International Financial Management 9th Edition by Jeff Madura Florida Atlantic University 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.

Centralized Multinational Financial Management for an MNC with two subsidiaries, A and B Financial Managers of Parent Capital Expenditures at A Inventory and Accounts Receivable Management at A Cash Management Financing at A at B Management at B Financing at B

Decentralized Multinational Financial Management for an MNC with two subsidiaries, A and B Financial Managers of A Capital Expenditures at A Inventory and Accounts Receivable Management at A Cash Management Financing at A at B Management at B Financing at B of B

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.

The International Product Life Cycle  Firm creates product to accommodate local demand.  Firm exports product to accommodate foreign demand.  Firm establishes foreign subsidiary to establish presence in foreign country and possibly to reduce costs. a. Firm differentiates product from competitors and/or expands product line in foreign country. b. Firm’s foreign business declines as its competitive advantages are eliminated. or

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.

Degree of International Business by MNCs

Online Application Check out the following international trade promotion sites.

http://www.tradenet.gov

http://www.business.gov/busadv/index.cfm

http://www.trade.gov http://www.export.gov

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 Cost-benefit Evaluation for Purely Domestic Firms versus MNCs Marginal Return on Projects Purely Domestic Firm MNC Asset Level of Firm Investment Opportunities Marginal Cost of Capital Purely Domestic Firm MNC Financing Opportunities Appropriate Size for Purely Domestic Firm Appropriate Size for MNC X Y

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.

Online Application For more information on the Asian crisis, check out the following sites: http://www.stern.nyu.edu/~nroubini/asia/AsiaHomepage.html http://www.asienhaus.org/navigat/english/asienhau.htm

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.

Exposure to International Risk 2000 2001 U.S. Firm’s Cost of Obtaining £100,000

Online Application Visit FRED®, Fed's economic time-series database, at http://www.stls.frb.org/fred for numerous economic and financial time series, e.g., balance of payment statistics, interest rates, foreign exchange rates. Visit http://www.ita.doc.gov/td/industry/otea (Office of Trade and Economic Analysis) for an outlook of international trade conditions for each of several industries.

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

How Chapters Relate to Valuation Background on International Financial Markets (Chapters 2-5) Exchange Rate Behavior (Chapters 6-8) Long-Term Investment and Financing Decisions (Chapters 13-18) Short-Term Investment and Financing Decisions (Chapters 19-21) Exchange Rate Risk Management (Chapters 9-12) Risk and Return of MNC Value and Stock Price of MNC

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 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 How Chapters Relate to Valuation

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.

Summary of U.S. International Transactions (For the Year of 2000 in Millions of Dollars) Current Account Exports of goods and services and income receipts 1418568 Goods, balance of payments basis 772210 Services 293492 Income receipts 352866 Imports of goods and services and income receipts -1809099 Goods, balance of payments basis -1224417 Services -217024 Income payments -367658 Unilateral current transfers, net -54136 Balance on current account -444667 Source: U.S. Bureau of Economic Analysis

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.

Summary of U.S. International Transactions (For the Year of 2000 in Millions of Dollars) Capital Account Capital account transactions, net 705 Source: U.S. Bureau of Economic Analysis

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.

Summary of U.S. International Transactions (For the Year of 2000 in Millions of Dollars) Financial Account U.S.-owned assets abroad, net (increase/financial outflow) -580952 U.S. official reserve assets, net -290 Other U.S. Gov’t assets, net -944 U.S. private assets, net -579718 Foreign-owned assets in the U.S., net (increase/financial inflow) 1024218 Foreign official assets in the U.S., net 37619 Other foreign assets in the U.S., net 986599 Net financial flows 443266 Statistical discrepancy (sum of items in all accounts with sign reversed) 696 Source: U.S. Bureau of Economic Analysis

Online Application The U.S. balance of payments and related data are disseminated by the Bureau of Economic Analysis. Visit the Bureau at http://www.bea.doc.gov.

Online Application For a snapshot of the latest international trade conditions, visit the White House’s Economic Statistics Briefing Room at www.whitehouse.gov/fsbr/international.html.

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.

