Risk Relevant? 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.

Is Exchange Rate Risk Relevant? Response from MNCs Many MNCs have attempted to stabilize their earnings with hedging strategies, which confirms the view that exchange rate risk is relevant.

Types of Exposure Although exchange rates cannot be forecasted with perfect accuracy, firms can at least measure their exposure to exchange rate fluctuations. Exposure to exchange rate fluctuations comes in three forms: Transaction exposure Economic exposure Translation exposure

Transaction Exposure The degree to which the value of future cash transactions can be affected by exchange rate fluctuations is referred to as transaction exposure. To measure transaction exposure: project the net amount of inflows or outflows in each foreign currency, and determine the overall risk of exposure to those currencies.

Transaction Exposure MNCs can usually anticipate foreign cash flows for an upcoming short-term period with reasonable accuracy. After the consolidated net currency flows for the entire MNC has been determined, each net flow is converted into either a point estimate or a range of a chosen currency, so as to standardize the exposure assessment for each currency.

Transaction Exposure An MNC’s overall exposure can be assessed by considering each currency position together with the currency’s variability and the correlations among the currencies. The standard deviation statistic on historical data serves as one measure of currency variability. Note that currency variability levels may change over time.

Transaction Exposure The correlations among currency movements can be measured by their correlation coefficients, which indicate the degree to which two currencies move in relation to each other. coefficient perfect positive correlation 1.00 no correlation 0.00 perfect negative correlation -1.00

Transaction Exposure The point in considering correlations is to detect positions that could somewhat offset each other. For example, if currencies X and Y are highly correlated, the exposures of a net X inflow and a net Y outflow will offset each other to a certain degree. Note that the corrrelations among currencies may change over time.

Transaction Exposure 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 firm’s 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.

Economic Exposure Transactions that Influence the Firm’s Cash Inflows Local Currency Appreciates Local Currency Depreciates Local sales (relative to foreign competition in local markets) Firm’s exports denominated in local currency Firm’s exports denominated in foreign currency Interest received from foreign investments Decrease Increase  Impact on Transactions Transactions reflecting transaction exposure.

Economic Exposure Transactions that Influence the Firm’s Cash Outflows Local Currency Appreciates Local Currency Depreciates  Impact on Transactions Transactions reflecting transaction exposure. Firm’s imported supplies denominated in local currency Firm’s imported supplies denominated in foreign currency Interest owed on foreign funds borrowed No Change Decrease Increase

Economic Exposure Even purely domestic firms may be affected by economic exposure if there is foreign competition within the local markets. MNCs are likely to be much more exposed to exchange rate fluctuations. The impact varies across MNCs according to their individual operating characteristics and net currency positions.

Economic Exposure One measure of economic exposure involves classifying the firm’s cash flows into income statement items, and then reviewing how the earnings forecast in the income statement changes in response to alternative exchange rate scenarios. In general, firms with more foreign costs than revenues will be unfavorably affected by stronger foreign currencies.

Economic Exposure Another method of assessing a firm’s economic exposure involves applying regression analysis to historical cash flow and exchange rate data.

Economic Exposure PCFt = a0 + a1et + t PCFt = % change in inflation-adjusted cash flows measured in the firm’s home currency over period t et = % change in the currency exchange rate over period t t = random error term a0 = intercept a1 = slope coefficient

Economic Exposure The regression model may be revised to handle multiple currencies by including them as additional independent variables, or by using a currency index (composite). By changing the dependent variable, the impact of exchange rates on the firm’s value (as measured by its stock price), earnings, exports, sales, etc. may also be assessed.

Translation Exposure The exposure of the MNC’s consolidated financial statements to exchange rate fluctuations is known as translation exposure. In particular, subsidiary earnings translated into the reporting currency on the consolidated income statement are subject to changing exchange rates.

Translation Exposure Does Translation Exposure Matter? Cash Flow Perspective - Translating financial statements for consolidated reporting purposes does not by itself affect an MNC’s cash flows. However, a weak foreign currency today may result in a forecast of a weak exchange rate at the time subsidiary earnings are actually remitted.

Translation Exposure Does Translation Exposure Matter? Stock Price Perspective - Since an MNC’s translation exposure affects its consolidated earnings and many investors tend to use earnings when valuing firms, the MNC’s valuation may be affected.

Translation Exposure In general, translation exposure is relevant because some MNC subsidiaries may want to remit their earnings to their parents now, the prevailing exchange rates may be used to forecast the expected cash flows that will result from future remittances, and consolidated earnings are used by many investors to value MNCs.

Translation Exposure An MNC’s degree of translation exposure is dependent on: the proportion of its business conducted by its foreign subsidiaries, the locations of its foreign subsidiaries, and the accounting method that it uses.

Translation Exposure According to World Research Advisory estimates, the translated earnings of U.S.-based MNCs in aggregate were reduced by $20 billion in the third quarter of 1998 alone simply because of the depreciation of Asian currencies against the dollar. In 2000, the weakness of the euro also caused several U.S.-based MNCs to report lower earnings than expected.

Impact of Exchange Rate Exposure on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Transaction Exposure Economic Exposure

Chapter Review Is Exchange Rate Risk Relevant? Purchasing Power Parity Argument The Investor Hedge Argument Currency Diversification Argument Stakeholder Diversification Argument Response from MNCs Types of Exposure Transaction, Economic, and Translation Exposures

Chapter Review Transaction Exposure Transaction Exposure to “Net” Cash Flows Transaction Exposure Based on Currency Variability Transaction Exposure Based on Currency Correlations Transaction Exposure Based on Value-at-Risk

Chapter Review Economic Exposure Economic Exposure to Local Currency Appreciation & Depreciation Economic Exposure of Domestic Firms & MNCs Measuring Economic Exposure Sensitivity of Earnings & Cash Flows to Exchange Rates

Chapter Review Translation Exposure Does Translation Exposure Matter? Cash Flow Perspective Stock Price Perspective Determinants of Translation Exposure Examples of Translation Exposure Impact of Exchange Rate Exposure on an MNC’s Value

Managing Transaction Exposure 11 Chapter Managing Transaction Exposure South-Western/Thomson Learning © 2003

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 of the identified hedging techniques; and

Chapter Objectives To suggest other methods of reducing exchange rate risk when hedging techniques are not available.

Transaction Exposure Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations. When transaction exposure exists, the firm faces three major tasks: Identify its degree of transaction exposure, Decide whether to hedge its exposure, and Choose among the available hedging techniques if it decides on hedging.

Identifying Net Transaction Exposure Centralized Approach - A centralized group consolidates subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency for the upcoming period(s). Note that sometimes, a firm may be able to reduce its transaction exposure by pricing some of its exports in the same currency as that needed to pay for its imports.

Techniques to Eliminate Transaction Exposure Hedging techniques include: Futures hedge, Forward hedge, Money market hedge, and Currency option hedge. MNCs will normally compare the cash flows that could be expected from each hedging technique before determining which technique to apply.

Techniques to Eliminate Transaction Exposure A futures hedge involves the use of currency futures. To hedge future payables, the firm may purchase a currency futures contract for the currency that it will be needing. To hedge future receivables, the firm may sell a currency futures contract for the currency that it will be receiving.

Techniques to Eliminate Transaction Exposure A forward hedge differs from a futures hedge in that forward contracts are used instead of futures contract to lock in the future exchange rate at which the firm will buy or sell a currency. Recall that forward contracts are common for large transactions, while the standardized futures contracts involve smaller amounts.

Techniques to Eliminate Transaction Exposure An exposure to exchange rate movements need not necessarily be hedged, despite the ease of futures and forward hedging. Based on the firm’s degree of risk aversion, the hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining unhedged.

Techniques to Eliminate Transaction Exposure Real cost of hedging payables (RCHp) = + nominal cost of payables with hedging – nominal cost of payables without hedging Real cost of hedging receivables (RCHr) = + nominal home currency revenues received without hedging – nominal home currency revenues received with hedging

Techniques to Eliminate Transaction Exposure If the real cost of hedging is negative, then hedging is more favorable than not hedging. To compute the expected value of the real cost of hedging, first develop a probability distribution for the future spot rate, and then use it to develop a probability distribution for the real cost of hedging.

