1. Managing the Risks of Multinational Operations
Part III
Managing the Risks of Multinational Operations
Chapter 8 Multinational Treasury Management
Chapter 9 Managing Transaction exposure
to Currency Risk
Chapter 10 Managing Operating Exposure
Chapter 11 Managing Translation Exposure
and Accounting for Financial Transactions

2. Multinational Treasury Management
Chapter 8
Multinational Treasury Management
Learning objectives
 Setting financial goals and strategies
 Managing operations
– Managing international trade
– Financing international trade
– Managing the firm’s cash flows
 Currency risk management
– Currency exposures and forward hedges
– Implementing a risk management policy

3. 8.1 Determining Financial Goals and Strategies
Functions of the modern treasury
Treasury serves as a corporate bank
Determine the firm’s overall financial goals.
Manage risks of domestic & international trade.
Arrange financing for domestic & international trade.
Consolidate and manage financial flows.
Identify, measure & manage financial price risks.

4. 8.1 Determining Financial Goals and Strategies
Setting financial goals & strategies
Identify the firm’s core competencies and potential growth opportunities.
Evaluate the business environment within which the firm operates.
Formulate a strategic plan for achieving sustainable competitive advantages.
Develop processes for implementing the strategic business plan.

5. If something can go wrong, it will.
8.2 Managing International Trade
“Murphy’s Law” applies to international business
If something can go wrong, it will.

6. 8.2 Managing International Trade
The problems of international trade
Importers must assure timely delivery of goods.
Exporters must assure timely payment.
Geographic and cultural distances usually are greater than in domestic trade, and disputes can span several legal jurisdictions.
Goods or services
Importer
Payment
Exporter

7. 8.2 Managing International Trade
Managing the risks of international shipments
Trade documentation reduces exposures to operating and financial risks.
- Documentation can include an invoice, packing list, certificates of origin, inspection and insurance certificates, import and export licenses, dock and warehouse receipts, etc.
Freight forwarders (shippers) coordinate the logistics of trade.

8. 8.3 Payment Methods and Financing for International Trade
International payment methods
Cash in advance is convenient for the seller:
Buyer provides financing for the seller.
Open account is convenient for the buyer:
Seller delivers goods and then bills the buyer.
Receivables can be discounted or factored; long-term receivables can be sold to a forfaiter.
Drafts or letters of credit (L/C):
Drafts include trade and banker’s acceptances.
These are the most common payment methods for international transactions.

9. 8.3 Payment Methods and Financing for International Trade
The risks of international payment methods
Seller’s Buyer’s
Payment mechanism perspective perspective
Open account Highest Most
risk advantageous
Drafts & letters of credit  
Cash in advance Lowest Least

10. 8.3 Payment Methods and Financing for International Trade
International payment methods
Drafts—in a variety of forms
Sight drafts are payable on demand.
Time drafts are payable on a specified date.
Trade acceptances are drawn on and “accepted” by the buyer.
Banker’s acceptances have been “accepted” by a commercial bank.
Trade and banker’s acceptances can be “discounted” (sold at a discount) in most countries.

11. 8.3 Payment Methods and Financing for International Trade
International payment methods
The letter of credit
A letter of credit issued by the buyer’s bank guarantees payment upon receipt of the specified trade documentation.
In some countries, letters of credit can be discounted (sold at a discount) or used as collateral for new borrowings.
Other countries do not follow this practice.

12. 8.3 Payment Methods and Financing for International Trade
Financing international trade
Exporter’s Perspective Importer’s Perspective
Open Accounts receivable can Financing is provided
account be discounted (sold). by the seller.
Trade Trade acceptances can In a time draft, seller
acceptance be discounted (sold). extends credit to buyer.
Banker’s Banker’s acceptances can The buyer’s bank charges
acceptance discounted (sold). a fee for this service.
Letter of In some countries, L/Cs L/Cs tie up the buyer’s
credit can be discounted (sold) borrowing capacity.
(L/C) or used as collateral.
Cash in Financing is provided Transaction not secured,
advance by buyer. & provides no financing.