Distribution of U.S. Exports and Imports Canada (179,231) Mexico (111,136) Colombia (4,7) Ecuador (1,2) Peru (2,2) Chile (3,3) Venezuela (6,19) Brazil (15,14) Argentina (5,3) Bahamas (1,0) Costa Rica (2,4) Dominican Republic (4,4) El Salvador (2,2) Jamaica (1,1) Panama (2,0) Guatemala (2,3) Honduras (3,3) Trinidad and Tobago (1,2) For the Year of 2000 (exports, imports) in Billions of $ Source: U.S. Census Bureau

Distribution of U.S. Exports and Imports (exports, imports) in Billions of $ for the Year of 2000 Austria (3,3) Belgium (14,10) Czech Republic (1,1) Denmark (2,3) Germany (29,59) Italy (11,25) Ireland (8,16) United Kingdom (42,43) Russia (2,8) Finland (2,3) Sweden (5,10) Norway (2,6) Netherlands (22,10) Poland Portugal (1,2) Spain (6,6) Hungary (1,3) France (20,30) Switzerland (10,10) Turkey (4,3) Greece (1,1) Source: U.S. Census Bureau

Distribution of U.S. Exports and Imports Algeria (1,3) Angola (0,4) Egypt (3,1) South Africa (3,4) Nigeria (1,11) Gabon (0,2) Distribution of U.S. Exports and Imports For the Year of 2000 (exports, imports) in Billions of $ Source: U.S. Census Bureau

Distribution of U.S. Exports and Imports Australia (12,6) Bangladesh (0,2) China (16,100) United Arab Emirates (2,1) New Zealand (2,2) Japan (65,146) South Korea (28,40) Taiwan (24,41) Philippines (9,14) Indonesia (2,10) Hong Kong (15,11) India (4,11) Iraq (0,6) Israel (8,13) Kuwait (1,3) Macao (0,1) Malaysia (11,26) Pakistan (0,2) Saudi Arabia (6,14) Singapore (18,19) Sri Lanka Thailand (7,16) Distribution of U.S. Exports and Imports For the Year of 2000 (exports, imports) in Billions of $ Source: U.S. Census Bureau

Distribution of U.S. Exports and Imports For the Year of 2000 in Billions of $ Australasia 14.8 1.9% Canada 178.8 22.8% Mexico 111.7 14.3% Other America 59.3 7.6% Eastern Europe 6.1 0.8% Western Europe 181.3 23.2% 11.0 1.4% Africa 27.6 2.3% 148.5 19.0% East Asia 340.3 28.0% South East Asia 47.4 6.1% Other Asia 23.6 3.0% 229.2 18.8% 135.9 11.2% 73.3 6.0% 16.2 1.3% 241.0 19.8% 88.0 7.2% 56.5 4.6% 8.8 0.7% Exports Imports Source: U.S. Office of Trade and Economic Analysis

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.

U.S. Balance of Trade Trend Billions of US$ U.S. Imports U.S. Exports U.S. Balance of Trade Source: U.S. Census Bureau

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.

J-Curve Effect U.S. Trade Balance Time J Curve

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.

Direct Foreign Investment Positions of the United States on a Historical Cost basis Billions of US$ DFI by U.S. Firms DFI in the U.S. Source: U.S. Bureau of Economic Analysis

Distribution of DFI for the U.S. For the Year of 2000 DFI by U.S. Firms DFI in the U.S. Canada 10.2% Other Western Hemisphere 19.2% 3.4% 8.1% France 3.1% Germany 4.3% United Kingdom 18.8% Other Europe 16.6% Africa 1.3% Middle East 1.0% Japan 4.5% Other Asia & Pacific 11.6% Other Asia & Pacific 2.5% 9.6% 9.9% Netherlands 9.3% 12.3% 18.5% 21.5% 0.7% 13.2% Source: U.S. Bureau of Economic Analysis

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

Online Application You may learn more about the IMF at http://www.imf.org.

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.

Online Application To learn more about the World Bank Group and its organizations, visit: http://www.worldbank.org http://www.worldbank.org/ibrd http://www.worldbank.org/ida http://www.ifc.org http://www.miga.org http://www.worldbank.org/icsid

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.