Techniques to Eliminate Transaction Exposure If the forward rate is an accurate predictor of the future spot rate, the real cost of hedging will be zero. If the forward rate is an unbiased predictor of the future spot rate, the real cost of hedging will be zero on average.

Techniques to Eliminate Transaction Exposure A money market hedge involves taking one or more money market position to cover a transaction exposure. Often, two positions are required. Payables: Borrow in the home currency, and invest in the foreign currency. Receivables: borrow in the foreign currency, and invest in the home currency.

Techniques to Eliminate Transaction Exposure Note that taking just one money market position may be sufficient. A firm that has excess cash need not borrow in the home currency when hedging payables. Similarly, a firm that is in need of cash need not invest in the home currency money market when hedging receivables.

Techniques to Eliminate Transaction Exposure The known results of money market hedging can be compared with the known results of forward or futures hedging to determine which the type of hedging that is preferable.

Techniques to Eliminate Transaction Exposure If interest rate parity (IRP) holds, and transaction costs do not exist, a money market hedge will yield the same result as a forward hedge. This is so because the forward premium on a forward rate reflects the interest rate differential between the two currencies.

Techniques to Eliminate Transaction Exposure A currency option hedge involves the use of currency call or put options to hedge transaction exposure. Since options need not be exercised, firms will be insulated from adverse exchange rate movements, and may still benefit from favorable movements. However, the firm must assess whether the premium paid is worthwhile.

Techniques to Eliminate Transaction Exposure Hedging Payables Hedging Receivables Futures Purchase currency Sell currency hedge futures contract(s). futures contract(s). Forward Negotiate forward Negotiate forward hedge contract to buy contract to sell foreign currency. foreign currency. Money Borrow local Borrow foreign market currency. Convert currency. Convert hedge to and then invest to and then invest in foreign currency. in local currency. Currency Purchase currency Purchase currency option call option(s). put option(s).

Techniques to Eliminate Transaction Exposure A comparison of hedging techniques should focus on minimizing payables, or maximizing receivables. Note that the cash flows associated with currency option hedging and remaining unhedged cannot be determined with certainty.

Techniques to Eliminate Transaction Exposure In general, hedging policies vary with the MNC management’s degree of risk aversion and exchange rate forecasts. The hedging policy of an MNC may be to hedge most of its exposure, none of its exposure, or to selectively hedge its exposure.

Limitations of Hedging Some international transactions involve an uncertain amount of foreign currency, such that overhedging may result. One way of avoiding overhedging is to hedge only the minimum known amount in the future transaction(s).

Limitations of Hedging In the long run, the continual hedging of repeated transactions may have limited effectiveness. For example, the forward rate often moves in tandem with the spot rate. Thus, an importer who uses one-period forward contracts continually will have to pay increasingly higher prices during a strong-foreign-currency cycle.

Hedging Long-Term Transaction Exposure MNCs that are certain of having cash flows denominated in foreign currencies for several years may attempt to use long-term hedging. Three commonly used techniques for long-term hedging are: long-term forward contracts, currency swaps, and parallel loans.

Hedging Long-Term Transaction Exposure 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.

Hedging Long-Term Transaction Exposure 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 and future date.

Alternative Hedging Techniques Sometimes, a perfect hedge is not available (or is too expensive) to eliminate transaction exposure. To reduce exposure under such a condition, the firm can consider: leading and lagging, cross-hedging, or currency diversification.

Alternative Hedging Techniques 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. Expediting a payment is referred to as leading, while deferring a payment is termed lagging.

Alternative Hedging Techniques When a currency cannot be hedged, a currency that is highly correlated with the currency of concern may be hedged instead. The stronger the positive correlation between the two currencies, the more effective this cross-hedging strategy will be.

Alternative Hedging Techniques With currency diversification, the firm diversifies its business among numerous countries whose currencies are not highly positively correlated.

Impact of Hedging Transaction Exposure on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Hedging Decisions on Transaction Exposure

Chapter Review Transaction Exposure Identifying Net Transaction Exposure

Chapter Review Techniques to Eliminate Transaction Exposure Futures Hedge Forward Hedge Measuring the Real Cost of Hedging Money Market Hedge Currency Option Hedge Comparison of Hedging Techniques Hedging Policies of MNCs

Chapter Review Limitations of Hedging Limitation of Hedging an Uncertain Amount Limitation of Repeated Short-Term Hedging Hedging Long-Term Transaction Exposure Long-Term Forward Contract Currency Swap Parallel Loan

Chapter Review Alternative Hedging Techniques Leading and Lagging Cross-Hedging Currency Diversification How Transaction Exposure Management Affects an MNC’s Value

Managing Economic Exposure And Translation Exposure 12 Chapter Managing Economic Exposure And Translation Exposure South-Western/Thomson Learning © 2003

Chapter Objectives To explain how an MNC’s economic exposure can be hedged; and To explain how an MNC’s translation exposure can be hedged.

Economic Exposure Economic exposure refers to the impact exchange rate fluctuations can have on a firm’s future cash flows. Recall that corporate cash flows can be affected by exchange rate movements in ways not directly associated with foreign transactions.

Economic Exposure Exchange rate changes are often linked to variability in real growth, inflation, interest rates, governmental actions,… If material, the changes may cause firms to adjust their financing and operating strategies. The importance of managing economic exposure can be seen from the case of the bankruptcy of Laker Airways, and from the the 1997-98 Asian crisis.

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 to balance its exchange-rate-sensitive cash flows. Note that computer spreadsheets are often used to expedite the analysis.

Economic Exposure Restructuring may involve: increasing/reducing sales in new or existing foreign markets, increasing/reducing dependency on foreign suppliers, establishing or eliminating production facilities in foreign markets, and/or increasing or reducing the level of debt denominated in foreign currencies.

Economic Exposure 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 Translation exposure results when an MNC translates each subsidiary’s financial data to its home currency for consolidated financial reporting. Translation exposure does not directly affect cash flows, but some firms are concerned about it because of its potential impact on reported consolidated earnings.

Translation Exposure An MNC may attempt to avoid translation exposure by matching its foreign liabilities with its foreign assets. To hedge translation exposure, forward or futures contracts can be used. Specifically, an MNC may sell the currency that its foreign subsidiary receive as earnings forward, thus creating an offsetting cash outflow in that currency.

Translation Exposure 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 will help to offset the translation loss.

Translation Exposure Hedging translation exposure is limited by: inaccurate earnings forecasts, inadequate forward contracts for some currencies, accounting distortions (the choice of the translation exchange rate, taxes, etc.), and increased transaction exposure (due to hedging activities).

Translation Exposure In particular, if the foreign currency depreciates during the fiscal year, the transaction loss generated by a forward contract position will somewhat offset the translation gain. Note that the translation gain is simply a paper gain, while the loss resulting from the hedge is a real loss.

Translation 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.

Impact of Hedging Economic Exposure on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Hedging Decisions on Economic Exposure

Chapter Review Managing Economic Exposure Assessing Economic Exposure Reducing Economic Exposure through Restructuring Issues Involved in the Restructuring Decision

Chapter Review 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 MNC’s 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 MNC’s Cost of Capital International Interest Rates on Long-Term Funds MNC’s 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

Direct Foreign Investment 13 Chapter Direct Foreign Investment South-Western/Thomson Learning © 2003

Chapter Objectives To describe common motives for initiating direct foreign investment (DFI); and To illustrate the benefits of international diversification.

Motives for DFI DFI can improve profitability and enhance shareholder wealth, either by boosting revenues or reducing costs. Revenue-Related Motives Attract new sources of demand, especially when the potential for growth in the home country is limited.

Motives for DFI Revenue-Related Motives Enter profitable markets. Exploit monopolistic advantages, especially for firms that possess resources or skills not available to competing firms. React to trade restrictions.

Motives for DFI Cost-Related Motives Fully benefit from economies of scale, especially for firms that utilize much machinery. Use cheaper foreign factors of production. Use foreign raw materials, especially if the MNC plans to sell the finished product back to the consumers in that country.