13. 8.3 Payment Methods and Financing for International Trade
The all-in cost of trade finance
All-in cost is the internal rate of return of the incremental cash flows associated with a financing alternative.
Periodic all-in cost
= (Forgone cash flow) / (Discounted value) – 1
Discounted value
Forgone cash flow

14. 8.3 Payment Methods and Financing for International Trade
All-in cost example
A ½ percent acceptance fee is charged on a €1 million banker’s acceptance that is due in three months, which is sold at a discount of 1 percent.
Solution:
The 0.5% fee is deducted at maturity, so the acceptance returns €995,000 at maturity.
This acceptance can be sold today for €995,000/(1.01) = €985,149.
All-in cost is then (€1,000,000/€985,149) – 1
= 1.51 percent per 3 months, or
= (1.0151)4 – 1 = 6.17 percent
+€985,149
3 months
–€1,000,000

15. 8.3 Payment Methods and Financing for International Trade
International payment methods
Countertrade is an exchange of goods or services that does not involve cash.
Counterpurchase is countertrade in which one contract is conditional upon fulfillment of another.
Offsets refer to countertrade that is required as a condition of trade.
Delivery and payment terms are negotiated.
Goods or services
Importer
Payment
Exporter

16. 8.4 Managing Cash Flows Managing multinational cash flows
Cash management
Multinational netting Chapter 9
Forecasting the firm’s need for funds Chapter 8
Relationship management
between the firm’s operating divisions and external partners
Transfer pricing Chapter 15
Credit management Chapter 8
Determination of hurdle rates Chapter 14

17. 8.5 Managing Exposures to Currency Risk
Types of exposure to currency risk
Economic exposure
Change in the value of all future cash flows from unexpected changes in exchange rates.
Transaction exposure
Change in the value of contractual cash flows from unexpected changes in fx rates.
Operating exposure
Change in the value of noncontractual cash flows from unexpected changes in fx rates.

18. 8.5 Managing Exposures to Currency Risk
Types of exposure to currency risk
Economic exposure
Change in the value of all future cash flows from unexpected changes in exchange rates
Translation (accounting) exposure
Change in financial statements from unexpected changes in exchange rates

19. 8.5 Managing Exposures to Currency Risk
Economic exposure
Monetary assets
Monetary liabilities
Real assets
Common equity
Economic exposure
= Change in the value of all future cash flows
from unexpected changes in exchange rates
= Transaction exposure + Operating exposure
Exposure of common equity
= Net monetary exposure + Operating exposure

20. 8.5 Managing Exposures to Currency Risk
The continuum of currency risk exposures
Consider the FX risk exposures of a cell phone network in India built by U.S.-based Verizon Communications…
Operating exposures Transaction exposures
(Nonmonetary or noncontractual cash flows) (Monetary contractual cash flows)
> >
Verizon The Indian Revenues flow Sales in India Royalties,
invests in a subsidiary into the business, generate dividends, or
cell phone opens. Initial depending on receivables management fees
system in sales are demand in denominated are repatriated
India. made. India. in rupees. to Verizon.

21. 8.5 Managing Exposures to Currency Risk
A survey of U.S. corporate treasurers
“Managing ______ is important.”
Mean score
Transaction exposure 1.4
Operating exposure 1.8
Translation exposure 2.4
Key: 1 = strongly agree
3 = neutral
5 = strongly disagree
Source: Jesswein, Kwok, and Folks, “Adoption of Innovative Products in Currency Risk Management: Effects of Management Orientations and Product Characteristics,” Journal of Applied Corporate Finance (1995).

22. 8.5 Managing Exposures to Currency Risk
For U.S. corporate treasurers
Transaction exposure is viewed by U.S. corporate treasurers as the most important currency risk exposure.

23. 8.5 Managing Exposures to Currency Risk
A 5-step currency risk management program
Anticipating and responding to changes in foreign exchange rates:
Identify the currencies to which the firm is exposed and estimate the distributions of future exchange rates in these currencies.
Estimate the sensitivity of revenues and expenses.
Determine the desirability of hedging.
Evaluate hedging alternatives.
Monitor the position and reevaluate.

24. 8.5 Managing Exposures to Currency Risk
Exchange rate forecasting
Market-based forecasts
Forward parity
E[Std/f] = Ftd/f
Relative purchasing power parity
E[Std/f] = S0d/f [(1+id)/(1+if)]t
with equal real interest rates
E[Std/f] = S0d/f [(1+pd)/(1+pf)]t

25. 8.5 Managing Exposures to Currency Risk
Exchange rate forecasting
Model-based forecasts
Technical analysis uses the recent history of exchange rates to predict exchange rates.
Fundamental analysis uses macroeconomic data to predict exchange rates.