Online Application To learn more about the WTO and the BIS, visit: http://www.wto.org http://www.bis.org

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 Distribution of U.S. Exports and Imports U.S. Balance of Trade Trend 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 Distribution of DFI by U.S. Firms Distribution of DFI in the U.S. 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 $

Online Application Check out these foreign exchange sites: http://pacific.commerce.ubc.ca/xr/ http://sonnet-financial.com/rates/full.asp http://www.oanda.com/

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.

Online Application Learn more about the Single European Act at http://europa.eu.int/abc/treaties_en.htm. Details about the 1988 Basel Accord can be found at http://www.bis.org/publ/bcbs04a.htm. Check out the new Basel Capital Accord (2001) at http://www.bis.org/publ/bcbsca.htm too.

$ 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.

Why U.S. Dollar Interest Rates Differ from Brazilian Real Interest Rates Quantity of $ Interest Rate for $ S D Quantity of Real for Real The curves are further to the right for the dollar because the U.S. economy is larger. The curves are higher for the Brazilian Real because of the higher inflation in Brazil.

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.

Online Application Check out the performance of ADRs at http://www.adr.com.

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.

Online Application For a summary of the performance of various stock markets, refer to http://www.worldbank.org/data/wdi2001/pdfs/tab5_3.pdf Visit the stock exchanges at: http://dir.yahoo.com/Business_and_Economy/Business_to_Business/Financial_Services/Exchanges/Stock_Exchanges/ http://www.aex.nl/finance/beurzen.html

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.

Foreign Cash Flow Chart of an MNC MNC Parent Foreign Subsidiaries Foreign Business Clients Eurocurrency Market Eurocredit & Eurobond Markets International Stock Markets Foreign Exchange Markets Export/Import Short-Term Investment & Financing Long-Term Financing Foreign Exchange Transactions Medium- & Dividend Remittance Long-Term Financing Medium- & Long-Term Financing Investment & Financing

Online Application For the latest information from financial markets around the world, visit: http://www.bloomberg.com/ http://finance.yahoo.com/ http://money.cnn.com/ http://www.reuters.com/

Online Application Find out how these offices regulate the U.S. financial markets. The Department of the Treasury http://www.ustreas.gov/ The Federal Reserve System http://www.federalreserve.gov/ The Securities and Exchange Commission http://www.sec.gov/

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.

Fluctuation of the British Pound Over Time Approximate £ that could be Purchased with $10,000 £ Approximate Spot Rate of £ $ Approximate Annual % D %

Online Application For the latest exchange rates, visit: http://www.bloomberg.com/ http://finance.yahoo.com/ http://money.cnn.com/ http://www.reuters.com/

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. Value of £ Quantity of £ D: Demand for £ $1.55 $1.50 $1.60 S: Supply of £ equilibrium exchange rate

Factors that Influence Exchange Rates Relative Inflation Rates U.S. inflation   U.S. demand for British goods, and hence £. $/£ Quantity of £ S0 D0 r0 S1 D1 r1  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 £. $/£ Quantity of £ r0 S0 D0 S1 D1 r1  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 £. $/£ Quantity of £ S0 D0 r0 D1 ,S1 r1 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.

How Factors Can Affect Exchange Rates Trade-Related Factors 1. Inflation Differential 2. Income 3. Gov’t Trade Restrictions Financial 1. Interest Rate 2. Capital Flow U.S. demand for foreign goods, i.e. demand for foreign currency Foreign demand for U.S. goods, i.e. supply of foreign currency U.S. demand for foreign securities, i.e. demand for foreign currency Foreign demand for U.S. securities, i.e. supply of foreign currency Exchange rate between foreign currency and the dollar

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.