Motives for DFI Cost-Related Motives Use foreign technology. React to exchange rate movements, such as when the foreign currency appears to be undervalued. DFI can also help reduce the MNC’s exposure to exchange rate fluctuations. Diversify sales/production internationally.

Motives for DFI The optimal method for a firm to penetrate a foreign market is partially dependent on the characteristics of the market. For example, if the consumers are used to buying domestic products, then licensing arrangements or joint ventures may be more appropriate.

Motives for DFI Before investing in a foreign country, the potential benefits must be weighed against the costs and risks. As conditions change over time, some countries may become more attractive targets for DFI, while other countries become less attractive.

Benefits of International Diversification The key to international diversification is to select foreign projects whose performance levels are not highly correlated over time.

Diversification Benefits for Merrimack Co. Merrimack Co. is a U.S. firm that is considering the location of a new investment project. Characteristics of Proposed Project If Located in the U.S. the U.K. Project’s mean expected annual after-tax return Standard deviation of project’s return Correlation of project’s return with return on existing U.S. business 25% .09 .80 .11 .02

Diversification Benefits for Merrimack Co. In terms of return, neither new project has an advantage. With regard to risk, the new project is expected to exhibit slightly less variability in returns if located in the U.S.

Diversification Benefits for Merrimack Co. Suppose that the project constitutes 30% of Merrimack’s total funds, and that the standard deviation of Merrimack’s return on existing U.S. business is .10. If the new project is located in the U.S., the portfolio variance for the overall firm

Diversification Benefits for Merrimack Co. If the new project is located in the U.K., the portfolio variance for the overall firm Thus, as a whole, Merrimack will generate more stable returns if the new project is located in the U.K.

Benefits of International Diversification An MNC may not be insulated from a global crisis, since many countries will be adversely affected. However, as can be seen from the 1997-98 Asian crisis, an MNC that had diversified among the Asian countries might have fared better than if it had focused on one country. Even better would be diversification among the continents.

Benefits of International Diversification As more projects are added to a portfolio, the portfolio variance should decrease on average, up to a certain point. However, the degree of risk reduction is greater for a global portfolio than for a domestic portfolio, due to the lower correlations among the returns of projects implemented in different economies.

Benefits of International Diversification An MNC with projects positioned around the world is concerned about the risk and return characteristics of its projects.

Benefits of International Diversification Project portfolios along the efficient frontier exhibit minimum risk for a given expected return. Of these efficient portfolios, an MNC may choose one that corresponds to its willingness to accept risk.

Benefits of International Diversification The frontiers of efficient project portfolios of some MNCs are more desirable than the frontiers of other MNCs.

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 For the government, the ideal DFI solves problems such as unemployment and lack of technology without taking business away from the local firms. The government may provide incentives to encourage the forms of DFI that it desires, and impose preventive barriers or conditions on the forms of DFI that it does not want.

Host Government View of DFI The ability of a host government to attract DFI is dependent on the country’s markets and resources, as well as government regulations and incentives. Common incentives offered by the host government include tax breaks, discounted rent for land and buildings, low-interest loans, subsidized energy, and reduced environmental restrictions.

Host Government View of DFI Common barriers imposed by the host government include the power to block a merger/acquisition, foreign majority ownership restrictions, excessive procedure and documentation requirements (red tape), and operational conditions.

Impact of DFI Decisions on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent DFI Decisions on Type of Business and Location

Chapter Review Motives for DFI Revenue-Related Motives Cost-Related Motives Comparing the Benefits of DFI Among Countries Comparing the Benefits of DFI Over Time

Chapter Review Benefits of International Diversification Example of Diversification Benefits Diversification Benefits During a Global Crisis Diversification Benefits of Multiple Projects Risk-Return Analysis of International Projects Comparing Portfolios Along the Frontier Comparing Frontiers Among MNCs

Chapter Review Decisions Subsequent to DFI Host Government View of DFI Incentives to Encourage DFI Barriers to DFI Impact of the DFI Decision on an MNC’s Value

Multinational Capital Budgeting 14 Chapter Multinational Capital Budgeting South-Western/Thomson Learning © 2003

Chapter Objectives To compare the capital budgeting analysis of an MNC’s 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 the capital budgeting for a multi-national project be conducted from the viewpoint of the subsidiary that will administer the project, or the parent that will provide most of the financing? The results may vary with the perspective taken because the net after-tax cash inflows to the parent can differ substantially from those to the subsidiary.

Subsidiary versus Parent Perspective The difference in cash inflows is due to : Tax differentials What is the tax rate on remitted funds? Regulations that restrict remittances Excessive remittances The parent may charge its subsidiary very high administrative fees. Exchange rate movements

Subsidiary versus Parent Perspective A parent’s perspective is appropriate when evaluating a project, since any project that can create a positive net present value for the parent should enhance the firm’s value. However, one exception to this rule may occur when the foreign subsidiary is not wholly owned by the parent.

Input for Multinational Capital Budgeting The following forecasts are usually required: 1. Initial investment 2. Consumer demand 3. Product price 4. Variable cost 5. Fixed cost 6. Project lifetime 7. Salvage (liquidation) value

Input for Multinational Capital Budgeting The following forecasts are usually required: 8. Fund-transfer restrictions 9. Tax laws 10. Exchange rates 11. Required rate of return

Multinational Capital Budgeting Capital budgeting is necessary for all long-term projects that deserve consideration. One common method of performing the analysis is to estimate the cash flows and salvage value to be received by the parent, and compute the net present value (NPV) of the project.

Multinational Capital Budgeting NPV = – initial outlay n + S cash flow in period t t =1 (1 + k )t + salvage value (1 + k )n k = the required rate of return on the project n = project lifetime in terms of periods If NPV > 0, the project can be accepted.

Capital Budgeting Analysis Period t 1. Demand (1) 2. Price per unit (2) 3. Total revenue (1)(2)=(3) 4. Variable cost per unit (4) 5. Total variable cost (1)(4)=(5) 6. Annual lease expense (6) 7. Other fixed periodic expenses (7) 8. Noncash expense (depreciation) (8) 9. Total expenses (5)+(6)+(7)+(8)=(9) 10. Before-tax earnings of subsidiary (3)–(9)=(10) 11. Host government tax tax rate(10)=(11) 12. After-tax earnings of subsidiary (10)–(11)=(12)

Capital Budgeting Analysis Period t 13. Net cash flow to subsidiary (12)+(8)=(13) 14. Remittance to parent (14) 15. Tax on remitted funds tax rate(14)=(15) 16. Remittance after withheld tax (14)–(15)=(16) 17. Salvage value (17) 18. Exchange rate (18) 19. Cash flow to parent (16)(18)+(17)(18)=(19) 20. Investment by parent (20) 21. Net cash flow to parent (19)–(20)=(21) 22. PV of net cash flow to parent (1+k) - t(21)=(22) 23. Cumulative NPV PVs=(23)

Factors to Consider in Multinational Capital Budgeting Exchange rate fluctuations. Different scenarios should be considered together with their probability of occurrence. Inflation. Although price/cost forecasting implicitly considers inflation, inflation can be quite volatile from year to year for some countries.

Factors to Consider in Multinational Capital Budgeting Financing arrangement. Financing costs are usually captured by the discount rate. However, many foreign projects are partially financed by foreign subsidiaries. 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.

Factors to Consider in Multinational Capital Budgeting Uncertain salvage value. The salvage value typically has a significant impact on the project’s NPV, and the MNC may want to compute the break-even salvage value. Impact of project on prevailing cash flows. The new investment may compete with the existing business for the same customers. Host government incentives. These should also be considered in the analysis.

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 on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Multinational Capital Budgeting Decisions

Chapter Review Subsidiary versus Parent Perspective Tax Differentials Restricted Remittances Excessive Remittances Exchange Rate Movements Input for Multinational Capital Budgeting Multinational Capital Budgeting

Chapter Review Factors to Consider in Multinational Capital Budgeting 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 MNC’s Value

Multinational Restructuring 15 Chapter Multinational Restructuring South-Western/Thomson Learning © 2003

Chapter Objectives To introduce international acquisitions by MNCs as a form of multinational restructuring; To explain how MNCs conduct valuations of foreign target firms; To explain why the valuations of a target firm may vary among MNCs; and To identify other methods of multinational restructuring.