26. 8.5 Managing Exposures to Currency Risk
Risk management should complement the overall business plan
Risk management policy
Passive management
Active management
Static approach
Dynamic approach
Technical forecasts
Fundamental forecasts

27. The Rationale for Hedging Currency Risk
Appendix 8-A
The Rationale for Hedging Currency Risk
Firm value V = ∑t E[CFt] / (1+it)t
If hedging is to increase firm value, then it must either increase expected future cash flows or decrease the discount rate in a way that cannot be replicated by investors.
Hedging matters when there are
Costs of financial distress
Agency conflicts
Other asymmetries

28. Appendix 8-A Costs of Financial Distress
Equity as a call option
Promised payment to bondholders is $1,000.
Firm value will be either $750 or $1,750 with equal probability.

29. Appendix 8-A Costs of Financial Distress
Payoffs with no costs of financial distress
Unhedged firm value is either $750 or $1,750
E[VBONDS ] = (½)($750) + (½)($1,000) = $875
+ E[VSTOCK ] = (½) ($0) + (½) ($750) = $375
E[VFIRM ] = (½)($750) + (½)($1,750) = $1,250
Hedged firm value is $1,250 for certain
E[VBONDS ] = $1,000
+ E[VSTOCK ] = $250
E[VFIRM ] = $1,250

30. Appendix 8-A Costs of Financial Distress
Without costs of financial distress:
A zero-sum game
In the absence of a market imperfection such as the costs of financial distress, hedging does not create value for the firm.
Risk shifting
When there is debt outstanding, hedging transfers wealth from shareholders to bondholders.
The benefits of a hedging policy
Instituting a hedging plan prior to borrowing can benefit shareholders by reducing borrowing costs.

31. Appendix 8-A Costs of Financial Distress
Equity call option with direct bankruptcy costs
Suppose the firm must pay $500 in bankruptcy

32. Appendix 8-A Costs of Financial Distress
Payoffs with direct bankruptcy costs
Unhedged firm value is either $750 or $1,750
E[VBONDS ] = (½)($250) + (½)($1,000) = $625
+ E[VSTOCK ] = (½) ($0) + (½) ($750) = $375
E[VFIRM ] = (½)($250) + (½)($1,750) = $1,000
Hedged firm value is $1,250 for certain
E[VBONDS ] = $1,000
+ E[VSTOCK ] = $250
E[VFIRM ] = $1,250

33. Appendix 8-A Costs of Financial Distress
Hedging with direct bankruptcy costs
Hedging can preserve firm value when there are direct bankruptcy costs.
Equity wins if the gain from hedging is larger than the wealth shift to debt.

34. Appendix 8-A Costs of Financial Distress
Direct and indirect costs
$500 direct costs if bankruptcy occurs
Changes debt’s payout if bankruptcy occurs
$250 indirect costs incurred prior to bankruptcy
Changes firm value prior to bankruptcy
$750
$1,750
Firm value before indirect costs of financial distress
$500
$1,500
Firm value after indirect costs of financial distress

35. Appendix 8-A Costs of Financial Distress
The equity call option with direct and indirect costs of financial distress

36. Appendix 8-A Costs of Financial Distress
Payoffs with direct and indirect costs of financial distress
Unhedged firm value is either $500 or $1,500
E[VBONDS ] = (½)($0) + (½)($1,000) = $500
+ E[VSTOCK ] = (½)($0) + (½) ($500) = $250
E[VFIRM ] = (½)($0) + (½)($1,500) = $750
Hedged firm value is $1,250 for certain
E[VBONDS ] = $1,000
+ E[VSTOCK ] = $250
E[VFIRM ] = $1,250

37. Appendix 8-A Costs of Financial Distress
and the consequences of hedging
Hedging can increase expected cash flows
by reducing the costs of financial distress.
Hedging can reduce debt’s required return
and hence the firm’s overall cost of capital.
Equity may or may not benefit,
depending on whether the increase in firm value is more or less than the value transfer to debt from the reduction in risk.

38. Appendix 8-A Agency Costs
Agency costs & the consequences of hedging
Agency costs are the costs of ensuring that managers act in the interests of other stakeholders.
Hedging can increase the value of the firm to shareholders by aligning managements’ incentives with shareholders’ objectives and thereby reducing agency costs.