Value of Foreign Currency Index Over Time With Respect to the Dollar  strengthens $ weakens  Note: The index reflects equal weights of £, ¥, French franc, German mark, and Swiss franc. Higher U.S. interest rates large balance of trade deficit $ due to relatively high U.S. inflation & growth Persian Gulf War U.S. interest rates  relatively high U.S. interest rates, & lower balance of trade deficit high U.S. interest rates, a somewhat depressed U.S. economy, & low inflation

Online Application Exchange rate releases and historical data may be found at the Federal Reserve website http://www.federalreserve.gov/. MONETARY COUNTRY UNIT Oct. 1 Oct. 2 Oct. 3 Oct. 4 Oct. 5 *AUSTRALIA DOLLAR 0.4923 0.4953 0.4971 0.4975 0.5060 BRAZIL REAL 2.6870 2.7000 2.7290 2.7290 2.7540 CANADA DOLLAR 1.5794 1.5696 1.5688 1.5680 1.5626 CHINA, P.R. YUAN 8.2768 8.2768 8.2768 8.2768 8.2768 DENMARK KRONE 8.1151 8.1267 8.0968 8.1339 8.1115 *EMU MEMBERS EURO 0.9159 0.9149 0.9181 0.9141 0.9168 DOLLAR 7.7992 7.7993 7.7995 7.7998 7.7999 RUPEE 48.03 48.03 47.96 48.04 48.05 YEN 120.27 120.78 120.67 120.63 120.37 .8003 3.8003 3.8005

Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to appreciate from its present level of $0.50 to $0.52 in 30 days. 1. Borrows $20 million Borrows at 7.20% for 30 days Exchange at $0.52/NZ$ 4. Holds $20,912,320 Returns $20,120,000 Profit of $792,320 2. Holds NZ$40 million Exchange at $0.50/NZ$ Lends at 6.48% for 30 days 3. Receives NZ$40,216,000

Speculating on Anticipated Exchange Rates Chicago Bank expects the exchange rate of the New Zealand dollar to depreciate from its present level of $0.50 to $0.48 in 30 days. 1. Borrows NZ$40 million Borrows at 6.96% for 30 days Exchange at $0.48/NZ$ 4. Holds NZ$41,900,000 Returns NZ$40,232,000 Profit of NZ$1,668,000 or $800,640 2. Holds $20 million Exchange at $0.50/NZ$ Lends at 6.72% for 30 days 3. Receives $20,112,000

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

Online Application Check out these foreign exchange sites: http://pacific.commerce.ubc.ca/xr/ http://sonnet-financial.com/rates/full.asp http://www.oanda.com/

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 Speculating on Anticipated Exchange Rates How Exchange Rates Affect an MNC’s Value

5 Currency Derivatives Chapter See c5.xls for spreadsheets to accompany this chapter. 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.

Online Application Forward rates can be found online at http://www.bmo.com/economic/regular/fxrates.html.

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. 1. Contract to sell 500,000 pesos @ $.09/peso ($45,000) on June 17. April 4 2. Buy 500,000 pesos @ $.08/peso ($40,000) from the spot market. June 17 3. Sell the pesos to fulfill contract. Gain $5,000.

Currency Futures Market Currency futures may be purchased by MNCs to hedge foreign currency payables, or sold to hedge receivables. 1. Expect to receive 500,000 pesos. Contract to sell 500,000 pesos @ $.09/peso on June 17. April 4 2. Receive 500,000 pesos as expected. June 17 3. Sell the pesos at the locked-in rate.

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. 1. Contract to buy A$100,000 @ $.53/A$ ($53,000) on March 19. January 10 2. Contract to sell A$100,000 @ $.50/A$ ($50,000) on March 19. February 15 3. Incurs $3000 loss from offsetting positions in futures contracts. March 19

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.

Online Application Visit the Commodity Futures Trading Commission at http://www.cftc.gov/. Also check out the National Futures Association at http://www.nfa.futures.org, and the Futures Industry Association at http://futuresindustry.org/.

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.

Contingency Graphs for Currency Options +$.02 +$.04 - $.02 - $.04 $1.46 $1.50 $1.54 Net Profit per Unit Future Spot Rate For Buyer of £ Call Option Strike price = $1.50 Premium = $ .02 +$.02 +$.04 - $.02 - $.04 $1.46 $1.50 $1.54 Net Profit per Unit Future Spot Rate For Seller of £ Call Option Strike price = $1.50 Premium = $ .02

Contingency Graphs for Currency Options +$.02 +$.04 - $.02 - $.04 $1.46 $1.50 $1.54 Net Profit per Unit Future Spot Rate For Buyer of £ Put Option Strike price = $1.50 Premium = $ .03 +$.02 +$.04 - $.02 - $.04 $1.46 $1.50 $1.54 Net Profit per Unit Future Spot Rate For Seller of £ Put Option Strike price = $1.50 Premium = $ .03

Online Application The Chicago Mercantile Exchange provides current and historical futures and option prices at http://www.cme.com/prices/index.cfm. Also visit the Chicago Board Options Exchange at http://www.cboe.com, and the London International Financial Futures and Options Exchange at www.liffe.com.