Multinational Restructuring Building a new subsidiary, acquiring a company, selling an existing subsidiary, downsizing operations, or shifting production among subsidiaries, are all forms of multinational restructuring. MNCs continually 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 target is already in place, and benefit from already-established customer relationships. However, establishing a new subsidiary usually costs less, and there will not be a need to integrate the parent management style with that of the acquired company.

International Acquisitions Like any other long-term project, capital budgeting analysis can be used to determine whether a firm should be acquired. Hence, the acquisition decision can be based on a comparison of the benefits and costs as measured by the net present value (NPV).

International Acquisitions NPV = – initial outlay n + S cash flow in period t t =1 (1 + k )t + salvage value (1 + k )n k = the acquisition’s required rate of return n = the lifetime of the acquired firm If NPV > 0, the firm can be acquired.

International Acquisitions Note that the relevant exchange rate, taxes, and blocked-funds restriction, should be taken into account. The cost of overcoming the barriers that may be imposed by the government agencies that monitor mergers and acquisitions should be taken into consideration too.

International Acquisitions Examples of such barriers include laws against hostile takeovers, restricted foreign majority ownership, “red tape,” and special requirements.

International Acquisitions While the Asian crisis had devastating effects, it created an opportunity for some MNCs to pursue new business in Asia. In Asia, property values had declined, the currencies were weakened, many firms were near bankruptcy, and the governments wanted to resolve the crisis. However, these MNCs must not ignore the lowered economic growth in Asia too.

International Acquisitions In Europe, the adoption of the euro as the local currency by several countries simplifies the analysis that an MNC has to perform when comparing various possible target firms in the participating countries.

Factors that Affect the Expected Cash Flows of the Foreign Target Target-Specific Factors Target’s previous cash flows. These may serve as an initial base from which future cash flows can be estimated. Managerial talent of the target. The acquiring firm may allow the acquired firm to be managed as it was before the acquisition, downsize the firm, or restructure its operations.

Factors that Affect the Expected Cash Flows of the Foreign Target Country-Specific Factors Target’s local economic conditions. Demand is likely to be higher when the economic conditions are strong. Target’s local political conditions. Cash flow shocks are less likely when the political conditions are favorable.

Factors that Affect the Expected Cash Flows of the Foreign Target Country-Specific Factors Target’s industry conditions. Industries with high growth potential and non-excessive competition are preferred. Target’s currency conditions. A currency that is expected to strengthen over time will usually be preferred.

Factors that Affect the Expected Cash Flows of the Foreign Target Country-Specific Factors Target’s local stock market conditions. When the local stock market prices are generally low, the target’s acceptable bid price is also likely to be low. Taxes applicable to the target. What matters to the acquiring firm is the after-tax cash flows that it will ultimately receive in the form of remitted funds.

The Valuation Process Prospective targets are first screened to identify those that deserve a closer assessment. Capital budgeting analysis is then applied to each of the targets that passed the initial screening process. Only those targets that are priced lower than their perceived net present values may be worth acquiring.

Why Valuations of a Target May Vary Among MNCs Estimated cash flows of the foreign target. Different MNCs will manage the target’s 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.

Why Valuations of a Target May Vary Among MNCs Exchange rate effects on remitted funds. Different MNCs have different schedules for remitting funds from the target to the acquirer.

Why Valuations of a Target May Vary Among MNCs Required rate of return of the acquirer. Different MNCs may have different plans for the target, such that the perceived risk of the target will be different. The local risk-free interest rate may differ for MNCs based in different countries.

Other Types of Multinational Restructuring International Partial Acquisitions An MNC may purchase a substantial portion of the existing stock of a foreign firm, so as to gain some control over the target’s management and operations. The valuation of the firm depends on whether the MNC plans to acquire enough shares to control the firm (and hence influence its cash flows).

Other Types of Multinational Restructuring International Acquisitions of Privatized Businesses Many MNCs have acquired businesses from foreign governments. These businesses are usually difficult to value because the transition entails many uncertainties - cash flows, benchmark data, economic and political conditions, exchange rates, financing costs, etc.

Other Types of Multinational Restructuring International Alliances MNCs commonly engage in 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 typically be smaller too.

Other Types of Multinational Restructuring International Divestitures An MNC should periodically reassess its DFIs to determine whether to retain them or to sell (divest) them. The MNC can compare the present value of the cash flows from the project if it is continued, to the proceeds that would be received (after taxes) if it is divested.

Restructuring Decisions As Real Options Restructuring decisions may involve real options, or implicit options on real assets. If a proposed project carries an option to pursue an additional venture, then the project has a call option on real assets. If a proposed project carries an option to divest part or all of itself, then the project has a put option on real assets.

Restructuring Decisions As Real Options The expected NPV of a project with real options may be estimated as the sum of the products of the probability of each scenario and the respective NPV for that scenario. E(NPV) = S pi  NPVi i pi = probability of scenario i NPVi = NPV for scenario i

Impact of Multinational Restructuring on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Multinational Restructuring Decisions

Chapter Review Introduction to Multinational Restructuring International Acquisitions Model for Valuing a Foreign Target Barriers to International Acquisitions Assessing Potential Acquisitions in Asia and Europe

Chapter Review Factors that Affect the Expected Cash Flows of the Foreign Target Target-Specific Factors Country-Specific Factors The Valuation Process International Screening Process Estimating the Target’s Value

Chapter Review Why a Target’s Value May Vary Among MNCs Expected Cash Flows of the Target Exchange Rate Effects on Remitted Funds Required Return of the Acquirer

Chapter Review Other Types of Multinational Restructuring International Partial Acquisitions International Acquisitions of Privatized Businesses International Alliances International Divestitures

Chapter Review Restructuring Decisions as Real Options Call and Put Options on Real Assets Impact of Multinational Restructuring on an MNC’s Value

16 Chapter Country Risk Analysis South-Western/Thomson Learning © 2003

Chapter Objectives To identify the common factors used by MNCs to measure a country’s political risk and 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.

Country Risk Analysis Country risk represents the potentially adverse impact of a country’s environment on the MNC’s cash flows.

Country Risk Analysis 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 homemade products. Attitude of Host Government The host government may impose special requirements or taxes, restrict fund transfers, subsidize local firms, or fail to enforce copyright laws.

Political Risk Factors Blockage of Fund Transfers Funds that are blocked may not be optimally used. Currency Inconvertibility The MNC parent may need to exchange earnings for goods.

Political Risk Factors War Internal and external battles, or even the threat of war, can have devastating effects. Bureaucracy Bureaucracy can complicate businesses. Corruption Corruption can increase the cost of conducting business or reduce revenue.

Financial Risk Factors Current and Potential State of the Country’s Economy A recession can severely reduce demand. Financial distress can also cause the government to restrict MNC operations. Indicators of Economic Growth A country’s economic growth is dependent on several financial factors - interest rates, exchange rates, inflation, etc.

Types of Country Risk Assessment A macro-assessment of country risk is an overall risk assessment of a country without consideration of the MNC’s business. A micro-assessment of country risk is the risk assessment of a country as related to the MNC’s type of business.

Types of Country Risk Assessment The overall assessment of country risk thus consists of : Macro-political risk Macro-financial risk Micro-political risk Micro-financial risk

Types of Country Risk Assessment Note that the opinions of different risk assessors often differ due to subjectivities in: identifying the relevant political and financial factors, determining the relative importance of each factor, and predicting the values of factors that cannot be measured objectively.

Techniques of Assessing Country Risk A checklist approach involves rating and weighting all the identified factors, and then consolidating the rates and weights to produce an overall assessment. The Delphi technique involves collecting various independent opinions and then averaging and measuring the dispersion of those opinions.

