1. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Multinational Financial Management Multinational vs. Domestic Financial Management Exchange Rates and Trading in Foreign Exchange International Money and Capital Markets Chapter 19 19-1

2. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is a multinational corporation? 19-2 A corporation that operates in two or more countries. Decision making within the corporation may be centralized in the home country, or may be decentralized across the countries in which the corporation does business.

3. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Why do firms expand into other countries? 1.To seek production efficiency. 2.To avoid political and regulatory hurdles. 3.To seek new markets. 4.To seek raw materials and new technology. 5.To protect processes and products. 6.To diversify. 7.To retain customers. 19-3

4. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Multinational Financial Management vs. Domestic Financial Management 1.Different currency denominations 2.Political risk 3.Economic and legal ramifications 4.Role of governments 5.Language and cultural differences 19-4

5. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Consider the Following Exchange Rates Are these currency prices direct or indirect quotations? – Since they are prices of foreign currencies expressed in dollars, they are direct quotations. 19-5 US $ to Buy 1 Unit Japanese yen0.009 Australian dollar0.650

6. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Calculate the Indirect Quotations for Yen and Australian Dollars The indirect quotation represents the number of units of a foreign currency needed to purchase one U.S. dollar. The indirect quotation is the reciprocal of the direct quotation. 19-6 # of Units of Foreign Currency per US $ Japanese yen111.11 Australian dollar1.5385

7. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is a cross rate? The exchange rate between any two currencies. Cross rates are actually calculated on the basis of various currencies relative to the U.S. dollar. Cross rate between Australian dollar and the Japanese yen. Cross rate= (Yen/U.S. Dollar) x (U.S. Dollar/A. Dollar) = 111.11 x 0.650 = 72.22 Yen/A. Dollar The inverse of this cross rate yields: 0.0138 A. Dollars/Yen 19-7

8. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Orange Juice Project: Setting the Appropriate Price A firm can produce a liter of orange juice and ship it to Japan for $1.75 per unit. If the firm wants a 50% markup on the project, what should the juice sell for in Japan? Price = ($1.75)(1.50)(111.11 yen/$) = 291.66 yen 19-8

9. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Orange Juice Project: Determining Profitability The product will cost 250 yen to produce and ship to Australia, where it can be sold for 6 Australian dollars. What is the U.S. dollar profit on the sale? 19-9

10. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is exchange rate risk? The risk that the value of a cash flow in one currency translated to another currency will decline due to a change in exchange rates. For example, in the last slide, a weakening Australian dollar (strengthening U.S. dollar) would lower the U.S. dollar profit. 19-10

11. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. International Monetary System The framework within which exchange rates are determined. The blueprint for international trade and capital flows. Exchange rate terminology – Spot vs. forward exchange rate – Fixed vs. floating exchange rate – Devaluation and revaluation – Depreciation and appreciation 19-11

12. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Floating Monetary Agreements Freely floating – Exchange rate determined by the market’s supply and demand for the currency. Governments may occasionally intervene and buy or sell their currency to stabilize fluctuations. Managed floating – Significant government intervention manages the exchange rate by manipulating the currency’s supply and demand. The target exchange rates are kept secret to prevent currency speculators profiting from it. 19-12

13. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Fixed Monetary Agreements No local currency – The country uses either another country’s currency as its legal tender (like the U.S. dollar in Ecuador) or else belongs to a group of countries that share a currency (like the euro). Currency board arrangement – The country technically has its own currency but commits to exchange it for a specified foreign currency at a fixed exchange rate (like Argentina before its January 2002 crisis). 19-13

14. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Fixed Monetary Agreements Fixed peg arrangement – The country “pegs” its currency to another (or a basket of currencies) at a fixed rate. Slight fluctuations are okay, but the rate must stay within a desired range. For example, the Chinese yuan is pegged to a basket of currencies. 19-14

15. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is difference between spot rates and forward rates? Spot rates are the rates to buy currency for immediate delivery. Forward rates are the rates to buy currency at some agreed-upon date in the future. 19-15

16. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. When is the forward rate at a premium to the spot rate? If the U.S. dollar buys fewer units of a foreign currency in the forward than in the spot market, the foreign currency is selling at a premium. In the opposite situation, the foreign currency is selling at a discount. The primary determinant of the spot/forward rate relationship is relative interest rates. 19-16

17. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is interest rate parity? 19-17 Interest rate parity holds that investors should expect to earn the same return in all countries after adjusting for risk. f t = t-period forward exchange rate e 0 = today’s spot exchange rate r h = periodic interest rate in home country r f = periodic interest rate in foreign country

18. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Evaluating Interest Rate Parity Suppose one yen buys $0.0095 in the 30-day forward exchange market and r NOM for a 30-day risk-free security in Japan and in the U.S. is 4%. 19-18

19. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Does interest rate parity hold? 19-19 For interest rate parity to hold, e 0 must equal $0.0095, but we were given earlier that e 0 = $0.0090, so interest rate parity does not hold.

20. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Which security offers the highest return? The Japanese security. – Convert $1,000 to yen in the spot market. $1,000 x 111.111 = 111,111 yen. – Invest 111,111 yen in 30-day Japanese security. In 30 days receive 111,111 yen x 1.00333 = 111,481 yen. – Agree today to exchange 111,481 yen 30 days from now at forward rate, 111,481/105.2632 = $1,059.07. – 30-day return = $59.07/$1,000 = 5.907%, nominal annual return = 12 x 5.907% = 70.88%. 19-20

21. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What is purchasing power parity? Purchasing power parity implies that the level of exchange rates adjusts so that identical goods cost the same amount in different countries. 19-21

22. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. If grapefruit juice costs $2.00 per liter in the U.S. and PPP holds, what is the price of grapefruit juice in Australia? e 0 = P h /P f $0.6500= $2.00/P f P f = $2.00/$0.6500 P f = 3.0769 Australian dollars 19-22

23. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. What impact does relative inflation have on interest rates and exchange rates? Lower inflation leads to lower interest rates, so borrowing in low-interest countries may appear attractive to multinational firms. However, currencies in low-inflation countries tend to appreciate against those in high-inflation rate countries, so the effective interest cost increases over the life of the loan. 19-23

24. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. International Credit Markets Eurocredits – Fixed term, floating-rate bank loans with no early repayment. – An example is a eurodollar deposit, which is U.S. dollars deposited in a bank outside the U.S. 19-24

25. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. International Credit Markets Eurobonds – Medium- to long-term international market for fixed- and floating-rate debt. – Underwritten by an international bank syndicate and sold to investors in countries other than the one in whose currency the bond is denominated. Foreign bonds – Issued in a capital market other than the issuer’s. – The only thing foreign about it is the borrower’s nationality. 19-25

26. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. American Depository Receipts (ADRs) Certificates representing ownership of foreign stock held in trust. About 1,700 ADRs are now available in the United States, with most of them traded on the over-the- counter (OTC) market. However, more and more ADRs are being listed on the New York Stock Exchange. 19-26

27. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. Impact of Multinational Operations on Capital Budgeting Decisions Foreign operations are taxed locally, then repatriated funds may be taxed in the U.S. Foreign projects are subject to political risk. Repatriated funds must be converted to U.S. dollars (subject to exchange rate risk). 19-27

28. © 2013 Cengage Learning. All Rights Reserved. May not be scanned, copied, or duplicated, or posted to a publicly accessible website, in whole or in part. To what extent do average capital structures vary across different countries? Previous studies suggested that average capital structures vary among the large industrial countries. However, a recent study, which controlled for differences in accounting practices, suggests that capital structures are more similar across different countries than previously thought. 19-28