Online Application You may also want to check out the Options Industry Council at http://www.optionscentral.com/, the Options Clearing Corporation at http://www.optionsclearing.com/, and the Futures and Options Association at http://www.foa.co.uk/.

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 Option Type Exercise Price Trigger Premium basic put $1.70 - $0.02 conditional put $1.70 $1.74 $0.04 $1.66 $1.70 $1.74 $1.78 $1.82 $1.68 $1.72 $1.76 Net Amount Received Spot Rate Basic Put Conditional Put

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

Online Application Check out the Futures magazine website at http://www.futuresmag.com/ for a discussion of the various aspects of derivatives trading. Also check out http://www.ino.com/.

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 Contingency Graphs for Currency Options Contingency Graphs for the Buyers and Sellers of Call and 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.

Online Application Find out more about the Bretton Woods conference and the Smithsonian Agreement at: http://www.imfsite.org/origins/confer.html http://www.mises.org/money.asp

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 ...

Online Application For more information on the Mexican peso crisis, visit: http://www.cfr.org/public/pubs/mexican.html http://www.frbatlanta.org/publica/ECO-REV/REV_ABS/janfeb96.html http://www.brook.edu/views/papers/lustig/114.htm

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.

Online Application Find out more about Hong Kong’s currency board system (and see a chart showing the resilience of the Hong Kong dollar against external shocks) at http://www.info.gov.hk/hkma/eng/currency/link_ex/index.htm.

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.

Online Application A table showing the currencies of the world and their exchange rate arrangements can be found at: http://pacific.commerce.ubc.ca/xr/currency_table.html

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.

A Single European Currency € €/£ €/$ €/100¥ €/SwF (Swiss Franc)  strengthens € weakens 

Online Application For more information on the euro, visit: http://www.euro.ecb.int/en.html http://www.ecb.int/ http://pacific.commerce.ubc.ca/xr/euro/

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.

Online Application To link to the websites of the central banks around the world, visit http://www.bis.org/cbanks.htm.

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 Quantity of £ S1 D1 D2 Value of £ V1 V2 Fed exchanges $ for £ to strengthen the £ Quantity of £ S2 D1 Value of £ V2 V1 Fed exchanges £ for $ to weaken the £ S1

Online Application http://www.federalreserve.gov Treasury and Federal Reserve Foreign Exchange Operations During the third quarter of 2000, the dollar appreciated 8.2 percent against the euro and 2.0 percent against the yen. On a trade- weighted basis, the dollar ended the quarter 4.1 percent stronger against the currencies of the United States' major trading partners. On September 22, the U.S. monetary authorities intervened in the foreign exchange markets, purchasing 1.5 billion euros against the dollar. The operation, which was divided evenly between the U.S. Treasury Department's Exchange Stabilization Fund and the Federal Reserve System, was coordinated with the European Central Bank and the monetary authorities of Japan, Canada, and the United Kingdom.

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.

Nonsterilized Intervention Federal Reserve Banks participating in the foreign exchange market $ C$ To Strengthen the C$: Federal Reserve Banks participating in the foreign exchange market $ C$ To Weaken the C$:

Sterilized Intervention Federal Reserve Banks participating in the foreign exchange market $ C$ $ Financial institutions that invest in Treasury securities T- securities To Strengthen the C$: Federal Reserve Banks participating in the foreign exchange market $ C$ To Weaken the C$:

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.

Online Application The Fed’s objective for open market operations has gradually shifted toward attaining a specified level of the federal funds rate. Find out more at http://www.federalreserve.gov/fomc/fundsrate.htm.