Techniques of Assessing Country Risk Quantitative analysis techniques like regression analysis can be applied to historical data to assess the sensitivity of a business to various risk factors. Inspection visits involve traveling to a country and meeting with government officials, firm executives, and/or consumers to clarify uncertainties.

Techniques of Assessing Country Risk Often, firms use a variety of techniques for making country risk assessments. For example, they may use a checklist approach to develop an overall country risk rating, and some of the other techniques to assign ratings to the factors considered.

Developing A Country Risk Rating A checklist approach will require the following steps: Assign values and weights to the political risk factors. Multiply the factor values with their respective weights, and sum up to give the political risk rating. Derive the financial risk rating similarly.

Developing A Country Risk Rating A checklist approach will require the following steps: Assign weights to the political and financial ratings according to their perceived importance. Multiply the ratings with their respective weights, and sum up to give the overall country risk rating.

Developing A Country Risk Rating Different country risk assessors have their own individual procedures for quantifying country risk. Although most procedures involve rating and weighting individual risk factors, the number, type, rating, and weighting of the factors will vary with the country being assessed, as well as the type of corporate operations being planned.

Developing A Country Risk Rating Firms may use country risk ratings when screening potential projects, or when monitoring existing projects. For example, decisions regarding subsidiary expansion, fund transfers to the parent, and sources of financing, can all be affected by changes in the country risk rating.

Comparing Risk Ratings Among Countries One approach to comparing political and financial ratings among countries is the foreign investment risk matrix (FIRM ). The matrix measures financial (or economic) risk on one axis and political risk on the other axis. Each country can be positioned on the matrix based on its political and financial ratings.

Actual Country Risk Ratings Across Countries Some countries are rated higher according to some risk factors, but lower according to others. On the whole, industrialized countries tend to be rated highly, while emerging countries tend to have lower risk ratings. Country risk ratings change over time in response to changes in the risk factors.

Incorporating Country Risk in Capital Budgeting If the risk rating of a country is in the acceptable zone, the projects related to that country deserve further consideration. Country risk can be incorporated into the capital budgeting analysis of a project by adjusting the discount rate, or by adjusting the estimated cash flows.

Incorporating Country Risk in Capital Budgeting Adjustment of the Discount Rate The higher the perceived risk, the higher the discount rate that should be applied to the project’s cash flows. Adjustment of the Estimated Cash Flows By estimating how the cash flows could be affected by each form of risk, the MNC can determine the probability distribution of the net present value of the project.

Applications of Country Risk Analysis Alerted by its risk assessor, Gulf Oil planned to deal with the loss of Iranian oil, and was able to avoid major losses when the Shah of Iran fell four months later. However, while the risk assessment of a country can be useful, it cannot always detect upcoming crises.

Applications of Country Risk Analysis Iraq’s invasion of Kuwait was difficult to forecast, for example. Nevertheless, many MNCs promptly reassessed their exposure to country risk and revised their operations. The 1997-98 Asian crisis also showed that MNCs had underestimated the potential financial problems that could occur in the high-growth Asian countries.

Reducing Exposure to Host Government Takeovers The benefits of DFI can be offset by country risk, the most severe of which is a host government takeover. To reduce the chance of a takeover by the host government, firms often use the following strategies: Use a Short-Term Horizon This technique concentrates on recovering cash flow quickly.

Reducing Exposure to Host Government Takeovers 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.

Reducing Exposure to Host Government Takeovers Borrow Local Funds The local banks can apply pressure on their government. Purchase Insurance Investment guarantee programs offered by the home country, host country, or an international agency insure to some extent various forms of country risk.

Impact of Country Risk on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Exposure of Foreign Projects to Country Risks

Chapter Review Why Country Risk Analysis Is Important Political Risk Factors Attitude of Consumers in the Host Country Attitude of Host Government Blockage of Fund Transfers Currency Inconvertibility War Bureaucracy Corruption

Chapter Review Financial Risk Factors Current and Potential State of the Country’s Economy Indicators of Economic Growth Types of Country Risk Assessment Macro-Assessment of Country Risk Micro-Assessment of Country Risk

Chapter Review Techniques of Assessing Country Risk Checklist Approach Delphi Technique Quantitative Analysis Inspection Visits Combination of Techniques

Chapter Review Developing a Country Risk Rating Example of Measuring Country Risk Variation in Methods of Measuring Country Risk Using the Country Risk Rating for Decision-Making Comparing Risk Ratings Among Countries Actual Country Risk Ratings Across Countries

Chapter Review Incorporating Country Risk in Capital Budgeting Adjustment of the Discount Rate Adjustment of the Estimated Cash Flows Applications of Country Risk Analysis

Chapter Review Reducing Exposure to Host Government Takeovers Use a Short-Term Horizon Rely on Unique Supplies or Technology Hire Local Labor Borrow Local Funds Purchase Insurance Impact of Country Risk on an MNC’s Value

Multinational Cost of Capital & Capital Structure 17 Chapter Multinational Cost of Capital & Capital Structure South-Western/Thomson Learning © 2003

Chapter Objectives To explain how corporate and country characteristics influence an MNC’s cost of capital; To explain why there are differences in the costs of capital across countries; and To explain how corporate and country characteristics are considered by an MNC when it establishes its capital structure.

Cost of Capital A firm’s 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 want a capital structure that will minimize their cost of capital, and hence the required rate of return on projects.

kc = ( D ) kd ( 1 _ t ) + ( E ) ke Cost of Capital A firm’s weighted average cost of capital kc = ( D ) kd ( 1 _ t ) + ( E ) ke D + E D + E where D is the amount of debt of the firm E is the equity of the firm kd is the before-tax cost of its debt t is the corporate tax rate ke is the cost of financing with equity

Cost of Capital The interest payments on debt are tax deductible. However, as interest expenses increase, the probability of bankruptcy will increase too. It is favorable to increase the use of debt financing until the point at which the bankruptcy probability becomes large enough to offset the tax advantage of using debt.

Cost of Capital for MNCs The cost of capital for MNCs may differ from that for domestic firms because of the following differences. Size of Firm. Because of their size, MNCs are often given preferential treatment by creditors. They can usually achieve smaller per unit flotation costs too.

Cost of Capital for MNCs Acess to International Capital Markets. MNCs are normally able to obtain funds through international capital markets, where the cost of funds may be lower. International Diversification. M NCs may have more stable cash inflows due to international diversification, such that their probability of bankruptcy may be lower.

Cost of Capital for MNCs Exposure to Exchange Rate Risk. MNCs may be more exposed to exchange rate fluctuations, such that their cash flows may be more uncertain and their probability of bankruptcy higher. Exposure to Country Risk. M NCs that have a higher percentage of assets invested in foreign countries are more exposed to country risk.

Cost of Capital for MNCs The capital asset pricing model (CAPM) can be used to assess how the required rates of return of MNCs differ from those of purely domestic firms. According to CAPM, ke = Rf + b (Rm – Rf ) where ke = the required return on a stock Rf = risk-free rate of return Rm = market return b = the beta of the stock

Cost of Capital for MNCs A stock’s beta represents the sensitivity of the stock’s returns to market returns, just as a project’s beta represents the sensitivity of the project’s cash flows to market conditions. The lower a project’s beta, the lower its systematic risk, and the lower its required rate of return, if its unsystematic risk can be diversified away.

Cost of Capital for MNCs An MNC that increases its foreign sales may be able to reduce its stock’s beta, and hence the return required by investors. This translates into a lower overall cost of capital. However, MNCs may consider unsystematic risk as an important factor when determining a foreign project’s required rate of return.

Cost of Capital for MNCs Hence, we cannot be certain if an MNC will have a lower cost of capital than a purely domestic firm in the same industry.

Costs of Capital Across Countries The cost of capital may vary across countries, such that: MNCs based in some countries may have a competitive advantage over others; MNCs may be able to adjust their international operations and sources of funds to capitalize on the differences; and MNCs based in some countries may have a more debt-intensive capital structure.

Costs of Capital Across Countries The cost of debt to a firm is primarily determined by  the prevailing risk-free interest rate of the borrowed currency and  the risk premium required by creditors. The risk-free rate is determined by the interaction of the supply and demand for funds. It may vary due to different tax laws, demographics, monetary policies, and economic conditions.

Costs of Capital Across Countries The risk premium compensates creditors for the risk that the borrower may be unable to meet its payment obligations. The risk premium may vary due to different economic conditions, relationships between corporations and creditors, government intervention, and degrees of financial leverage.

Costs of Capital Across Countries Although the cost of debt may vary across countries, there is some positive correlation among country cost-of-debt levels over time.

Costs of Capital Across Countries A country’s cost of equity represents an opportunity cost – what the shareholders could have earned on investments with similar risk if the equity funds had been distributed to them. The return on equity can be measured by the risk-free interest rate plus a premium that reflects the risk of the firm.

Costs of Capital Across Countries A country’s cost of equity can also be estimated by applying the price/earnings multiple to a given stream of earnings. A high price/earnings multiple implies that the firm receives a high price when selling new stock for a given level of earnings. So, the cost of equity financing is low.

Costs of Capital Across Countries The costs of debt and equity can be combined, using the relative proportions of debt and equity as weights, to derive an overall cost of capital.

Using the Cost of Capital for Assessing Foreign Projects Foreign projects may have risk levels different from that of the MNC, such that the MNC’s weighted average cost of capital (WACC) may not be the appropriate required rate of return. There are various ways to account for this risk differential in the capital budgeting process.

Using the Cost of Capital for Assessing Foreign Projects Derive NPVs based on the WACC. The probability distribution of NPVs can be computed to determine the probability that the foreign project will generate a return that is at least equal to the firm’s WACC. Adjust the WACC for the risk differential. The MNC may estimate the cost of equity and the after-tax cost of debt of the funds needed to finance the project.

The MNC’s Capital Structure Decision The overall capital structure of an MNC is essentially a combination of the capital structures of the parent body and its subsidiaries. The capital structure decision involves the choice of debt versus equity financing, and is influenced by both corporate and country characteristics.

The MNC’s Capital Structure Decision Corporate Characteristics Stability of cash flows. MNCs with more stable cash flows can handle more debt. Credit risk. MNCs that have lower credit risk have more access to credit. Access to retained earnings. Profitable MNCs and MNCs with less growth may be able to finance most of their investment with retained earnings.

The MNC’s Capital Structure Decision Corporate Characteristics Guarantees on debt. If the parent backs the subsidiary’s debt, the subsidiary may be able to borrow more. Agency problems. Host country shareholders may monitor a subsidiary, though not from the parent’s perspective.

The MNC’s Capital Structure Decision Country Characteristics Stock restrictions. MNCs in countries where investors have less investment opportunities may be able to raise equity at a lower cost. Interest rates. MNCs may be able to obtain loanable funds (debt) at a lower cost in some countries.

The MNC’s Capital Structure Decision Country Characteristics Strength of currencies. MNCs tend to borrow the host country currency if they expect it to weaken, so as to reduce their exposure to exchange rate risk. Country risk. If the host government is likely to block funds or confiscate assets, the subsidiary may prefer debt financing.

The MNC’s Capital Structure Decision Country Characteristics Tax laws. MNCs may use more local debt financing if the local tax rates (corporate tax rate, withholding tax rate, etc.) are higher.

Interaction Between Subsidiary and Parent Financing Decisions Increased debt financing by the subsidiary A larger amount of internal funds may be available to the parent. The need for debt financing by the parent may be reduced. The revised composition of debt financing may affect the interest charged on debt as well as the MNC’s overall exposure to exchange rate risk.

Interaction Between Subsidiary and Parent Financing Decisions Reduced debt financing by the subsidiary A smaller amount of internal funds may be available to the parent. The need for debt financing by the parent may be increased. The revised composition of debt financing may affect the interest charged on debt as well as the MNC’s overall exposure to exchange rate risk.

Using a Target Capital Structure on a Local versus Global Basis An MNC may deviate from its “local” target capital structure as necessitated by local conditions. However, the proportions of debt and equity financing in one subsidiary may be adjusted to offset an abnormal degree of financial leverage in another subsidiary. Hence, the MNC may still achieve its “global” target capital structure.

Using a Target Capital Structure on a Local versus Global Basis Note that a capital structure revision may result in a higher cost of capital. Hence, an unusually high or low degree of financial leverage should only be adopted if the benefits outweigh the overall costs.

Using a Target Capital Structure on a Local versus Global Basis The volumes of debt and equity issued in financial markets vary across countries, indicating that firms in some countries (such as Japan) have a higher degree of financial leverage on average. However, conditions may change over time. In Germany for example, firms are shifting from local bank loans to the use of debt security and equity markets.

Impact of Multinational Capital Structure Decisions on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Parent’s Capital Structure Decisions

Chapter Review Introduction to the Cost of Capital Comparing the Costs of Equity and Debt Cost of Capital for MNCs Size of Firm Access to International Capital Markets International Diversification Exposure to Exchange Rate Risk Exposure to Country Risk

Chapter Review Cost of Capital for MNCs … continued Cost of Capital Comparison Using the CAPM Implications of the CAPM for an MNC’s Risk

Chapter Review Costs of Capital Across Countries Country Differences in the Cost of Debt Country Differences in the Cost of Equity Combining the Costs of Debt and Equity Using the Cost of Capital for Assessing Foreign Projects Derive NPVs Based on the WACC Adjust the WACC for the Risk Differential

Chapter Review The MNC’s Capital Structure Decision Influence of Corporate Characteristics Influence of Country Characteristics Interaction Between Subsidiary and Parent Financing Decisions Impact of Increased Debt Financing by the Subsidiary Impact of Reduced Debt Financing by the Subsidiary

Chapter Review Using a Target Capital Structure on a Local versus Global Basis Offsetting a Subsidiary’s Abnormal Degree of Financial Leverage Limitations of Offsets Differences in Financing Tendencies Among Countries Impact of Capital Structure Decisions on an MNC’s Value

18 Chapter Long-Term Financing South-Western/Thomson Learning © 2003

Chapter Objectives To explain why MNCs consider long-term financing in foreign currencies; To explain how the feasibility of long-term financing in foreign currencies can be assessed; and To explain how the assessment of long-term financing in foreign currencies can be adjusted for bonds with floating interest rates.

The Long-Term Financing Decision Because bonds denominated in foreign currencies sometimes require lower yields, MNCs often consider long-term financing in foreign currencies. The actual cost of such financing depends on the quoted interest rate, as well as the changes in the value of the borrowed currency over the life of the loan.

The Long-Term Financing Decision To make the long-term financing decision, the MNC must determine the amount of funds needed, forecast the price (interest rate) at which the bond may be issued, and forecast the exchange rates of the borrowed currency for the times when it has to make payments (coupons and principal) to the bondholders.

The Long-Term Financing Decision Then the probability distribution of the bond’s financing costs may be determined. An MNC that denominates bonds in a foreign currency may achieve major cost reductions, but is subject to the possibility of incurring high costs if the borrowed currency appreciates over time.

Managing Exchange Rate Risk Point-estimate exchange rate forecasts cannot adequately account for the potential impact of exchange rate fluctuations. Instead, the probability distribution of the exchange rate should be developed, so as to determine the expected financing cost and its probability distribution. Computer simulation may aid the process.

Managing Exchange Rate Risk The exchange rate risk from financing with bonds in foreign currencies can be reduced by using: offsetting cash inflows in the borrowed currency forward contracts currency swaps

Managing Exchange Rate Risk The exchange rate risk from financing with bonds in foreign currencies can be reduced by using: parallel (or back-to-back) loans diversified portfolios of bonds that are denominated in several foreign currencies or currency cocktail bonds (which are bonds denominated in a multicurrency unit e.g. SDR)

Floating-Rate Bonds 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, forecasts are required for both exchange rates and interest rates.

Floating-Rate Bonds When MNCs issue floating-rate bonds that expose them to interest rate risk, they may use interest rate swaps to hedge the risk. Interest rate swaps enable a firm to exchange fixed rate payments for variable rate payments, and vice versa. They are used by bond issuers to reconfigure future bond payments to a more preferable structure.