Online Application During the 1997-98 Asian financial crisis, some governments intervened in an attempt to control their exchange rates. Find out more about the crisis (and the consequences of the intervention efforts) at http://www.stern.nyu.edu/globalmacro/.

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 Government Actions on Exchange Rates Government Intervention in Foreign Exchange Market Government Monetary and Fiscal Policies Relative Interest Rates Relative Inflation Relative National Income Levels International Capital Flows Exchange Rates Trade Tax Laws, etc. Quotas, Tariffs, etc. Government Purchases & Sales of Currencies

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 See c7.xls for spreadsheets to accompany this chapter. 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 $ MYR £ Value of £ in $ Value of MYR in $ £ in MYR 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 = 4% 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%.

Online Application Spot exchange rates can be found online at http://sonnet-financial.com/rates/full.asp, while forward rates can be found at http://www.bmo.com/economic/regular/fxrates.html, and interest rates at http://www.federalreserve.gov/releases/H15/update/.

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.

Graphic Analysis of Interest Rate Parity Interest Rate Differential (%) home interest rate – foreign interest rate Forward Premium (%) Discount (%) - 2 - 4 2 4 1 3 - 1 - 3 IRP line

Graphic Analysis of Interest Rate Parity Interest Rate Differential (%) home interest rate – foreign interest rate Forward Premium (%) Discount (%) - 2 - 4 2 4 1 3 - 1 - 3 IRP line Zone of potential covered interest arbitrage by foreign investors Zone of potential covered interest arbitrage by local investors

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 iH – iF p Zone of potential covered interest arbitrage by foreign investors Zone of potential covered interest arbitrage by local investors IRP line Zone where covered interest arbitrage is not feasible due to 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 Because of IRP, a forward rate will normally move in tandem with the spot rate. This correlation depends on interest rate movements, i.e. p  iH–iF t0 t2 t1 Interest Rates iA iU.S. time Forward Rates Spot and SA FA

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.

Online Application Find out more about the 1997-98 Asian financial crisis by visiting http://www.stern.nyu.edu/globalmacro/.

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 Graphic Analysis of IRP 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

Measuring Exposure To Exchange Rate Fluctuations 10 Chapter Measuring Exposure To Exchange Rate Fluctuations See c10.xls for spreadsheets to accompany this chapter. 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.

Online Application For current and historic exchange rates, as well as implied currency volatilities, visit http://www.ny.frb.org/pihome/statistics/. 11/30/01 Implied Vols 1 Week 1 Month 2 Month 3 Month 6 Month 12 Month 2 Year 3 Year EUR 10.9 9.9 10.9 11.2 11.7 11.9 11.9 11.8 JPY 9.1 8.9 9.5 9.9 10.4 10.6 10.7 10.7 CHF 11.2 10.3 11.2 11.5 11.9 12.1 12.0 12.0 GBP 9.0 8.1 8.8 9.1 9.4 9.5 9.6 9.7 CAD 6.2 5.9 6.0 6.1 6.1 6.1 6.2 6.1 AUD 10.4 10.3 11.0 11.4 11.8 12.0 12.0 12.0 GBPEUR 8.1 6.9 7.4 7.7 8.4 8.7 8.6 8.5 EURJPY 9.3 9.0 9.7 10.3 10.8 11.3 11.4 11.4

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.

Standard Deviations of Exchange Rate Movements Transaction Exposure Standard Deviations of Exchange Rate Movements Based on Monthly Data Currency 1981-1993 1994-1998 British pound 0.0309 0.0148 Canadian dollar 0.0100 0.0110 Indian rupee 0.0219 0.0168 Japanese yen 0.0279 0.0298 New Zealand dollar 0.0289 0.0190 Swedish krona 0.0287 0.0195 Swiss franc 0.0330 0.0246 Singapore dollar 0.0111 0.0174

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

Correlations Among Exchange Rate Movements Transaction Exposure Correlations Among Exchange Rate Movements £ Can$ ¥ NZ$ Sk SwF British pound (£) 1.00 Canadian dollar (Can$) .18 1.00 Japanese yen (¥) .45 .06 1.00 New Zealand dollar (NZ$) .39 .20 .33 1.00 Swedish krona (Sk) .62 .16 .46 .33 1.00 Swiss franc (SwF) .63 .12 .61 .37 .70 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.