Floating-Rate Bonds Note that financial intermediaries are usually involved in swap agreements. They match up participants and also assume the default risk involved for a fee.

Use of Yield Curves to Make 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 in the country of the currency to be borrowed. Since the slopes of the yield curves may vary across countries, the choice of short-term, medium-term, or long-term debt financing may vary across countries too.

Impact of Long-Term Financing Decisions on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Parent’s Long-Term Financing Decisions

Chapter Review The Long-Term Financing Decision Measuring the Cost of Financing Actual Effects of Exchange Rate Movements on Financing Costs Managing Exchange Rate Risk Accounting for Exchange Rate Risk Reducing Exchange Rate Risk

Chapter Review Floating-Rate Bonds Hedging Interest Rate Risk Use of Yield Curves to Make Debt Maturity Decisions Impact of Long-Term Financing Decisions on an MNC’s Value

Part V Short-Term Asset and Liability Management Subsidiaries of MNC with Excess Funds Deficient Funds International Commercial Paper Market Eurobanks in Eurocurrency Market MNC Parent Deposits Purchase Securities Provision of Loans Borrow Funds Borrow Funds

Financing International Trade 19 Chapter Financing International Trade South-Western/Thomson Learning © 2003

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.

Payment Methods for International Trade Method  : Prepayments The goods will not be shipped until the buyer has paid the seller. 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

Payment Methods for International Trade Method  : 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 Goods available to buyers : After payment Risk to exporter : Very little or none Risk to importer : Relies on exporter to ship goods as described in documents

Payment Methods for International Trade Method  : Drafts (Bills of Exchange) These are unconditional promises drawn by the exporter instructing the buyer to pay the face amount of the drafts. Banks on both ends usually act as intermediaries in the processing of shipping documents and the collection of payment. In banking terminology, the transactions are known as documentary collections.

Payment Methods for International Trade Method  : Drafts (Bills of Exchange) Sight drafts (documents against payment) : When the shipment has been made, the draft is presented to the buyer for payment. Time of payment : On presentation of draft Goods available to buyers : After payment Risk to exporter : Disposal of unpaid goods Risk to importer : Relies on exporter to ship goods as described in documents

Payment Methods for International Trade Method  : Drafts (Bills of Exchange) Time drafts (documents against acceptance) : When the shipment has been made, the buyer accepts (signs) the presented draft. Time of payment : On maturity of draft Goods available to buyers : Before payment Risk to exporter : Relies on buyer to pay Risk to importer : Relies on exporter to ship goods as described in documents

Payment Methods for International Trade Method  : Consignments The exporter retains actual title to the goods that are shipped to the importer. Time of payment : At time of sale to third party Goods available to buyers : Before payment Risk to exporter : Allows importer to sell inventory before paying exporter Risk to importer : None

Payment Methods for International Trade Method  : 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 Goods available to buyers : Before payment Risk to exporter : Relies completely on buyer to pay account as agreed upon Risk to importer : None

Trade Finance Methods Accounts Receivable Financing An exporter that needs funds immediately may obtain a bank loan that is secured by an assignment of the account receivable. Factoring (Cross-Border Factoring) The accounts receivable are sold to a third party (the factor), that then assumes all the responsibilities and exposure associated with collecting from the buyer.

Trade Finance Methods 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. The importer pays the issuing bank the amount of the L/C plus associated fees. Commercial or import/export L/Cs are usually irrevocable.

Trade Finance Methods Letters of Credit (L/C) The required documents typically include a draft (sight or time), a commercial invoice, and a bill of lading (receipt for shipment). Sometimes, the exporter may request that a local bank confirm (guarantee) the L/C.

Trade Finance Methods Letters of Credit (L/C) Variations include standby L/Cs : funded only if the buyer does not pay the seller as agreed upon transferable L/Cs : the first beneficiary can transfer all or part of the original L/C to a third party assignments of proceeds under an L/C : the original beneficiary assigns the proceeds to the end supplier

Trade Finance Methods Banker’s Acceptance (BA) This is a time draft that is drawn on and accepted by a bank (the importer’s bank). The accepting bank is obliged to pay the holder of the draft at maturity. If the exporter does not want to wait for payment, it can request that the BA be sold in the money market. Trade financing is provided by the holder of the BA.

Trade Finance Methods Banker’s Acceptance (BA) The bank accepting the drafts charges an all-in-rate (interest rate) that consists of the discount rate plus the acceptance commission. In general, all-in-rates are lower than bank loan rates. They usually fall between the rates of short-term Treasury bills and commercial papers.

Trade Finance Methods Working Capital Financing Banks may provide short-term loans that finance the working capital cycle, from the purchase of inventory until the eventual conversion to cash.

Trade Finance Methods Medium-Term Capital Goods Financing (Forfaiting) The importer issues a promissory note to the exporter to pay for its imported capital goods over a period that generally ranges from three to seven years. The exporter then sells the note, without recourse, to a bank (the forfaiting bank).

Trade Finance Methods Countertrade These are 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. Common countertrade types include barter, compensation (product buy-back), and counterpurchase. The primary participants are governments and multinationals.

Agencies that Motivate International Trade Due to the inherent risks of international trade, government institutions and the private sector offer various forms of export credit, export finance, and guarantee programs to reduce risk and stimulate foreign trade.

Agencies that Motivate International Trade Export-Import Bank of the U.S. (Ex-Imbank) This U.S. government agency aims to create jobs by financing and facilitating the export of U.S. goods and services and maintaining the competitiveness of U.S. companies in overseas markets. It offers guarantees of commercial loans, direct loans, and export credit insurance.

Agencies that Motivate International Trade Private Export Funding Corporation (PEFCO) PEFCO is a private corporation that is owned by a consortium of commercial banks and industrial companies. In cooperation with Ex-Imbank, PEFCO provides medium- and long-term fixed-rate financing for foreign buyers through the issuance of long-term bonds.

Agencies that Motivate International Trade Overseas Private Investment Corporation (OPIC) OPIC is a U.S. government agency that assists U.S. investors by insuring their overseas investments against a broad range of political risks. It also provides financing for overseas businesses through loans and loan guaranties.

Agencies that Motivate International Trade Beyond insurance and financing, the U.S. has tax provisions that encourage international trade. The FSC Repeal and Extraterritorial Income Exclusion Act of 2000, which replaced the 1984 Foreign Sales Corporation provisions in response to WTO concerns, excludes certain extraterritorial income from the definition of gross income for U.S. tax purposes.

Impact of International Trade Financing Decisions on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Trade Financing Decisions

Chapter Review Payment Methods for International Trade Prepayments Letters of Credit Sight Drafts and Time Drafts Consignments Open Accounts

Chapter Review Trade Finance Methods Accounts Receivable Financing Factoring Letters of Credit Banker’s Acceptances Working Capital Financing Medium-Term Capital Goods Financing (Forfaiting) Countertrade

Chapter Review Agencies that Motivate International Trade Export-Import Bank of the U.S. Private Export Funding Corporation Overseas Private Investment Corporation Other Considerations Impact of International Trade Financing on an MNC’s Value

20 Chapter Short-Term Financing South-Western/Thomson Learning © 2003

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 utilize direct Eurobank loans to maintain a relationship with the banks too.

Internal Financing by MNCs Before an MNC’s 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. An MNC may also consider borrowing foreign currencies when the interest rates on such currencies are attractive, so as to reduce the costs of financing.

Determining the Effective Financing Rate The actual cost of financing depends on the interest rate on the loan, and the movement in the value of the borrowed currency over the life of the loan.

Determining the Effective Financing Rate Effective financing rate, rf = {( 1 + if )  St+1} – {1  St} = ( 1 + if )St+1 – 1 {1  St} St where if = the interest rate on the loan St = beginning spot rate St+1 = ending spot rate The effective rate can be rewritten as rf = ( 1 + if ) ( 1 + ef ) – 1 where ef = the % D in the 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.

Criteria Considered for Foreign Financing Interest Rate Parity (IRP) If IRP holds, foreign financing with a simultaneous hedge of that position in the forward market will result in financing costs similar to those for domestic financing.

Criteria Considered for Foreign Financing The Forward Rate as a Forecast If the forward rate is an unbiased predictor of the future spot rate, then the effective financing rate of a foreign loan will on average be equal to the domestic financing rate.

Criteria Considered for Foreign Financing Exchange Rate Forecasts Firms may use exchange rate forecasts to forecast the effective financing rate of a foreign currency, or they may compute the break-even exchange rate that will equate the domestic and foreign financing rates. Sometimes, it may be useful to develop probability distributions, instead of relying on single point estimates.

Financing with a Portfolio of Currencies While foreign financing can result in significantly 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.

Financing with a Portfolio of Currencies If the chosen currencies are not highly positively correlated, they will not be likely to experience a high level of appreciation simultaneously. Thus, the chances that the portfolio’s effective financing rate will exceed the domestic financing rate are reduced.

Financing with a Portfolio of Currencies 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 on a periodic basis. When comparing different financing packages, the variance can be used to measure how volatile a portfolio’s effective financing rate is.

Financing with a Portfolio of Currencies For a two-currency portfolio, E(rP) = wAE(rA) + wBE(rB) where rP = the effective financing rate of the portfolio rX = the effective financing rate of currency X wX = the % of total funds financed from currency X

Financing with a Portfolio of Currencies For a two-currency portfolio, Var(rP) = wA2A2 + wB2B2 + 2wAwBABCORRAB X2 = the variance of currency X’s effective financing rate CORRAB = the correlation coefficient of the two currencies’ effective finance rates

Impact of Short-Term Financing Decisions on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Expenses Incurred from Short-Term Financing

Chapter Review Sources of Short-Term Financing Euronotes Euro-Commercial Paper Eurobank Loans Internal Financing by MNCs Why MNCs Consider Foreign Financing Foreign Financing to Offset Foreign Receivables Foreign Financing to Reduce Costs

Chapter Review Determining the Effective Financing Rate Criteria Considered for Foreign Financing Interest Rate Parity The Forward Rate as a Forecast Exchange Rate Forecasts

Chapter Review Financing with a Portfolio of Currencies Portfolio Diversification Effects Repeated Financing with a Currency Portfolio Impact of Short-Term Financing Decisions on an MNC’s Value

International Cash Management 21 Chapter International Cash Management South-Western/Thomson Learning © 2003

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

Cash Flow Analysis: Subsidiary Perspective Subsidiary Expenses International purchases of raw materials or supplies are more likely to be difficult to manage because of exchange rate fluctuations, quotas, etc. If the sales volume is highly volatile, larger cash balances may need to be maintained in order to cover unexpected inventory demands.

Cash Flow Analysis: Subsidiary Perspective Subsidiary Revenue International sales are more likely to be volatile because of exchange rate fluctuations, business cycles, etc. Looser credit standards may increase sales (accounts receivable), though often at the expense of slower cash inflows.

Cash Flow Analysis: Subsidiary Perspective Subsidiary Dividend Payments Forecasting cash flows will be easier if the dividend payments and fees (royalties and overhead charges) to be sent to the parent are known in advance and denominated in the subsidiary’s currency.

Cash Flow Analysis: Subsidiary Perspective Subsidiary Liquidity Management After accounting for all cash outflows and inflows, the subsidiary must either invest its excess cash or borrow to cover its cash deficiencies. If the subsidiary has access to lines of credit and overdraft facilities, it may maintain adequate liquidity without substantial cash balances.

Centralized Cash Management While each subsidiary is managing its own working capital, a centralized cash management group is needed to monitor, and possibly manage, the parent-subsidiary and intersubsidiary cash flows. International cash management can be segmented into two functions: optimizing cash flow movements, and investing excess cash.

Centralized Cash Management The centralized cash management division of an MNC cannot always accurately forecast the events that may affect parent- subsidiary or intersubsidiary cash flows. It should, however, be ready to react to any event by considering any potential adverse impact on cash flows, and how to avoid such adverse impacts.

Techniques to Optimize Cash Flows Accelerating Cash Inflows The more quickly the cash 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 (to reduce mail float) and preauthorized payments (direct charging of a customer’s bank account).

Techniques to Optimize Cash Flows Minimizing Currency Conversion Costs Netting reduces administrative and transaction costs through the accounting of all transactions that occur over a period to determine one net payment. A bilateral netting system involves transactions between two units, while a multilateral netting system usually involves more complex interchanges.

Techniques to Optimize Cash Flows Managing Blocked Funds A government may require that funds remain within the country in order to create jobs and reduce unemployment. The MNC should then reinvest the excess funds in the host country, adjust the transfer pricing policy (such that higher fees have to be paid to the parent), borrow locally rather than from the parent, etc.

Techniques to Optimize Cash Flows Managing Intersubsidiary Cash Transfers A subsidiary with excess funds can provide financing by paying for its supplies earlier than is necessary. This technique is called leading. Alternatively, a subsidiary in need of funds can be allowed to lag its payments. This technique 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.

Complications in Optimizing Cash Flows Characteristics of Banking Systems The abilities of banks to facilitate cash transfers for MNCs may vary among countries. The banking systems in different countries usually differ too.

Investing Excess Cash Excess funds can be invested in domestic or foreign short-term securities, such as Eurocurrency deposits, bills, and commercial papers. Sometimes, foreign short-term securities have higher interest rates. However, firms must also account for the possible exchange rate movements.

Investing Excess Cash Centralized Cash Management Centralized cash management allows for more efficient usage of funds and possibly higher returns. When multiple currencies are involved, a separate pool may be formed for each currency. The investment securities may also be denominated in the currencies that will be needed in the future.

Investing Excess Cash Determining the Effective Yield The effective rate for foreign investments rf = ( 1 + if ) ( 1 + ef ) – 1 where if = the quoted interest rate on the investment ef = the % D in the spot rate If the foreign currency depreciates over the investment period, the effective yield will be less than the quoted rate.

Investing Excess Cash Implications of Interest Rate Parity (IRP) A foreign currency with a high interest rate will normally exhibit a forward discount that reflects the differential between its interest rate and the investor’s home interest rate. However, short-term foreign investing on an uncovered basis may still result in a higher effective yield.

Investing Excess Cash Use of the Forward Rate as a Forecast If IRP exists, the forward rate can be used as a break-even point to assess the short-term investment decision. The effective yield will be higher if the spot rate at maturity is more than the forward rate at the time the investment is undertaken, and vice versa.

Investing Excess Cash Use of Exchange Rate Forecasts Given an exchange rate forecast, the expected effective yield of a foreign investment can be computed, and then compared with the local investment yield. It may be useful to use probability distributions instead of point estimates, or to compute the break-even exchange rate that will equate foreign and local yields.

Investing Excess Cash Diversifying Cash Across Currencies If an MNC is not sure of how exchange rates will change over time, it may prefer to diversify its cash among securities that are denominated in different currencies. The degree to which such a portfolio will reduce risk depends on the correlations among the currencies.

Investing Excess Cash Use of Dynamic Hedging to Manage Cash Dynamic hedging refers to the strategy of hedging when the currencies held are expected to depreciate, and not hedging when they are expected to appreciate. The overall performance is dependent on the firm’s ability to accurately forecast the direction of exchange rate movements.

Impact of International Cash Management on an MNC’s Value E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent Returns on International Cash Management

Chapter Review Cash Flow Analysis: Subsidiary Perspective Subsidiary Expenses Subsidiary Revenue Subsidiary Dividend Payments Subsidiary Liquidity Management Centralized Cash Management

Chapter Review Techniques to Optimize Cash Flows Accelerating Cash Inflows Minimizing Currency Conversion Costs Managing Blocked Funds Managing Intersubsidiary Cash Transfers Complications in Optimizing Cash Flows Company-Related Characteristics Government Restrictions Characteristics of Banking Systems

Chapter Review Investing Excess Cash How to Invest Excess Cash 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 Use of Dynamic Hedging to Manage Cash

Chapter Review Impact of International Cash Management on an MNC’s Value