Movements of Selected Currencies Against the Dollar $/100 ¥ $/10 Indian rupees $/Chinese yuan $/5 Swedish krona $/Canadian$ $/Singapore$ $ per unit

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.

Online Application The annual reports for many MNCs may be found at http://www.reportgallery.com. Review some annual reports and see if you can find any comments that describe the MNCs’ transaction, economic, or translation exposures.

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 See c11.xls for spreadsheets to accompany this chapter. 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.

The Real Cost of Hedging for Each £ in Payables Nominal Cost Nominal Cost Real Cost Probability With Hedging Without Hedging of Hedging 5 % $1.40 $1.30 $0.10 10 $1.40 $1.32 $0.08 15 $1.40 $1.34 $0.06 20 $1.40 $1.36 $0.04 20 $1.40 $1.38 $0.02 15 $1.40 $1.40 $0.00 10 $1.40 $1.42 - $0.02 5 $1.40 $1.45 - $0.05 Expected RCHp =  Pi RCHi = $0.0295

The Real Cost of Hedging for Each £ in Payables Probability There is a 15% chance that the real cost of hedging will be negative.

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.

The Real Cost of Hedging British Pounds Over Time RCH (receivables) RCH (payables)

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 A firm needs to pay NZ$1,000,000 in 30 days. 1. Borrows $646,766 Borrows at 8.40% for 30 days 3. Pays $651,293 3. Receives NZ$1,000,000 2. Holds NZ$995,025 Exchange at $0.6500/NZ$ Effective exchange rate $0.6513/NZ$ Lends at 6.00% for 30 days

Techniques to Eliminate Transaction Exposure A firm expects to receive S$400,000 in 90 days. 1. Borrows S$392,157 Borrows at 8.00% for 90 days 3. Pays S$400,000 3. Receives $219,568 2. Holds $215,686 Exchange at $0.5500/S$ Effective exchange rate $0.5489/S$ Lends at 7.20% for 90 days

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 For the two examples shown, 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.

Using Currency Call Options for Hedging Payables For each £ : Nominal Cost Nominal Cost Scenario without Hedging with Hedging = Spot Rate = Min(Spot,$1.60)+$.04 1 $1.58 $1.62 2 $1.62 $1.64 3 $1.66 $1.64 British Pound Call Option: Exercise Price = $1.60, Premium = $.04.

Using Put Options for Hedging Receivables For each NZ$ : Nominal Income Nominal Income Scenario without Hedging with Hedging = Spot Rate = Max(Spot,$0.50)- $.03 1 $0.44 $0.47 2 $0.46 $0.47 3 $0.51 $0.48 New Zealand Dollar Put Option: Exercise Price = $0.50, Premium = $.03.

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.

Online Application Forward rates can be found online at http://www.ny.frb.org/pihome/statistics/forex10.shtml http://pacific.commerce.ubc.ca/xr/telerate.html http://www.bmo.com/economic/regular/fxrates.html

Online Application The Chicago Mercantile Exchange provides current and historical futures and option prices at http://www.cme.com/prices/index.cfm. Also visit the Chicago Board Options Exchange at http://www.cboe.com, and the London International Financial Futures and Options Exchange at www.liffe.com.

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.

Limitations of Hedging Time Forward Rate Spot Repeated Hedging of Foreign Payables when the Foreign Currency is Appreciating Costs are increasing … although there are savings from hedging.

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.

Hedging Long-Term Transaction Exposure Year Spot Rate Long-Term Hedging of Foreign Payables when the Foreign Currency is Appreciating Savings from hedging 1 2 3 1-yr forward 2-yr 3-yr

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.

Online Application The annual reports for many MNCs may be found at http://www.reportgallery.com. Review some annual reports and see if you can find any comments that describe the MNCs’ hedging of transaction exposures.

Online Application Check out the Futures magazine website at http://www.futuresmag.com/ for a discussion of the various aspects of derivatives trading, such as new products, strategies, and market analyses. Also check out http://www.ino.com/.

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